What Would You Pay to Be in Charge?
The evolving state of control premiums
Investors theoretically pay a premium to control a business. “Control premiums” are intended to measure what control really is worth to investors. But quantifying these premiums can be problematic.
For years, appraisers have tried to quantify control premiums by comparing a public company’s acquisition price to the price of its publicly traded stock before the acquisition. But applying this data to private firms — in the form of traditional control premiums — has become increasingly controversial.
The Appraisal Practices Board (APB) has identified control premiums among the top four areas in which it observes the “greatest diversity” in appraisal practice. Its discussion draft, “The Measurement and Application of Market Participant Acquisition Premiums,” addresses the issue of control in the context of valuations prepared for financial reporting purposes. The APB draft provides “helpful guidance” but isn’t intended to be an authoritative valuation standard.
The APB asserts that traditional control premium studies — such as the FactSet Mergerstat® / BVR Control Premium Study™ — don’t necessarily represent a premium for conceptual control. Rather, these traditional studies represent a premium paid for actual changes that the buyer’s management can make by exercising its control. According to the APB:
Control, and whether one has it, is not really the focal point. What matters is that, after an acquisition, the acquired company is now under different management… If no improvements or risk reduction could reasonably be expected, there is little reason for an acquirer to pay a price higher than the publicly-traded price.
Premiums observed from public company transactions may include an element of strategic value, specific to an individual investor (usually in the form of revenue enhancement, cost cutting or risk reduction) and unavailable to the hypothetical universe of buyers and sellers.
The APB’s discussion draft introduces a new term when studying control called the “Market Participant Acquisition Premium” (MPAP). When valuing a controlling interest, only those cash flow improvements or risk reductions that a hypothetical buyer, known as a “market participant,” could reasonably expect should be factored into the appraisal.
The APB cautions against relying exclusively upon “observed transaction premiums without careful analysis of the subject entity’s relative financial performance, valuation multiples and other metrics.” Instead, appraisers should support MPAP with clear explanations of the incremental economic benefits available to investors. This requires adjustments for enhanced cash flows or lower returns.
Using empirical data
Traditional control premium studies still have their place. The APB suggests using them to corroborate (or challenge) the reasonableness of cash flow forecasts, discount rates and pricing multiples underlying the results of the market and income approaches.
For example, an implicit control premium can be imputed by comparing an interest’s controlling value to its value on a minority basis without making adjustments for control. In turn, the implied control premium can be compared to acquisition premiums observed in traditional control premium studies. Examples of business characteristics that may influence MPAP include:
Stage in the company’s life cycle. Startups and emerging growth firms may offer greater opportunities for growth and enhanced cash flows — and, therefore, warrant a higher MPAP — than mature firms.
Size of the subject company. Market participant acquirers are often larger than the subject entity. Small companies might warrant a large MPAP because they offer opportunities to achieve economies of scale or synergies that aren’t available to smaller companies on a standalone basis.
Management quality and nonfinancial objectives. An opportunity to improve cash flows exists if a company is run inefficiently — as evidenced by inferior financial performance compared to industry benchmarks, for example. Potential for enhanced cash flows and/or a lower cost of capital contributes to a larger MPAP.
After considering these factors and others, an appraiser can narrow the range of observed premiums to use as a sanity check. Appraisers also use selection criteria — such as size of the interest and financial condition of the seller — when deciding which public company transactions to evaluate.
Hiring a pro
What control is worth varies depending on the characteristics of the subject company and the type of prospective buyers involved. An experienced, credentialed valuation professional knows how to handle this complex issue.
Sidebar: On the flipside: Discounts for lack of control
Minority investors typically pay less for their ownership interests than the investment’s pro rata share of the company’s controlling value. Rather than use the mathematical inverse of a control premium from a public transaction study, the Appraisal Practices Board suggests it’s possible to address an investor’s lack of control by adjusting the projected income stream or returns. Appraisers must look beyond use of the mathematical inverse because of differences in the financial and (lack of) control attributes of the companies included in the transaction studies vs. the same attributes of the subject company.
To illustrate: A minority interest discount may be implicit in the valuation methodology if an appraiser doesn’t adjust the company’s financial statements for inferior management or discretionary spending. (Examples of discretionary spending include related-party transactions or above-market owners compensation.) When an appraiser abstains from making these discretionary adjustments, application of a separate discount for lack of control may sometimes be unnecessary.