Valuation Methodology, Control Premiums, Minority Interestand Lack of Marketability Discounting


Definition of Fair Market Value (“FMV”)

For purposes of this opinion, the term, Fair Market Value, is defined as noted under the Internal Revenue Service Code [per Revenue Ruling 59-60, subsequently noted, and the American Society of Appraisers Business Valuation Standards; also, the wording is virtually identical in Reg. 1.170A- 1(c)(2) ( income tax, charitable contributions of property); see Reg. 20.2031-1(b) (second sentence) (estate tax), 25.2512-1 (second sentence) (gift tax)] as: “the amount at which property [in this case, shares of the Company’s common stock] would exchange hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and when both parties have reasonable knowledge of relevant facts. [as is the case herein presented].”

Note should also be made of the AICPA’s IAS 39, further described herein plus the new requirements under SFAS 141R, Business Combinations for disclosures (particularly paragraphs 67-73) and deal costs (paragraphs 43-46).

Valuation Considerations

Before any Method of Valuation can be selected, the valuation of closely held securities [as is the case herein] requires consideration of a number of relevant factors that may influence the market price. The primary 12 factors below are recognized by the Tax Courts, the Internal Revenue Service, and what professional investors generally consider before making an investment or purchase of the securities under investigation. Once this information has been assembled and reviewed, then one can determine what the best method of valuation might be.

  • The nature and history of the business enterprise;
  • The outlook of the economy and the specific industry;
  • The book value and the financial condition of the business;
  • The determinate on of what business enterprises might or might not be comparable;
  • Current market conditions in the Financial Marketplace;
  • The earnings capacity of the business;
  • The dividend paying capacity of the business;
  • The nature and value of the tangible and intangible assets (goodwill) of the business;
  • The market price of securities of publicly traded corporations engaged in the same or similar lines of business;
  • The marketability, or lack thereof, of the securities;
  • The existence, if any, of a control premium with regard to the block of securities being valued; and
  • Sales of the stock and the size of the block of the stock to be valued.

These considerations are outlined and described in Revenue Ruling 59-60, 1959-1 CB237, as modified by Revenue Ruling 65-193, 1965-2 CB 370, and Revenue Ruling 77-287, IRB 1977-33. Although Revenue Ruling 59-60 specifically addresses itself to stock valuations for gift and estate tax purposes, the principles set forth may be applied to a wide spectrum of valuation problems, including those related to stockholder buy/sell agreements, mergers and acquisitions, Employee Stock Ownership Plans, corporate reorganizations, marital dissolutions, and bankruptcy.

Valuation Method: Fair or Fair Market Value

There are four primary methods of valuation that are most used and accepted are: Asset Value; Income Value; Market Comparisons and Industry Standards. Each is described below and are considered to be an outgrowth of Revenue Ruling 59-60.

  1. Asset: This considers the business to be a collection of assets that have a marketable value to a third party in an asset sale. Asset valuations are typically used for businesses that are ceasing operation and for specific types of businesses such as holding companies and investment companies. Asset valuation methods include the book value method, the adjusted book value method, the economic balance sheet method, and the liquidation method.
  2. Income: Under this method valuations are based on the premise that the current value of a small business is a function of the future value that an investor can expect to receive from purchasing all or part of the business. Income valuations are the most widely used type of valuation. They are generally used for valuing small businesses that are expected to continue operating for the foreseeable future. Income valuation methods include: the capitalization of earnings method, the discounted future income method, the discounted cash flow method, the economic income method, plus other formula methods. Caution has to be exercised here because its use is highly dependent upon the continuation of the level of historical earnings and projected economic trends which as we know can often change during a company’s business cycle.
  3. Market Comparison: This is based upon current conditions amongst active business buyers, recent buy-sell transactions, and other fairly comparable business entities. Financial attributes of these comparable companies and the prices at which they have transferred can server as strong indicators of fair market value of the subject company. One of the best examples of this is the capitalization determinations of publicly-traded companies as expressed on the various publicly-traded market exchanges, like the NYSE or for smaller companies, the OTC Market (Over-the-Counter).
  4. Industry Standards: Often times a particular industry, like the distribution and separately a service business, is valued based on a multiple of its annual revenues. However, caution has to be used here for many companies are a composure of multiple industries and thus it is not unusual to find an appraiser using more than one valuation methods in determining the value of a business enterprise.

If all fails in assigning one of the above Methods, EMCO/Hanover then uses an unwritten standard, given its credentials in mergers and acquisition which is also used by investment bankers. It is 3x – 5x times pre-tax cash flowor if patented technology exists, then this might be increased to 7x, [based on certain analysis of a Company’s financial statements] but adjusted for any extraordinary or non-direct business expenses, to determine an investment’s fair value. EMCO/Hanover believes that such a standard is reasonable for non-publicly-traded, non-technology, based businesses, excluding real estate which has its own capitalization procedures.

One should also be cognizant of the alternative of establishing a “Fair Value” which is not a quoted price on any Stock Exchange which is the best evidence of fair value - quoted prices in an active market. However, if the market for a financial instrument is not active, then an entity can establish fair value by using valuation technique/ guidelines, as defined and referenced above particularly under the three other primary methods plus originally set out under Revenue Ruling 59-60 along with that presented under the AICPA’s IAS 39 Financial Instruments: Recognition and Measurement.. . . . A valuation technique: (a) incorporates all factors that market participants would consider in setting a price and (b) is consistent with accepted economic methodologies for pricing financial instruments.

Please also refer to the Section - - Compensation: Restricted Stock Valuation Standards on our website for valuing restricted shares issued to employees and executives plus Board Directors.

Basis of Minority and Marketability Discounts

The Minority Interest/ Lack of Control/ Marketability of the Interest Being Valued (Discount Composite: 48%).

In support for the application of Minority Interest/Lack of Control and Marketability Discounts, EMCO/Hanover has presented herein a cross-section of actual Case references of individual and joint discounts which were applied under varying circumstances plus examples of actual premiums (reciprocal discounts) paid in various publicly-traded corporate acquisition transactions to support its conclusion for a discount(s). In most situations EMCO/Hanover has typically applied a composite discount of forty-eight percent for lack of control and marketability when valuing one’s interest, particularly in privately-held circumstances – as determined below.
{.40, for lack of control + .08 [40% x 20%, for lack of marketability]} = .48 or 48%, the reciprocal of which is 52% when multiplying it against the stated value of the enterprise or asset involved}, as prior noted.
Various studies include analysis of selective restricted stocks and the pre-IPO transactions. The aggregate of these studies indicate average discounts of 35% and 50%, respectively. Some experts believe the Lack of Control and Marketability Discounts can aggregate discounts for as much as ninety percent of a Company's fair market value, specifically with family owned companies. However, each case must be analyzed based on the specific circumstances involved.
a.) Minority Interest: lack of control (40%)
1.) General Background
The first step is to determine the value of having control. Control premium studies examine the differences in stock prices of a particular company immediately before and after a majority or the “controlling interest” of an enterprises stock or units in a partnership is tendered. Since the minority interest discount is a function of the control premium one must first examine this principle first.
The minority interest principle refers to the fact that ownership of less than a majority or controlling interest in an enterprise or partnership by itself cannot: (1) elect directors and the appointment of management, (2) determinate management compensation or perquisites; (3) control day-to-day or long range managerial decisions, impact future earnings, or control efforts for growth potential; (4) declare or pay dividends or distribute to interest holders; (5) the acquisition or sale of treasury shares; (6) consolidate or divest or merger; or (6) alter the Articles of Incorporation , bylaws or partnership agreement(s). Most importantly, minority shareholders/ partners do not have the right to establish executive or specific partner compensation, buy or sell major business assets, or cause the liquidation of all corporate or partnership assets. That right is invested in the majority shareholder(s).
Because the owner of a minority interest lacks the ability to control the business, an acquirer of a minority interest will pay less for that interest, on a pro-rata basis, than if he or she were acquiring a controlling interest in a business which is either privately-held, there are restrictions on the securities themselves, or where there is an absence of a “ready market” (See Section Sub-3, below, for definition according to the National Association of Securities Dealers, Inc.) for the liquidation of the securities once purchased. Further, in instances where the interest holder lacks the ability to exercise control over the operations of the enterprise, his or her interest might be worth “significantly less than its “liquidation” value.
2.) Control Premiums and Minority Interest Discount Studies
In the Houlihan, Lokey, Howard and Zukin’sMergerstat Review - 2001, an annual publication that provides comprehensive statistics on control premium in over 50 industries, they analyzed the average price paid over the market price for the past 10 years in various publicly recorded, corporate transactions. They found that the premiums paid ranged from a low of 35.1% in 1991 to a high of 49.2% in 2000 - averaging 41.35% over the recent eight years analyzed and still valid today.
In The Perspective: The Source for Partnership Information, a publication that lists real estate limited partnerships (“RELPs”), along with an estimate of their underlying asset value, as estimated by the general partner or based on recent appraised values. The discounts were derived by comparing 1998 year-end value s as reported by the general partner with the weighted average prices at which investors purchased units in these real estate limited partnerships in the secondary market during the sixty-day period ended May 31, 1999. For “distributing” RELPs, the average discount was 29.0%; for “non-distributing “RELPs”, the average was 46.0%.
Numerous studies have also been undertaken by Spencer Jeffries, Messrs. Kam, Schroeder and Smith plus Messrs.. Johnson and Park where minority discounts for average returns under nine percent have caused average discounts from net asset value to be sixty to eighty percent.
According to Mary Boehler, Vice President and Division Manager of the Family Business Division of The Northern Trust Company, per an Internet article on Business Succession – Northern Trust in 2004: minority discounts can range from 25 to 35 percent and discounts for non-marketability from 20 to 40 percent [or thus, when taken as a composite, 49% (35% + 12%[.35 x 45%])].
3.) Selective Corporate Transactions involving Majority Ownership, 2007-2009
Supporting Ms. Boehler’s position also is the proposed 2007 merger (April 23, 2007: Reuters) between British Bank – Barclays Plc. (trading symbol: BARC.L) and ABN AMRO (trading symbol: AAH.AS) which represents a 33% premium (or conversely its reciprocal in discounting terms, a 47% discount) to ABN’s trading price before the banks announced its merger talks, which some analysts believe is too low. Further, the merger will result in the new bank becoming one of the top 10 in the World - - - - but not the largest or top three bank holding companies, where an acquisition premium would be even greater.
Note should also be made that probably one of the best historical examples in transaction discounting was between 1976 and 1990, where premiums averaged 41 percent, with many over 100 percent (Jensen, 1993), like when Campeau paid a 124 percent premium to acquire Federated Department Stores.
More recent examples include, in 2007, where Rupert Murdoch’s New Corporation acquisition of Dow Jones & Co. Inc. was at an “accepted” price of $60 per share where the initial offer was at $36 per share – a 66% premium. Also, Natro, Inc. (“NTOL”), a company in the manufacture and marketing of dietary supplements, herbal teas, and sports nutrition products with annual revenues of $74 million, was tendered by Plethico Pharmaceuticals Ltd..in November, 2007 at $4.30, a 90% premium over its then price of $2.27 for a 90% controlling interest.
Brewers Carlsberg and Heineken Agreement to purchase Scottish & Newcastle (S&N) in January, 2008 - a premium of 50.7% over the closing share price on March 28, the day before speculation arose about a possible bid for S&N according to its own press release dated January 25, 2008.
In February, 2008 this was followed by an announcement by Microsoft – “MSFT” that it offered $44.6 billion in cash and stock for search engine operator Yahoo Inc. – “YHOO” (# 2 behind industry leader - Google). This represented a 62 percent premium (before raising by another 48% when the actual announcement was made on February 1, 2008) to Yahoo's closing stock price on January 31st.
This was followed in February 20, 2008 announcement that Reed Elsevier, a London-based educational publisher and parent of the LexisNexis information service, will buy ChoicePoint for $3.6 Billion in Cash - the purchase price for which amounts to $50 a share, a 49 percent premium given ChoicePoint's closing stock price of $33.66 on the 20th.
On July 20, 2008 Dow Chemical Co. agreed to buy its rival Rohm and Haas, whose revenues are 1/6 of Dow’s, for $78 per share or a 74 percent premium over Rohm and Haas’s closing share price of $44.83 on July 19, 2008. Further announced in July was the acquisition of Barr Pharmaceuticals by Teva Pharmaceutical for $66.50 per shares, which is a 42% premium over Barr’s closing price of $46.82 when the transaction became known.
Lloyds TSB, Britain's fifth-biggest bank (LSE:LLOY.L) and HBOS Plc (LSE:HBOS.L) ranked sixth, Britain's biggest home loan lender, agreed in an all-share deal transaction by Lloyds to purchase HBOS for 232 pence per share, a 58% premium over 147.1 pence trading price on September 17, 2008 (but from an all-time low of 88p earlier in the day), valuing the transaction at over 12 billion British pounds.
On March 9, 2009 Merck announced that it was buying Schering-Plough in a $41.1 Billion deal (56% in stock and 44% in cash), a 44% premium over the two companies’ average closing share prices over the past 30 trading days. The transaction was structured as a reverse merger, with Schering-Plough as the surviving company, in an attempt to avoid triggering change-of-control provisions with Johnson & Johnson.
In December, 2009 drug-maker Sanofi-Aventis initiates a Buy for Chattem (CHTT) for $1.9 Billion, a 34 percent premium at $93.14 (December 21, 2009) over the prior closing price of $69.98 on December 18, 2009.
In June, 2010 Ralcorp Holdings, Inc. ((NYSE: RAH) said it will pay $53 per share for American Italian Pasta Co. (NasdaqGS: AIPC), with $589M in revenues), a 42% cashoffered premium (the deal is being funded with cash on hand, an existing credit facilities and a bridge facility) based on its closing price on June 10th of $37.36 over the Kansas City pasta maker's closing price of $41.73 on June 18, 2010 in the mix of a highly volatile and recession-oriented market.
On June 30, 2010 Boeing's offer of $34.50 per share is a 41 percent premium to Argon SR, Inc.'s (STST) closing price on the prior day. Argon had $366 million in revenues during the 2009 fiscal year.
On July 12, 2010 insurance broker Aon Corp., who is also engaged in consulting and outsourcing operations, agreed to purchase Hewitt Associates (NYSE: HEW), a human resources and outsourcing company, by paying a 41% premium over Hewitt’s closing price on July 8th.
Playboy Enterprises Inc. said Monday, July 12, 2010, that its iconic founder Hugh Hefner is offering to buy the remaining, minority and non-voting shares of the media empire, taking the company private, in a deal that values the company at $185 million or a 51% premium offer over market based on the number of shares outstanding on April 30th.
ATC Technology Corp. (NasdaqGS Symbol: ATAC, with annual revenues of $476M) said Monday it has agreed to be acquired by privately held Genco Distribution System Inc., an engineering and supply chain logistics firm, for $512.6 million in cash, a 64% percent premium over the company's closing price ($15.28) on July 6, 2010.
4.) National Association of Securities Dealers, Inc.’s Definition of “Ready Market”
The key Guideline is according to the National Association of Securities Dealers, Inc. Manual dated July, 1997 where on Page 8113 it refers to Non-Marketable Securities and Rule 15c3-1[c][2][vii] and states:
“Deducting 100 percent of the carrying value in the case of securities or evidence of indebtedness in the proprietary or other accounts of the broker or dealer, for which there is no ready market, as defined in subparagraph [c][11] of this section . . . [can be justified]”.
On Page 8122, it further defines “Ready Market” under Section [11], sub Section (i): “the term ‘ready market’ shall include a recognized established securities market in which there exists independent bona fide offers to buy and sell so that a price reasonably related to the last sales price or current bona fide competitive bid and offer quotations can be determined for a particular security almost instantaneously and where payment will be received in settlement of a sale at such a price within a relatively short time conforming to trade custom.”