Valuation Discounts and Premiums

As the majority owner of Mars Inc., the Mars family has complete control of the family business, and that comes with a lot of power. That influence can really impact the company's value, whether it be through selling the family's stake or acquiring more shares, especially when compared to a public company. But how do you think such a large position can impact the value versus a public entity?

What would doing so do to the price you'd pay?

No. That wouldn't lower the value.

That's not it. A controlling position impacts the business.

Way to go! The controlling position requires a higher value because of the synergies that you want to implement. That's called a control premium. A synergistic or investment buyer is often called a __strategic buyer__. A strategic buyer requires the highest value, especially versus a regular __financial buyer__ with no strategic plans, who would probably pay a lower price.

But that's not the only way a large position can impact a private investment's value. Say you're in the opposite situation and can only buy a small percentage of the business. In that case, you don't have the ability to implement your own vision without the majority of other investors going along with you. How might that impact your valuation?

Yes!

No. That's the opposite situation from a control premium.

The value would be lower because you'd take a __discount for lack of control (DLOC)__, which is an amount or percentage deducted from the pro rata share of 100% of the value of an equity interest in a business, to reflect the absence of some or all powers of control. Being a minority owner means that you can't nominate executives for leadership positions or distribute any assets to investors without support from other investors. But that lack of control doesn't always show up in how the investment is valued by regulators. There could be times when you'd need to prove that minority investors were harmed by the actions taken by the majority owner.

The process of calculating the lack of control discount is also up for debate, as there's not a definitive formula to capture the disadvantages of the minority position. But in general the formula is $$\displaystyle \text{DLOC} = 1 - \left[ \frac{1}{(1 + \text{Control Premium})} \right]$$ It's typically found in using what's called a "guideline transactions method" when valuing a controlling position, or "capitalized cash flow" or free cash flow models depending on the cash flow structure and discount rate.

But that's not the only discount that can be factored into your minority position. Think about your liquidation potential after purchasing the private investment. Do you think that would impact the value?

Definitely! A reduced opportunity to sell private shares would lower the value. It's called a __discount for lack of marketability (DLOM)__, which is an amount or percentage deducted from value of an ownership interest to reflect the relative absence of a ready market for the company's shares. Typically, a DLOM is tied to a DLOC because an investor with a minority stake in a private company won't have a market to sell the business stake.

That's not it. A private investment isn't easier to sell.

No. Actually, it does impact the value.

And that marketability discount not only captures the lack of a market, but also the opportunity cost associated with not being able to sell the stake. But that's hard to measure, so to measure the lack of marketability discount, three different approaches can be used.

The first is to analyze restricted stock transactions. Why might that help value a marketability discount?

Not quite. That's not the rule that restricted shares have to follow.

No, actually. Restricted stock can be sold to lots of different investors, so that's not the restriction.

Bingo! Restricted stock rules prevent early resale for shares issued in IPOs, so those shares have similar characteristics as private shares with marketability issues. You could analyze those transactions to see how those shares are valued. Another marketability valuation technique is to analyze IPOs. That's because as a company moves towards an IPO, the uncertainty that's priced into the valuation of the IPO decreases, so valuation experts have tried to capture that appreciation as part of a marketability discount.

But other valuation experts use a put option technique, where an at-the-money put option is priced and then compared as a percentage of the stock's value. That way, the DLOM can be determined as a percentage. The put option approach typically values companies in the development stage because investors are concerned about intermediate liquidity, but that's also a downside risk of the technique. That's because put contracts have an expiration. What's a crucial estimation of the approach?

You got it!

No. The strike needs to be at the money to value the DLOM.

The time period to the liquidity event will need to be estimated, and it needs to be accurate to forecast the put's value versus the stock's value. The other estimation is the level of volatility in the stock, because that's another key input to pricing the put option. It's also a helpful indicator of the company's risk because it can better capture the risks of the stock versus the restricted stock or IPO approach.

To value a private position, you'd need to consider both a discount for control and for marketability. And since most private companies will involve both discounts, it's crucial to know that the discounts are multiplied together because the process involves discrete steps. $$\displaystyle \text{Total Discount} = [1- (1 - \text{DLOC})(1 - \text{DLOM})]$$

To sum it up: [[summary]]

Yes! Actually, a position like that can impact the price both ways. For example, say you're interested in a controlling position in a private company in order to improve efficiency and grow the business. In that case, you'd really want to own the majority percentage, so you could implement your strategic plan.

Lower value

Higher value

Lower

Higher

No impact

Lower value

Higher value

Yes, it'd be lower

Yes, it'd be higher

No way, that doesn't impact value

Restricted stock can only be sold in large quantities

Restricted stock can only be sold to accredited investors

Restricted stock rules prevent resale of shares according to certain rules

The strike price

The expected term

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