June 26, 2019
We’ve all heard the phrase that the “whole is greater than the sum of its parts.” But you might not know that the same theory can apply in the valuation of interests in a business.
Control is Valuable
When a publicly traded business is acquired in the whole by an outside buyer, it is often purchased for a greater value on a per share basis than the market value of individual shares. Of course, part of that difference could be traced to the synergistic value between the buyer and the seller. However, it is also due, at least partially, to the fact that the publicly traded shares are all minority interests in the company. This lack of control results in a diminution of the value of the shares.
Consider the example of a private company with five equal shareholders owning 20% each. If we were to add the value of each of the 20% interests together, they would not equal a 100% value of the equity of the company. Why? Because each interest, standing alone, isn’t a controlling interest.
Once again, this lack of control means that the interest is less valuable than an interest where you could exercise control. For example, with a controlling interest, you can set compensation, determine dividends or other distributions, and affect many other actions that a minority shareholder can’t control. Minority interests in a private company also might be subject to discounts for lack of marketability, because they cannot be readily sold in the marketplace.
Would You Pay More Than An Interest’s Pro Rata Share of the Entire Business?
Now suppose that there is one 60% owner and four other owners with 10% each. You might be inclined to say that the combined values of these five interests should equal 100% of the equity value of the company. However, this would require that the 60% owner to pay more than the interest’s pro rata share of the entire business’s fair market value on a controlling basis. In other words, the owner would pay a premium to control the business.
Suppose the fair market value of this private business on a controlling basis is $1 million. Each 10% owner’s interest would be worth $100,000 on a controlling basis (10% of $1 million). The 60% owner’s interest would be worth $600,000 on a controlling basis (60% of $1 million). However, the 10% owners would recognize that they lack control and discount their interests accordingly. They might also expect an additional discount, because they interests can’t be readily converted in cash (commonly referred to as a discount for lack of marketability).
For illustrative purposes, let’s assume that the 10% interests warrant a combined discount of 30% for lack of control and marketability. That would mean their interests are each worth $70,000 on a minority, non-marketable basis.
Here, the parts, combined, would only be worth $880,000 (4 times $70,000 equals $280,000 plus $600,000). As this example shows, the sum of the parts is significantly lower than the value of the entire business on a controlling basis ($1 million).
A 100% shareholder could pay $1 million for a 100% interest and possess the same control privileges as — if not more than — the 60% control owner. So, the 60% isn’t likely to pay more than $600,000 for a 60% interest, unless it’s a strategic buyer.
As this simple example show, the whole can often be greater than the sum of its parts when estimating fair market value. In the world of business valuation, this logic makes perfect sense.