Valuation Implications of Control
Core Valuation Principle & Objective
“During the current start-up landscape of India, valuation has obtained a significant stronghold than it had in the past. Valuation is an intricate exercise, often involving the consideration of multiple factors to arrive at a fair value of a particular asset. One of the factors to consider during the valuation exercise is the impact of controlling interest the acquirer is positioned to gain if any during the acquisition. The article aims to demystify the key mechanics of control and its nuances on the valuation of equity.”
1. Historical Attempts at “Control” & The “Cobra Effect”
During the days of the “British Raj”, The British Colonial Government was plagued by the venomous cobras terrorizing the inhabitants of Delhi. In an attempt to control the vile creatures, the government put up a bounty on cobras, wherein for every dead cobra the people brought, they would be rewarded by the administration officials. Consequently, over time, the population of cobras in the city started diminishing & the scheme appeared successful.
However, little to the knowledge of the British, the opportunist people of Delhi started breeding cobras, which resulted in the population of cobras becoming higher than it was before the initiation of the scheme. Soon the Raj realised that they had backfired and scrapped the whole idea. The cobra breeders set the snakes free, further contributing to the original problem at hand. This came to be known as the “Cobra Effect”, wherein the solution to the problem made the situation worse.
2. Conceptual Framework: What is Control?
Control concerning any company or firm means the real decision-making power available to any party. In layman’s terms, it means voting power available to move resolutions or decisions. Control can be exercised directly or indirectly through cross-holding or pyramid structures. Control has always been apex in determining value and acquisitions. It is not unnatural for acquirers to often pay a premium for substantial control.
Prerogatives Encompassed by Control:
Control includes the ability to choose management, its compensation, acquisition and liquidation policy, recapitalization of the company and registration of the company’s stock for an initial public offering.
Illustrative Example: Minority Interest vs. 51% Majority Control
For the sake of simplicity, let’s consider the valuation of equity shares of an investor holding only 10 shares out of 100 equity shares in a company, i.e. 10% of the total equity capital and each share carries only a single vote. Since the investor is holding only 10% equity, he can’t propose and pass a special resolution on his motion. Therefore, the shares are not entitling him to any controlling power in the company. He has a vote, but not a powerful one to move the entire resolution on his own.
Accordingly, it is not wise to value shares held by this investor with the shares held by promoters holding 51% of the equity capital or more. The amount by which the valuation of these shares differs is the control discount for the investor. Viewing the same from the opposite angle, the price differential for acquiring majority shares is known as the control premium.
3. Valuation Nuances & Judicial Rationale
Valuation, not only controls valuation itself, but involves consideration of many inputs and judgement which can lead to a whole spectrum of valuation for a specific financial asset. Control’s valuation depends on many factors including–
Poorly managed vs. well-managed company.
Industry and maturity stage of the business.
Number of voting shares about total shares.
To value control, the first input is to arrive at the fair value of the financial asset using any of the suitable approaches. After arriving at the equity value, a control discount/premium is applied.
Judicial Recognition in United States Courts:
“The minority discount is recognized because the holder of a minority interest lacks control over corporate policy, cannot direct the payment of dividends, and cannot compel a liquidation of corporate assets.”
4. Valuation Methodology & Mathematical Relationship
Although there are only a few approaches to value control, the simplest method is to arrive at a specific percentage to account for a discount for lack of control.
The comparable method helps in arriving at a control premium by comparing the excess price paid concerning the market capitalization of the company. The excess percentage over and above the market capitalization is the control premium.
Formula for Conversion of Control Premium to Minority Discount:
It is suggested to incorporate multiple companies in a particular industry if available to ensure that a wide range of values and discounts are considered to ensure that the discount rate applied is representative of a wider population of data.
5. Empirical Evidence of Discount for Lack of Control (1998–2006)
The table below compiles buyout transaction data highlighting mean and median premiums paid and their mathematically implied minority discounts:
| Year of Buyout | Without Negatives (Mean) | Without Negatives (Median) | With Negatives (Mean) | With Negatives (Median) | ||||
|---|---|---|---|---|---|---|---|---|
| Mean Premium (%) | Implied Discount (%) | Median Premium (%) | Implied Discount (%) | Mean Premium (%) | Implied Discount (%) | Median Premium (%) | Implied Discount (%) | |
| 1998 | 35.9 | 26.4 | 29.3 | 22.7 | 23.6 | 19.1 | 22.7 | 18.5 |
| 1999 | 46.5 | 31.7 | 32.4 | 24.5 | 40.0 | 28.6 | 28.7 | 22.3 |
| 2000 | 48.7 | 32.8 | 37.1 | 27.1 | 35.3 | 26.1 | 28.9 | 22.4 |
| 2001 | 52.1 | 34.3 | 35.9 | 26.4 | 34.0 | 25.4 | 25.9 | 20.6 |
| 2002 | 49.1 | 32.9 | 34.0 | 25.4 | 33.1 | 24.9 | 24.6 | 19.7 |
| 2003 | 53.9 | 35.0 | 37.7 | 27.4 | 46.2 | 31.6 | 33.3 | 25.0 |
| 2004 | 36.4 | 26.7 | 26.2 | 20.8 | 28.6 | 22.2 | 22.5 | 18.4 |
| 2005 | 33.1 | 24.9 | 24.3 | 19.5 | 23.1 | 18.8 | 16.7 | 14.3 |
| 2006 | 29.0 | 22.5 | 20.5 | 17.0 | 23.5 | 19.0 | 17.2 | 14.7 |
Key Empirical Boundaries:
Accordingly, the range of control premium is estimated at ~29.0%-53.9%, and the range of implied minority discount arrives at ~22.5% to 35.0%. Control premium as computed above is also known as acquisition premium. Acquisition premium is a combination of control premium and synergies. It is appropriate to account for synergies to ensure that the whole acquisition premium is misapplied as a control premium.
Empirical discounts and premiums can serve as a necessary yardstick for the valuation. For the valuations to be done for Indian companies, comparable companies’ data must be relevant. It is recommended to use publically available market information of companies engaged in the same industry as that of the company being valued.
6. Application of Control Premium and Minority Discount Across Approaches
1. Cost Approach – Net Asset Value
The cost approach is used for the valuation of investment and real estate companies/REITs and other asset-heavy industries. If listed comparable companies are used to arrive at a fair value of controlling interest, the control premium is required to be adjusted since the comparable companies listed in the market are being traded at minority pricing and are indicative of minority discounts.
2. Income Approach (Discounted Cash Flow)
Valuation of non-controlling or controlling interests can be arrived at by considering cash flows that the business is expected to generate under each of the cases. Valuation is done based on Discounted Cash Flow method. There is no need to account for minority discount/control premium since the cash flows are already adjusted and need no further adjustment.
3. Market Approach (Comparable Companies Method)
In the case of the Market Approach/Comparable Companies Method, the valuation must be undertaken based on the appropriate comparable and proper adjustment has to be made. The subject company’s ownership interest must be compared with the comparable company’s controlling/non-controlling interests.
The fair market values of non-controlling ownership interests in closely held companies typically cluster between 35 per cent to 50 per cent less than prices of comparative non-controlling equity interests in liquid, publicly traded companies, all other things being equal.6
7. Landmark Judicial Decisions Involving Control Valuation
I. Rapid-American Corp. v. Harris, 603 A.2d 796 (Del. 1992)
In the United States State Supreme Court of Delaware, the court held that control premium is to be applied wherein the subject company was a controlled subsidiary.
II. Lane v. Cancer Treatment Centres of America Inc. & Montgomery Cellular Holdings Co. Inc. v. Dobler
Control Premium is not to be applied in case valuation is arrived at expressly using the DCF method.
III. Bomarko Inc. v. International Telecharge, Inc.
Control Premium is not to be applied in case valuation is arrived at expressly using the DCF method. The Court of Chancery affirmed the application of control premium in the case where the guideline public company method is followed. The court acknowledged that the market approach produced a minority value.
IV. Cases Involving Rejection of Discounts by State Courts:
- U. S. Inspect, Inc. v. McGreevy, 57 Va. Cir. (2000)
- First Western Bank of Wall v. Kenneth Olsen, et al., 2001 SD 16 (2001)
- Cavalier Oil Corp v. Harnett, Civ. A Nos 7959-60 7967-68, 1988 WL 15816 at *8 (Dl. Ch. Feb. 22, 1988)
- Blitch v. People’s Bank, 264 Ga. App. 453, 540 S.E. 2d 667 (2000)
- Katherine B. Arnaud, et al. v. Stockgrowers State Bank of Ashland Kansas and Stockgrowers Banc Corp., 992 P.2d 216 (Kan. 1999)
8. Conclusion
A careful examination of the key mechanics of the transaction and deep-dive into the control aspects of the transaction is necessary for the Valuer to arrive at appropriate methods for ascertaining its impact in the valuation exercise. Therefore, control premium as well as minority discount form an integral part of the valuation exercise and should not be overlooked.
It should also not be the case that the application of incorrect values or aspirational premiums is added to the fair value that ends in crippling the valuation exercise and leaves it worse than the non-application of the aforesaid discount/premiums, thereon giving precedence to the cobra effect.
If all aspects of the transaction are kept in mind while constructing a valuation model and choosing the appropriate valuation approach, valuations with strong reasoning and mental models are to be expected. ❖❖❖
- The Value of Control - Aswath Damodaran
- The Value of Control: Some General Propositions - Aswath Damodaran
- Financial Valuation, Application and Models by James R. Hitchner
- Valuing a Business: The Analysis and Appraisal of Closely Held Companies, Fifth Edition by Shannon P. Pratt
- Standards of Value: Theory and Applications by Jay E. Fishman, Shannon P. Pratt and William J Morrison
- As per Shannon P. Pratt in Valuing a Business, The Analysis and Appraisal of Closely Held Companies