Issue 17-49 | December 11, 2013

Views on Control Premiums

By Eric Nath, ASA, Eric Nath & Associates, LLC

Many valuation analysts believe that public companystocks trade at a “marketable noncontrolling”, or“marketable minority” interest level of value. In myopinion, this is simply not true. Public stocks arenon-controlling interests, but they do not trade as ifthey are.

One of the simplest ways to test this assertion is asfollows. Next time you are buying or selling publicstocks, stop and ask yourself if you have adequatelydiscounted the price because you personally were notable to appoint management, change the board ofdirectors, set operational or strategic policy, change thecourse of the business, liquidate, dissolve, sell out, etc.,etc., etc. This basic mental exercise should suffice toillustrate how ludicrous it is to regard publicly-tradedguideline company prices as reflecting “marketableminority” or “non-controlling” levels of value. Publicstocks trade at public market prices, and those priceshave nothing to do with each share’s lack of control(with perhaps a few outlier exceptions).

If public shares are noncontrolling minority interests, butaren't priced in the market as noncontrolling minorityinterests, how can this be?

Reflecting back on our experience investing in the publicmarket, the obvious first answer is that there's no needto worry about this because the liquidity of our sharesgives us complete control over our investments. We can

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buy or sell whenever we want and no one can stop us.The process of converting a private company into a

public company (via IPO) essentially represents aquantum transformation of the investment. One day youare a private company minority owner with no controlover the company and no control over your investment,the next day you can buy more or sell your entireposition (assuming you are not subject to Rule 144,obviously). Control over the investment is created in theIPO process, and that is all that is required to eliminateany "discount for lack of control".

Not only do public shareholders have total control overtheir investment, but the beauty of the public marketalso means that shareholders are relieved of theresponsibility of having to exercise management control.All those "prerogatives of control" listed in the valuationliterature would be chains around the neck of the publicshareholder. One of the main reasons stock marketswere invented in the first place was to intentionallyoutsource the traditional “prerogatives of control”. In away, public markets convey the blissful "prerogative ofnot having to control anything".

Not being required to control anything in the companiesin which they invest, public shareholders are freed up tofocus on more fundamental issues of cash flows andrisks of the business itself rather than on the problemsof being a minority owner. This is why public shares tendto trade at or near their ”control”, or “takeover” value andwhy the public market equivalent value for a privatecompany equals a control level of value. In fact, myexperience has been that the liquidity of the publicmarket allows most listed companies to actually tradeabove their takeover value. (I have long suspected thatthe ability of individual investors to completely diversifytheir portfolios using mutual funds lowers their weightedaverage required rate of return to the point thatoverpaying for many individual public companies isalmost inevitable. The effect of this overpaymentbecomes a systemic issue throughout the market ratherthan an individual company valuation issue.)

But, don’t just take my word for it. To quote the AppraisalFoundation’s current Working Group discussion draft on"The Measurement and Application of Market ParticipantAcquisition Premiums" (note that the title of this draft

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shouldincludethecaveatthatitisforfinancialreporting only):

"There is no argument that the shares thattransact in the public market are minority

Although the Appraisal Foundations’ discussion draft onacquisition premiums comes to many wrongconclusions, its premises are promising, with manyprogressive observations. For example:

"In any case, it has become relatively widelyaccepted that the market evidence supplied bydividing the acquisition price by the publiclytraded price does not represent a premium forconceptual control but, rather, represents apremium paid linked to actual changes that canbe made by exercising that control. Control, andwhether one has it, is not really the focal point.What matters is that, after an acquisition, theacquired company is now under differentmanagement. A price higher than the publicly-traded price is reasonable if the newmanagement and/or combined entity expect(s)improved cash flow or growth; or reduced risk. Ifno cash flow improvement or risk reduction couldreasonably be expected, there is little reason foran acquirer to pay a price higher than thepublicly-traded price. In such cases, the controlvalue may approximate the publicly traded price.The Working Group believes that the economicbenefits of control that support MPAPs (MarketParticipant Acquisition Premium) are ultimatelymanifest in two ways: enhanced cash flows orlower required returns."

Given all this, what then are these premiums being paidfor public companies if not for control? After all, thebuyer of a public company is gaining control over theacquired entity. So, why doesn't the premium paidquantify some differential between control and lack ofcontrol? Much has been written, listing all the reasonswhy it makes sense for premiums to be paid for publiccompanies and why this does NOT quantify anydifferential between control and lack of control. Another

interests. However, that does not mean that theprice paid for them represents ‘only’ a minorityvalue and that something more would be paid togain control of that company."

analogy which illustrates the market dynamic between acontrol seller (i.e., the public company) and a control buyer:

Suppose you own a house. You bought it manyyears ago and are very happy living there. It was

neither case are we dealing with lack of controlissues.

The Appraisal Foundation’s discussion draft onAcquisition Premiums by the Working Group suggestsconverting the acquisition premium analysis from anequity basis to an enterprise basis to mitigate potentialbias problems arising from the use of premiums on anequity basis only. Timothy Meinhart’s editorial onNovember 6, 2012 (BV Success Issue 17-45) proposedthe same type of solution. Analysis of premiums basedon capital structure and enterprise value may representsome improvement over the traditional equity approach,particularly because buyers usually analyze acquisitionson an enterprise value basis. But merely converting theequity premium analysis to an enterprise premiumanalysis does not deal with the more fundamentalconceptual shortcomings of the data and the overalltheory.

Let’s look at yet another reason why even an enterprisevalue approach to premiums fails: the upward bias ofthe acquisition/control premium databases, not fromtiming issues, selection bias or measurement problems,but because of mistakes.

A quick search reinforces what we already know: atleast half of all M&A deals fail. In “The Big Idea: TheNew M&A Playbook” (Harvard Business Review, March2011), Christensen, et al. state that “study after studyputs the failure rate of mergers and acquisitions

market. You have no intention of moving,however. Along comes a buyer who really likesyour house. She is very motivated for her ownreasons, and offers you $540,000, a 35%premium to its market value. You might or mightnot sell, but there will be some price at which yourealize it makes financial sense to take themoney and find another place to live. In asomewhat more complex way, this is the genesisof public company acquisition premiums. In

recently appraised at $400,000 and that isexactly what it would sell for if you put it on the

somewhere between 70% and 90%.” The authorsattribute this to buyers’ misunderstanding of the truegoal of M&A (i.e. to redirect the company into highergrowth opportunities), compounded by the fact that“buyers too often pay the wrong price and integrate theacquisition in the wrong way.” In other words, the vast

Control premiums were hotly debated during the 1990s.By the beginning of the 21st Century it was generallyrecognized by ASA and most practitioners that the useof “control premiums” should be considered much morecarefully and used with great caution, if at all. ASA’seducational offerings were intentionally updated in the2000s to advise a default assumption to not useacquisition/control premiums unless a compelling casefor them could be made. (Editor’s note: While Mr.Nath’s representation regarding ASA’s course content iscorrect, the reader is reminded that ASA course contentis non-authoritative.) Application of a "control premium"to a publicly-traded equivalent indication of value for aprivate company or reporting unit, whether through themarket approach or the income approach, will almostalways overstate value and will therefore be misleading.

The views and opinions contained in BV Success do not necessarilyrepresent those of the ASA, the Business Valuation Committee, or theeditor of BV Success. Information contained in BV Success should notbe relied upon without independent verification.

ASA BV Success E-Letter Contact Information:Editorial - Arlene Ashcraft, ASA, CFA: aashcraft@cfai.comTechnical Issues/Subscription Problems - asainfo@appraisers.orgBack issues of the ASA BV Success E-Letter are available to membersonly at www.appraisers.org.

Conclusion

a mistake, then the buyer clearly overpaid for what theyhoped would be a financially prudent deal. If the buyeroverpaid, then the premium is defacto overstatedregardless of whether it is calculated on an equity basisor an enterprise basis. Then, along comes the appraiserwho relies on a so-called “control premium” database inwhich the majority of the premiums, because they weremistakes, are overstated. Overstated premium datameans that the appraiser’s value conclusion willinevitably be overstated as well, irrespective of whetherthe appraiser uses the traditional equity method or theenterprise method. Added to all the other compellingreasons to avoid using acquisition/control premium dataand methods (do the research if you are not familiar withthese reasons), the systematic bias of the premiumsdue to overpaying in the majority of cases should be thefinal nail in the control-premium coffin.

majority of acquisitions are mistakes. If an acquisition is