All Share Are Not Created Equal
On January 18th, Catalyst magazine will host a seminar on two questions that are near and dear to every business owner’s heart: “What is my company worth?” and “What am I going to do with it?” As a backdrop to this seminar, I thought it would be helpful to clarify an aspect of business valuation that is not widely understood in the business world: Not all shares are created equal. In other words, individuals can own shares in a company that may not be worth the same as other shares in the same company.
Recently, I was valuing a one-third interest in a company that the owner of a highly successful Atlanta based architectural engineering firm planned to sell to his employees. He needed an independent party to establish the value for a variety of reasons. When we told him that we had determined an appropriate value for his company to be $12 million, he nodded that our conclusion was consistent with his expectation. However, when we further explained that the one-third interest he was selling to the employees was not worth $4 million, he thought our mathematical skills were seriously deficient.
The reality is that a minority interest in a company is worth less on a per share basis than a controlling interest. If you control a company, you can determine its strategic direction, decide when to sell the business, determine everyone’s pay and establish the timing and amount of cash distributions to the shareholders.
If you don’t control at least 50.1 percent of the shares, you can’t do any of the above. Therefore, all the academic studies show, not surprisingly, that there is a meaningful discount applied to the values paid for shares if they are part of a minority position in the company. The minority interest discount that is applied depends on the governance mechanisms in place and the size of the other holdings in the company. For example, if a two-thirds vote is required to effect major decisions, and one shareholder owns 51 percent, while another owns 30 percent, the minority interest discount applied to the shares of the 30 percent owner will be a lot less than if a simple majority could control all relevant decisions. Without the 30 percent owner’s consent, the controlling shareholder would have his or her hands tied on major decisions.
There are several other discounts that are applied to the shares of a private company when assessing their fair market value. Many owners of privately held businesses will use public companies that operate in the same line of business as a benchmark for valuing their shares. This is not only a valid approach, it is the one most respected by the IRS if you are filing an estate tax or gift tax return. For example, the stock of the average publicly traded homebuilder might be valued at five to seven times its EBITDA (earnings before interest, taxes, depreciation and amortization.) However, when valuing a privately owned homebuilder, you can’t simply apply a multiple in this range to determine its market value. One of the adjustments that must be made when applying multiples paid for public companies to the shares of a private company is a lack of marketability discount.
If you wanted to sell 100 shares in Beazer Homes, which is traded on the New York Stock Exchange, all you have to do is pick up the phone and call your broker and, after you get the voicemail that says “do not leave trade instructions on this voicemail,” dial his or her assistant and place a sell order. Within a nano-second your trade is completed and a few days later you receive your cash. If you owned 100 shares in John Wieland Homes, which is a private company, it would not be quite so simple to convert those shares to cash. In fact, in most private companies there is no established mechanism for a shareholder to sell their shares. Consequently, it could take years to turn those shares into cash, and the value you received could be much lower than your pro-rata ownership of the total company value.
Another common discount that is frequently applied to the shares of privately held businesses is what is referred to as a key person discount. Presumably, the management team in most public companies is sufficiently strong that the company could survive the loss of any single individual without it having a material impact on the future performance of the business. In the typical private company, this is not the case.
Often a single individual is responsible for a majority of the customer relationships, for the management of production or some other critical function. The loss of that individual would have a deleterious impact on performance. The key person discount, which studies justify in the range of 5 percent to 10 percent on average, is a combination of the expected loss in profitability that would occur if the key person died or left, multiplied by the probability that such an event might occur.
There are other discounts that apply as well. For example, there is a lack of voting rights discount that is applied when there are two classes of shares of stock in a company and one of the classes has greater voting rights than the other. Besides the fact that this constitutes a dysfunctional corporate governance structure, in my opinion, there are countless academic studies that show that shares with inferior voting rights trade at lower values.
It gets tricky when there is more than one premium or discount to be applied to the shares being valued. Let’s say, for example, that you are valuing a controlling interest in a private company using public company shares of similar businesses as the benchmark. After you have adjusted the multiples for differences in performance, size and other factors, you have to apply a lack of marketability discount to factor in the absence of a ready market for the shares of the private company. You also have to factor in a control premium to account for the fact that the price paid for the shares of the public company are for small lots, i.e., 100 or so shares, yet the block of private company shares being valued is a control position.
When an offer is made to acquire a public company, there is almost always a premium paid for the shares. This is because a controlling stake is worth more per share than what is paid in daily trades of small amounts of those shares. When applying more than one premium or discount, the total premium or discount is multiplicative, not additive. In plain English, a 25 percent lack of marketability discount and a 10 percent key person discount results in a total value that is not 35 percent (25 percent +10 percent) lower, but one that is 32.5 percent lower (75 percent X 90 percent = 67.5 percent, and 67.5 percent is 32.5 percent lower than 100 percent.)
As you can see, valuing the stock of a private company is not an exercise you should try at home. Besides the fact that these various discounts and premiums need to be applied to arrive at a sound valuation, the appraiser needs to understand a great deal about the specific governance mechanisms of the company and the contributions of the individuals involved. So if you own stock in a private company, and that investment is a meaningful percentage of your net worth, it would be worthwhile to have a professional appraisal done periodically. This will enable you to better understand how a potential buyer of your stock might evaluate it, should you ever have the opportunity to sell your shares. It also will give you a better feel for how the IRS might value it, enabling you to prepare for a significant estate tax bill, in the event you were to pass away unexpectedly.
Michael Jacobs, Author
Michael Jacobs is the CEO of Jacobs Capital and Professor of the Practice of Finance at The University of North Carolina at Chapel Hill. He's the author of several books and a certified speaker.
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