A business may have more than one value, depending on the purpose of the business valuation and the characteristics of the ownership interest. Before an expert starts working on a business valuation, it’s important to discuss the appropriate level of value. Otherwise, confusion over levels of value may lead to miscommunication and misinformed business decisions. Moreover, when multiple experts calculate different levels of value, discrepancies and disputes abound. Here’s an overview of the three main levels of value.

1. Controlling interests

Control value is one level. The ability to control a business’s decisions has impact on value, especially on the value of a closely held business. Potential buyers often may be willing to pay a premium for the ability to control business decisions. The key to arriving at a control value is to make discretionary adjustments to the company’s cash flow, such as adjusting for above- (or below-) market related-party transactions or owners’ compensation.

Control value can be broken down further into 1)  strategic and financial control value or 2) public and private control value. But valuators don’t always agree on these classifications. The difference between strategic and financial control is the expected synergies available to a strategic buyer. Strategic buyers often pay a significant premium over financial buyers.

Public and private merger-and-acquisition (M&A) methods generate cash-equivalent control values. Some valuators contend that controlling interests take time and resources to sell and, therefore, may warrant an illiquidity discount — regardless of whether they are based on public or private transactions. No empirical studies exist, however, that directly quantify illiquidity discounts.

2. Non-controlling, marketable interests

Another level is non-controlling (minority), marketable value. Shareholders who can’t control day-to-day business operations may be unwilling to pay as much per share as controlling shareholders. Rather than applying a discount for lack of control, valuators may arrive at a non-controlling level of value by abstaining from making discretionary adjustments to cash flow.

Because public companies’ professional management teams typically try to maximize earnings per share, their financial statements may require few or no discretionary adjustments. Assuming controlling shareholders don’t abuse their discretion, the pro-rata share of a public company’s value on a controlling basis may closely approximate the value of shares on a non-controlling, marketable basis. In other words, there’s little to no discount for lack of control in these cases.

Conversely, marketability refers to how quickly and easily shares can be converted to cash. For example, shares of Microsoft Corporation are sold on the New York Stock Exchange and can be bought or sold simply by calling an investment advisor. Marketability is worth something to investors. Both the guideline public company method and the income approach can generate a marketable value because they’re based on public stock data.

3. Non-controlling, non-marketable interests

Finally, there’s non-controlling, non-marketable value. Many valuation assignments call for the value of a non-controlling interest in a private company. This is generally the least valuable of the levels and is difficult to estimate directly, except by using previous arm’s-length transactions of the subject company’s stock. But previous transactions may not exist — or, if they do, they may not be relevant.

The typical starting point for this level of value is a non-controlling, marketable value, as described previously. From there, a marketability discount is taken. Sources of empirical data for marketability discounts include restricted stock and initial public offering (IPO) studies.

Lay down the ground rules

When obtaining a business valuation, it’s important to work with your expert to establish the appropriate level of value, because it affects the valuator’s analyses and techniques. The appropriate level of value may vary depending on the situation.

(This is Blog Post #1498)