The first result of a business valuation – termed the ‘base value’ – is not necessarily the final one – it is subjected to adjustments based on premiums and discounts. The business value goes up with a premium and it goes down with a discount.
Premiums and discounts are usually added to accommodate the effects of other factors related to the ownership interest of the business. A classic example in Singapore and Malaysia would be that a controlling interest is worth more than a minority interest on a per-share basis, since the former allows direct influence over major decisions that would affect the business direction.
The Common Premiums And Discounts Are Listed As Follows:-
- Control Premium
A controlling interest usually refers to having ‘more than 50% of the voting power’ in a business and hence it is more valuable than a non-controlling interest.
Premiums for such controlling interests can be from 30% to 50% of the base value.
- Strategic Acquisition Premium
This is used when a mergers and acquisition transaction helps to realize a strategic perspective, such as complementing an existing product line, broadening the market geographically, ensuring a source of supply or eliminating a key competitor for a particular buyer.
- Minority Interest Discount
This is also called ‘a discount for the lack of control’ and it serves a rationale opposite to that of the control premium. Hence a minority interest is less worthy.
- Lack-of-Marketability Discount
Ownership interests in private businesses would usually consider discounts for their lack of marketability.
Publicly traded equity shares are high in liquidity so they can be readily converted into cash near to prevailing prices.
As investors value liquidity, the lack of ability to sell the shares on a short notice at a market price will be considered a negative factor.
Based on studies, thinly traded stocks will see a 30% to 50% of reduction in prices when the brokerage firm, the sole market-maker, ends business.
Restricted stock of public businesses which cannot be publicly traded would also use discounts for their lack of marketability, which can go from 20% to 70%.
- Key Person Discount
Some mergers and acquisitions in Singapore and Malaysia would involve arrangements for a key member to join or leave (due to death or retirement) the newly owned business over a certain operational time.
Following the departure of this key member, there will be losses for the business such as the member’s unique talents and the loyalty of customers, other employees and suppliers.
Hence discounts are used here and usually it can go from 5% to 10% in public businesses; 10% to 25% in private businesses.
- Discount for Contingent Liabilities
This reflects the potential future claims due to past activities of the business that will eventually become the new owner’s responsibility.
This discount would involve litigations like potential environmental claims or tax adjustments, and product liability for previous years.
Since the liabilities considered are unique to the circumstances, the business valuation expert must be able to detect their presence.
Discounts can also be applied to the base value of a business valuation in other scenarios – not just the ones mentioned above.
So if the discounted cash flow approach was used in a business valuation, a higher or lower discount rate would indicate the business’s special characteristics. Another way is to adjust the base value according to the business’ special features.
Usually after obtaining the base value of a business valuation, the valuation expert would consider the appropriate factors to identify the discounts and premiums for proper adjustments.
The effect of the factors can also be applied prior to the result, such as adjusting the estimation of future income or cash flows when analysing the base value. It can also be applied during the calculations.
Whichever the method, it will affect the overall result.
Let us decide which method suits your business best.