Valuation: Illiquidity discounts, control premiums and minority discounts

Valuation: Illiquidity discounts, Control premiums, Minority discounts

Joris Kersten, Uden/ Netherlands, 15th January 2020

Source: Book “The real cost of capital: A business field guide to better financial decisions (2004)” of Tim Ogier & John Rugman & Lucinda Spicer.

Consultant & Trainer Joris Kersten

I am an independent M&A consultant and Valuator from The Netherlands.

In addition, I provide training in “Financial Modelling”, “Business Valuation” and “Mergers & Acquisitions” all over the world (New York, London, Asia, Middle East).

This at leading (“bulge bracket”) investment banks, corporates and universities.

I also provide inhouse training on request and I have open training programs in business valuation in The Netherlands and different places in the world (e.g. New York, Mumbai, Dubai, Amsterdam and Uden).

My full training calendar can be found at the very end of this article. And my next upcoming training is:

-Business Valuation & Deal Structuring @ Uden/ The Netherlands @ 18, 19, 20, 21 and 23, 24 March 2020. Price is 2.900 euro ex vat when you register before early bird date: 31st January 2020. After 31st January regular price is 3.900 euro ex vat. Visit for all info and registration: www.joriskersten.nl

In addition, I write blogs and articles on business valuation related issues, earlier blogs can be found also at the very end of this article.

This blog is about “premiums and discounts” in business valuation.

I have used the brilliant book “The real cost of capital: A business field guide to better financial decisions (2004)” of Tim Ogier & John Rugman & Lucinda Spicer as a source.

The book is just fantastic since it has theoretical depth but always looks at practical application. ??            

Premiums and discounts

A valuator needs to take potential premiums and discounts into account.

The most common ones are:

1.     Discount for a lack of marketability;

2.     Premium for control;

3.     Discount for small companies.

In this article I will talk about the “discount for a lack of marketability” (1) and the “premium for control (and discount for minority shareholdings)” (2).

And the topic “discount for small companies” will be discussed in the next article later this week.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Discounts for lack of marketability (1)

The first adjustment I will consider is the lack of marketability, or liquidity, of an investment.

While an equity investment in a publicly traded company is highly liquid, this is not the case for an investment in a closely held company.

These investments are worth less, because it may take longer to sell the asset, it may be sold at a discount, or there are costs involved in finding a buyer.

There are three key factors which influence the extent of marketability of an investment:

A.    Whether the asset is privately held or publicly traded;

B.    Whether there are restrictions on the sale of the investment;

C.     Whether the market for the investment is “thin” or “active”.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Factors influencing the illiquidity discount

The most liquid type of investment is one in an unrestricted publicly traded stock, traded on an active market.

An example would be to purchase a minority holding of the common stock of a company traded on a well-established and liquid stock market such as the New York Stock Exchange or London Stock Exchange.

If the value of such an investment is used to benchmark the value of an investment where liquidity is impaired (e.g. because of “thin trading” (C), stock sale restrictions (B) or stock is privately held (A)), then it is necessary to make adjustment to the value to reflect this lower level of liquidity.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Quantifying the discount for illiquidity

There have been numerous studies which have attempted to estimate the reduction in value as a result of an investment being illiquid.

These studies have looked at evidence relating to the three key sources of the impairment to value:

• Studies examining discounts in the value of restricted stock (B);
• Studies examining the lower value attributed to closely held stock as opposed to publicly traded stock (A);
• Studies relating discounts to thin trading (C).

Let’s now take a look at these three sources in more depth.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Discounts for restricted shares (B)

Restricted stock issued by a public company is identical in all respects to its freely traded stock with the exception that it is restricted from trading on the open market for a certain period.

Such restricted stock is generally issued when a company is making an acquisition or raising capital, because of the time and costs associated with registering the new stock with the SEC.

Many studies have been conducted on the difference in value between restricted trades and public and public market trades in the US on the same date.

For trades which took place before 1990 the studies came up with average discounts on the value of restricted stock of around 30% to 35%.

Since 1990 a loosening of rules relating to restricted stocks in the US appears to have reduced the size of the average discount, and later studies discounts of about 20% to 30%.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Estimating the discount for closely held stock (A)

A purchaser of closely held stock has no established market in which he or she can eventually trade the stock.

Studies in seeking to estimate the discount in value for closely held stock have concentrated on the difference in the transaction prices between IPOs and private transactions conducted immediately before an IPO.

The size of the illiquidity discount of closely held investments depend on whether the investment represents a majority or minority interest.

For a majority interest there is still some discount, courts in the US have allowed discounts for a lack of marketability on controlling interests of 3% to 33%.

But for minority interests the potential size of the discount is likely to be higher, perhaps up to 60%.

But there is a wide range for this discount, and its level depends on the particular circumstances affecting the marketability of the minority interest.

For example, whether there is a near or medium term prospect of a sale, whether dividends are paid etc. So here a range of 20% to 60% is typically applied.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Evidence on discounts of thin trading (C)

PWC looked in 1997 with research at three UK markets in which shares are publicly traded.

They ranked the shares listed on these markets according to turnover percentage and concluded that LSE was by far most liquid, AIM (alternative investment market) the next most liquid, and the Ofex market being the least liquid.

The PWC team examined companies which switched exchanges, and looked at the effect on share price of the announcement of the switch.

PWC found no evidence of a discount for illiquidity between LSE and AIM, but they found evidence of a 10% discount on value for companies quoted on the Ofex market compared to both LSE and AIM.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Discounting enterprise value of equity value ?

Value discounts for lack of marketability could affect the EV (enterprise value) of a business.

So the value of both debt and equity since all investors will attach less value to investments which are illiquid.

But in practise all the evidence presented by valuation practitioners on these discounts apply the discount to share value.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Discounts for a lack of marketability (in summary)

The biggest reduction in value for a lack of liquidity is associated with holding a minority stake in a closely held company. Empirical studies show discounts of in between 20% and 60%.

Value is also reduced when you hold an investment in a shareholding in a publicly quoted company, when restrictions are placed on the disposal of shares. Here empirical studies suggest a reduction of 15% to 35% in such situation in the US.

And value is reduced where the stock is publicly quoted, if there is a lack of marketability in the market. PWC found a value of around 10% in a certain market.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Control premium (2)

It is generally recognized by valuation practitioners that an investment which gives an investor control of a business is worth more than a minority stake.

So there is a “control premium” and a “minority discount”.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

The sources of extra value in control

First source, there is control over the distribution of cash generated by the enterprise. An individual with a controlling stake can have a direct influence on matters like timing of the dividends, the payment of a director, and the liquidation of the business.

Second source, there is an effect on the actual amount of cash generated by the enterprise. Since controlling shareholders will be able to direct the company’s policy in a way which will enhance value to them. For example by obtaining “synergies”.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Evidence on the size of the control premium

Typically estimates of the size of the control premium are based on data relating to the analysis of premiums paid by companies which acquire majority stakes in other companies (so “controlling stakes”).

When you have reasons to believe that securing control will boost company value while you are conduction a business valuation. Then it is preferable (and ideal) to analyse the source(s) of this increased value objectively by modelling the cash flows.

Nevertheless, valuation practitioners often calculate a value in the standard way (DCF or a multiples) and then adjust the resulting valuation for a controlling stake.

So there would be a “control premium” when a strategic controlling stake is valued giving access to synergies. And there would be a “minority discount” when a minority stake is being valued.

Concerning the typical premiums paid in the market when investors acquire control, this can be as high as 40% above the value of a minority stake.

And with a minority stake, very rough guidance on the discount is in between 10% and 15%.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Benefits of control depend on minority shareholder rights

To adjust the effects of a minority stake in a privately held company it is necessary to understand what rights the shareholder enjoys.

The most important factors that affect the discount for lack of control are:

-Election of directors;

-Ability to select management;

-Control over dividend policy;

-Ability to establish compensation and benefits;

-Ability to set corporate strategies;

-Ability to acquire or liquidate the assets;

-Control to compel the sale of the company;

-Ability to liquidate, dissolve, or recapitalize the company;

-Establish buy/ sell agreements;

-Revise the articles of incorporation and bylaws;

-Restrictions on an initial public offering;

-Ability to affect future earnings;

-Control efforts for growth potential.

And as always, the best approach is to understand the implications of the size and structure of the shareholding agreements on the cash flows between shareholders!

At last, when there are benefits of controlling a company it should boost the entire value of a company (EV). However, the evidence on the size of the control premium (or minority discount) is based on equity values, so in general the control premium (or minority discount) is based on equity values.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Next article

In my next article I will talk about “discounts for small companies”!

Sources used for this blog

·       The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer. 9780273688747.

This book is fantastic and very practical, just a pleasure to read for every investment professional. Highly recommended! ??

Earlier blogs on the “cost of capital”

Article 1: Valuation & Betas (CAPM)

https://www.dhirubhai.net/pulse/valuation-betas-capm-joris-kersten-msc-bsc-rab/

Article 2: Valuation & Equity Market Risk Premium (CAPM)

https://www.dhirubhai.net/pulse/valuation-equity-market-risk-premium-capm-joris-kersten-msc-bsc-rab/

Article 3: Is the Capital Asset Pricing Model dead ? (CAPM)

https://www.dhirubhai.net/pulse/capital-asset-pricing-model-dead-capm-joris-kersten-msc-bsc-rab/

Article 4: Valuation & the cost of debt (WACC)

https://www.dhirubhai.net/pulse/valuation-cost-debt-wacc-joris-kersten-msc-bsc-rab/

Article 5: Valuation & Capital Structure (WACC)

https://www.dhirubhai.net/pulse/valuation-capital-structure-wacc-joris-kersten-msc-bsc-rab/

Article 6: International WACC & Country Risk – Part 1

https://www.dhirubhai.net/pulse/valuation-international-wacc-country-risk-part-1-joris/

Article 7: International WACC – Part 2

https://www.dhirubhai.net/pulse/valuation-international-wacc-part-2-joris-kersten-msc-bsc-rab/

Article 8: Present Values, Real Options, the Dot.com Bubble

https://www.dhirubhai.net/pulse/valuation-present-values-real-options-dotcom-bubble-joris/

Article 9: Valuation: Different DCF & WACC techniques

https://www.dhirubhai.net/pulse/valuation-different-dcf-wacc-techniques-joris-kersten-msc-bsc-rab/

Article 10: Valuation of a company abroad

https://www.dhirubhai.net/pulse/valuation-company-abroad-joris-kersten-msc-bsc-rab/

Earlier blogs on “Business valuation to Enterprise Value”

From June until August I have written the following blogs on valuation:

1)    Leveraged Buyout (LBO) Analysis:

https://www.dhirubhai.net/pulse/leveraged-buyouts-lbos-joris-kersten-msc-bsc-rab/

2)    M&A Analysis – Accretion/ Dilution:

https://www.dhirubhai.net/pulse/ma-model-accretion-dilution-joris-kersten-msc-bsc-rab/

3)    Discounted Cash Flow Valuation:

https://www.dhirubhai.net/pulse/discounted-cash-flow-valuation-dcf-joris-kersten-msc-bsc-rab/

4)    Valuation Multiples 1 – Comparable Companies Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-1-comparable-companies-analysis-joris

5)    Excel Shortcuts & Business Valuation:

https://www.dhirubhai.net/pulse/excel-shortcuts-business-valuation-joris-kersten-msc-bsc-rab

6)    Valuation Multiples 2 – Precedent Transaction Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-2-precedent-transaction-kersten-msc-bsc-rab

Earlier blogs on Wall Street

Article 1: Wall Street – A general introduction

https://www.dhirubhai.net/pulse/wall-street-general-introduction-joris-kersten-msc-bsc-rab/

Article 2: Wall Street – The Federal Reserve banking system

https://www.dhirubhai.net/pulse/wall-street-federal-reserve-banking-system-kersten-msc-bsc-rab/

Earlier blogs on Financial Modelling

Scoping a financial model built primarily for business valuation:

https://www.dhirubhai.net/pulse/scoping-financial-model-built-primarily-business-joris/

Training agenda Joris Kersten:

• Financial Modelling in Excel (5 days): 2, 3, 4, 5, 6 February 2020. Location: Riyadh/ Saudi Arabia;
• Business Valuation & Deal Structuring (6 days): 18, 19, 20, 21 and 23, 24 March 2020. Location: Uden/ The Netherlands;
• Financial Modelling in Excel (4 days): 20, 21, 22, 23 April 2020. Location: Uden/ The Netherlands;
• Business Valuation & Deal Structuring (5 days): 22, 23, 24, 25, 26 June 2020. Location: New York City/ United States.
• Business Valuation & Deal Structuring (5 days): 21, 22, 23, 24, 25 July 2020. Location: Dubai/ United Arab Emirates.
• Business Valuation & Deal Structuring (5 days): 3, 4, 5, 6, 7 August 2020. Location: Mumbai/ India.
• Business Valuation & Deal Structuring (6 days): 28, 29, 30, 31 October 2020 + 2, 3 November 2020. Location: Amsterdam/ The Netherlands.
• Financial Modelling in Excel (4 days): 16, 17, 18, 19 November 2020. Location: Amsterdam/ The Netherlands.

All info on these open training sessions can be found on: www.joriskersten.nl  

And 130 references on my training sessions can be found on: www.joriskersten.nl  

The “Business Valuation & Deal Structuring” course @ 18, 19, 20, 21 and 23, 24 March 2020 in Uden/ The Netherlands has a 1.000 euro early bird discount when you book before 31st January 2020. Price is then 2.900 euro ex vat instead of 3.900 euro ex vat. (when max of 20 participants has not yet been reached).