What are the three levels of value?
From the July/August 2018 issue of BCC Advisers Litigation & Valuation Report
How much control does a business owner have? And how readily can the business interest be converted to cash? Those are the main questions that need to be addressed when determining the level of value in a business valuation. That level may affect your expert’s analyses and techniques. So, it’s important to get it right as soon as you hire an expert. Here’s an overview of the three main levels of fair market value.
1. Value of a controlling interest
Control value is the first level. The ability to control a business’s decisions has impact on value, especially on the value of a private firm. So, potential buyers often may be willing to pay more for a controlling interest than for a minority interest. The key to arriving at a control value is to make discretionary adjustments to the company’s cash flow, such as adjusting for above- (or below-) market-related party transactions or owners’ compensation.
Control value can be broken down further into 1) strategic and financial control value or 2) public and private control value. But appraisers don’t always agree on these classifications. The difference between strategic and financial control is the expected synergies available to a strategic buyer. Strategic buyers often pay a premium over financial buyers, if they possess synergies that may not be available to other buyers.
Public and private merger-and-acquisition (M&A) methods generate cash-equivalent control values. Some business valuation experts contend that controlling interests take time and resources to sell and, therefore, may warrant an illiquidity discount — regardless of whether they’re based on public or private transactions. No empirical studies exist, however, that directly quantify illiquidity discounts.
2. Value on a minority, marketable basis
Minority shareholders who can’t control day-to-day business operations sometimes are unwilling to pay as much per share as controlling shareholders. Rather than take a discrete discount for lack of control, valuation experts typically arrive at a minority level of value by abstaining from making discretionary adjustments to cash flow.
Because public companies’ professional management teams usually want to maximize earnings per share, their financial statements may require few or no discretionary adjustments. Assuming controlling shareholders don’t abuse their discretion (as may be the case with a public company), the pro rata share of a public company’s value on a controlling basis closely approximates the value of shares on a minority, marketable basis. In other words, there’s little to no discount for lack of control in these cases.
Conversely, marketability refers to how quickly and easily shares can be converted to cash. Shares of Apple or Johnson & Johnson are sold on the New York Stock Exchange and can be bought or sold simply by calling an investment advisor, for example. Marketability is worth something to investors. Both the guideline public company method and the income approach can generate a marketable value, because they’re based on public stock data.
3. Value on a minority, nonmarketable basis
Many business valuation assignments call for the value of a minority interest in a private company. This is generally the least valuable of the levels and is difficult to estimate directly, except by using previous arm’s-length transactions of the subject company’s stock. But previous transactions may not exist — or, if they do, they may not be relevant.
The typical starting point for this level of value is a minority, marketable value, as described previously. From there, a marketability discount is taken. Sources of empirical data for marketability discounts include restricted stock and initial public offering (IPO) studies.
Consult with a valuation expert
Take the guesswork out of determining the appropriate level of value or converting a preliminary value to the appropriate level of value. A business valuation professional knows how to quantify valuation discounts and adjust earnings using objective market data that can withstand scrutiny from the IRS, opposing counsel, judges and juries.