A business is conventionally valued by its ability to generate future income; the buyer then uses the latest of this value to calculate the present worth of the business. Though in common day practice, the process is theoretically viable but, in reality, it is still lacking in determining the true worth of a business. This is due to the variable elements – situational and circumstantial – of the transaction that are not always considered in the business’s financial statements.
An Equity Ownership Has Two Important Components:
- Degree of Control
- Liquidity (marketability)
These two factors will determine the level of value of the equity ownership during a transaction. This will then lead to the subsequent effect of a premium or discount, which will eventually be considered in the business valuation and then the fair market price.
The Hierarchy of Value
The kind of claim that an investor has is defined by the level of value of its equity ownership.
In the hierarchy of value in Singapore and Malaysia, the strategic investor is at the top and it usually involves significant investors of a business whose financial, reputational or operational clout has a strong influence, even in established businesses.
At the lowest level of the hierarchy, there is the limited and illiquid equity with a non-controlling interest in a business.
In either direction, there are appropriate discounts and premiums for enterprise-level or security-level of restrictions.
Applying the Hierarcy in Business Valuation
Typically, a business valuation starts with using market inputs, such as observable data points, to calculate a price that equates to the minority share in public stock. Here, the hierarchy is applied to align the valuation with the marketability and the playing control scenarios.
The following is a list of highly recommended suggestions on appropriate application of discounts and premiums:
- Apply discounts/premiums from the level next to the appraising one. E.g. at the public stock level, use the Discounts for Lack Of Control (DLOC) and then the Discounts for Lack Of Liquidity (DLOL) respectively.
- Apply discounts to the value and not sum them up as a time value-based discount rate. E.g. use 30% discount for DLOC on the public stock level instead of moving up the discount rate by 3%.
- Convert discounts into a premium with the equation: Discount = 1 – (1 / (1 + premium))
- Make the inputs relevant to the considered level. E.g. DLOC would not be required for inputs used as cash flow for the minority shareholders under DCF. This is due to the irrelevance of the control at this point.
The Following Discusses The Discounts/Premiums Used At Each Level Of The Hierarchy, Starting With The Lowest, And The Relevant Adjustments Required:
- Discounts for Transferability Restrictions
When there are restrictions on the transferability of equity shares, they are less valuable to the holder as these constraints limit the liquidity potential through reducing the number of potential buyers and/or making more arduous timings for the sale.
One example is between a private limited and a closely-held public firm. The former has more restrictions guarded by statutory limits usually included in a shareholder agreement, hence there is a need to be familiar with the laws and articles of association and the partnership agreement.
The restrictions usually appear as provisions related to the right of first refusal (ROFR) or right of first offer (ROFO) – both will be prioritised before the sale of the shares to external parties. Examples of such descriptions are as follow:
– ROFO: When a selling shareholder first offer their asset to the holder of a ROFO, if an offer is made, the owner can only sell to another 3rd party if its bid is higher than that of the right holder.
– ROFR: When a 3rd party makes an offer to buy a shareholding, holders of a ROFR are given the option to match the bid before any sale to external parties can be made.
Lastly, the insistence on a board-appointed valuation consultant or a predetermined formula-based valuation approach can be a barrier to transferability during the actual valuation of the asset.
Provisions then become additional hurdles for the transfer of shares which then force the buyer to have a separate discount for transferability restrictions.
- Discounts for Lack Of Marketability (DLOM)
Marketability refers to the saleability (not just liquidity) of the asset or the asset’s ability to convert a property to cash at a minimal cost in the shortest time.
Hence DLMO is the amount of percentage deducted from the value of an ownership interest for reflecting the relative absence of marketability.
Here, the transaction risk of anticipated proceeds that are actually realized is usually accounted for.
For the actual theory of DLOM, valuation experts used a set of prescribed elements called the Mandelbaum Factors, and they are listed as follows:
– Financial Statement Analysis
– Company Dividend Policy
– Private v.s. Public Sales of Shares
– Nature of the Company (i.e. economic outlook, history, industrial position)
– Company management
– Amount of control in the transferred shares
– Restrictions on transferability of shares
– Company redemption policy
– Costs associated with public offering
– Holding period for stock
These factors are to be considered when determining the marketability discount.
Created for taxation purposes, these tests are the basis of the assessment of discounts/premiums for marketability. There are also approaches – from pre-IPO studies of stock performance to the costs of using option pricing method and going public – accepted by the regulatory and professional body standards of the world for calculating the DLOM figure.
- Discounts for Lack of Control (DLOC)
Control allows the shaping of a direction of the asset throughout its holding period which is an advantage for the investor. This would involve decision making processes on matters like appointing a director to the board, which will in turn impact the busness’s investment, financing and operating decisions.
Factors affecting control can be found in activities that require an ordinary or special majority from shareholders, share classes and super-voting rights.
Benchmarks for DLOC are based mainly on observations of control premiums from the latest sale transactions, which will include a degree of mutual exclusivity with the transaction’s valuation multiple.
- Discounts for Lack of Liquidity (DLOL)
Liquidity refers to the ability of an asset to be converted into cash in the shortest amount of time without a significant loss of the principal.
However, most liquid assets have a limit in this ability and would incur a trade execution cost. Hence there are tangible and intangible considerations for the liquidity discount as listed below:
– Delayed and missed trades such as opportunity/internal costs. This has the largest impact.
– Bid-ask spread of the market price such as the difference between the purchase and selling price. This is usually visible and has a larger impact.
– Brokerage or transaction costs. This is visible and has a small impact.
Benchmarks for this discount are not fixed and depend on the markets of the assets as well as the size of the selling shareholder interest. Generally, the recommended range for the benchmark is between 20% to 30%.
Synergy is commonly used to justify a business value during a sale transaction. However, it is often based on hubris oversound economic logic hence it tends to destroy the value of a business in a mergers and acquisition deal.
There are three sources of synergies arising from visible components of Free Cash Flow (FCF) and weighted average cost of capital (WACC):
This is when two combined entities profit from better customer access. This can be achieved through pricing, market and distribution advantages.
Revenue synergies are relevant in product markets and are affected by uncontrollable factors. So it is the least predictable and reliable to model during a business valuation.
Cost reduction helps a combined entity gain margin expansion through the economies of scale and sharing, when moving below the line of revenue.
Cost synergies are recurring and are mainly controllable by the entity. Hence they are more reliable. A one-time cost elimination activity, such as a site closure, can have a high degree of certainty, which can be activated according to the buyer.
Here, debt, tax and cash flow can be merged in a financial advantageous way.
Financial synergiesare less ‘romantic’ options. They are easier to understand but difficult to realize.
– Debt synergies may seem direct on a spreadsheet when the cost of loan decreases and the absolute capacity increases. But it is questionable on the definition of synergy. E.g. should a buyer achieve the same result through optimizing the balance sheet then the acquisition is no longer a unique necessity.
True debt synergies occur when borrowing power arises. This changes the optimum debt capacity and reduces the WACC. The result is then taken from diversifying or combining the two entities with flawed correlated cash flows to achieve a more stable total cash flow.
– Tax benefits are uncertain to an extent because of the limitations imposed on the carried forward losses and ownership changes.
Synergies can also take the shape of real options, which are the benefits based on the choices made on the future direction of the business.
A real transaction usually involves more real options that can be valued using various methods. These methods should then be considered when determining the synergies that are relevant in a transaction and would impact the subsequent considerations for pricing.
Business valuation is an art and a science but the aspects of its process requires a certain level of skillset and experience. Hence there is a tendency of unforgivable errors committed during a valuation.
Building discount rates and valuing cash flows is usually considered a science; applying discounts / premiums for marketability, illiquidity, control or synergies would then be more of an art as it is subjected to personal judgement.
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