Investors need control; they will often pay less for a business interest where there is a lack of control over key decisions. The old saying “the whole is greater than the sum of its parts,” rings true for business valuations. This article explains how control affects the valuation of a business interest.
Control is Valuable
When a publicly traded business is acquired by an external buyer, often it is purchased at a greater value on a per share basis than the market price of individual shares. A part of this may well be traced to the synergistic value between those involved in the deal. It may also be due, at least in part, to the fact that the publicly traded shares are all minority interests in the company. This lack of control results in a fall of the value of the shares.
Let us consider what happens in a private company with five equal shareholders each owning 20%. Adding the value of each of the 20% interests together, they still would not equal a 100% value of company equity. This seems a little odd but the reason is because, each interest, on its own, is not a controlling interest.
This lack of overall control means that noncontrolling interest is less valuable than an interest where one could exercise control. With a controlling interest, you can do certain tasks such as, for example, set compensation, and determine dividends that a minority shareholder (i.e. one with a noncontrolling interest) cannot control. Noncontrolling interests in a private company may also be subject to discounts for reasons such as difficulties in marketability.
Is It Worth Paying More Than An Interest’s Pro Rata Share of the Entire Business?
Let us suppose that, within a firm, there is one 60% owner and four other owners with 10% each. You might think that the combined value of all of these interests should equal 100% of the value of the company. For this to be true, it would require that the 60% owner pay more than the interest’s pro rata share of the fair market value (FMV) on a controlling basis. Put simply, the owner would pay a premium to control the business.
Imagine that the FMV of the private business in question on a controlling basis is $1 million. Each 10% owner’s interest would therefore be worth 10% of that controlling basis (i.e. $100,000). The 60% owner’s interest would be worth $600,000 on a controlling basis (60% of $1 million). In this situation, the 10% owners would discount their interests accordingly under the recognition that they lack control.
The noncontrolling investors might expect an additional discount because their interests cannot be readily converted into cash. Such a discount is more commonly referred to as a discount for lack of marketability.
Another example to consider is what happens if the 10% interests warrant a combined discount of 30% for lack of control and marketability? If this were true, their interests are worth $70,000 on a minority, nonmarketable basis each.
In this example, the parts, taken together, would only be worth $880,000 (4 times $70,000 equals $280,000 plus $600,000). Therefore, in line with the old adage mentioned above, the sum of the parts is substantially lower than the value of the entire business ($1 million) on a controlling basis.
A 100% shareholder could pay $1 million for a 100% interest and possess, in essence, the same control as someone who has bought 60%. It does not make sense for the 60% buyer to pay more than $600,000 for a 60% interest, unless there is a strategic motive.
As the example above shows, when estimating FMV, the whole can indeed be greater than the sum of its parts. While this seems counter-intuitive on the face of things, in the world of business valuation, this logic makes perfect sense.
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