Now that we are comfortable deriving acquisition multiples using the Guideline Company Method and the Similar Transactions Method, we must learn how to select the proper multiple before applying it to our subject Company and reaching a value conclusion.
It can be reasonably assumed that a prudent investor would pay more for the controlling interest in a company than he/she would for a minority (non-controlling) ownership interest. Having the ability to dictate the direction of the company means paying a premium over what one might pay for little to no influence.
It can also be reasonably assumed that the shares of a marketable company would trade at a premium to nonmarketable shares due to their ability to be quickly converted to cash. Remember the example from our last post where we discovered we cannot apply the same multiple to value an ownership interest in Wal-Mart as we would an ownership interest in the local retail shop? This is due to the marketability of the shares. There exists an active market (i.e. a public stock exchange) in which shares of Wal-Mart and other major companies are traded. So, we can quickly convert these shares into cash. The shares of the local retail shop however require that we hire a business broker or M&A professional to create a market for our shares. This is a much more time consuming and difficult process than selling our shares on the publicly traded open market.
When attempting to value a controlling interest in a subject company you are often best served with the Similar Transactions Method for controlling interests. There is transaction data available for minority ownership interest transfers but most transaction data reflects a change of control. Therefore when we calculate the acquisition multiple for a transaction, our resulting multiple reflects the price a prudent investor would pay for a controlling interest. If your multiples are derived from publicly traded Guideline Companies (based on the price a company’s shares are trading on a public exchange) your multiple reflects a minority interest. Investors are not usually purchasing stock on the open market in an attempt to gain control of a publicly traded company. They are purchasing a minority interest in the business and the price paid (and resulting multiples) reflect this fact.
When attempting to value a marketable ownership shares, the Guideline Company Method is an excellent option. Since the Guideline Company multiples have been derived from the valuation of marketable shares, they can easily be applied to the shares of your subject company to imply the marketable value of your shares. However, since we are using a Guideline Company multiple, our resulting value is a marketable, minority interest value.
When attempting to value a nonmarketable ownership interest, the Similar Transactions Method using data from the sale of closely held companies is very reliable. Similar Transaction Multiples are derived from databases of transactions “similar” to that of our subject company. Remember the example from our last post? If, the house across the street sold for $300,000 and our house has one more bathroom, 500 more square feet, and is in better condition than that house, surely our house is worth more than $300,000? Databases of business transactions involving privately held companies exist. So, we can fairly easily look to transactions involving companies “similar” to our private subject company for a value indication. Private transactions involve nonmarketable ownership shares. By applying the multiples from a similar transaction analysis, the result is the value of nonmarketable shares. However, since we used the Similar Transactions Method, we are valuing a controlling interest in those nonmarketable shares (assuming the transactions involved a change of control).
If the Guideline Company Method provides us with a value indication for a marketable, minority interest and the Similar Transactions Method provides us with a value indication for a controlling interest in nonmarketable shares, what happens if we are looking to value a controlling interest in marketable shares? We use the Guideline Company Method to get to the value indication for a marketable, minority value and then apply a “control” premium.
What if we were attempting to value a minority non-marketable interest? We use the Guideline Company Method to get to the value indication for a marketable, minority interest and then apply a discount for lack of marketability. Or, we could use the Similar Transactions Method to get to the value indication for a controlling, non-marketable interest and apply a discount for lack of control.
In order to select the proper multiple and arrive at the right value conclusion for your ownership interest, you must ask yourself the following questions:
- Are you valuing a controlling ownership interest or minority ownership interest in the subject company?
- Are the shares of the subject company marketable or non-marketable?
- Are the multiples you’ve obtained controlling ownership multiples or minority ownership multiples?
- Are the multiples you’ve obtained marketable or non-marketable multiples?
It is imperative to understand that your answers to these questions will dictate how business acquisition multiples are adjusted and applied to your subject company.
We will take a closer look at discounts and premiums in our next post.