Discounts and Premiums: Artistic Licence and Science

• Author: James L. Horvath & Tim Dunham
• Pages: 667-686

667

Chapter 24

Discounts and Premiums:

Artistic Licence and Science

james l. horvath & tim dunham

A. INTRODUCT ION

Valuators frequently have to make signif‌icant discount or premium adjust-

ments to rateable value when analyzing a subject shareholding of a specif‌ic

size such that it differs from the level of value targeted in the underlying

methodology.

A per-share value derived from an overall enterprise value and intended

to represent the va lue of a minority position may require one or more dis-

counts to ref‌lect additional investment risk. Although a methodology ap-

plied to value a company as a whole may effectively estimate the value of the

total company, it is not necessarily indicative of the value of smaller share-

holdings on a pro rata basis — a 10 percent minority ownership interest may

or may not equal 10 percent of the en bloc fair market value of shareholders’

equity. As a result, t he valuator must adjust the specif‌ic shareholding via

discounts — where appropriate, in order to ref‌lect any additional risk accru-

ing to the investment.

Per-share values resulting from a methodology involving minority posi-

tions may require a specif‌ic premium adjustment if t hey a re intended to

ref‌lect the value of a larger controlling block or of the entire company. If a

valuator uses a publicly-traded stock price in h is methodology as indicative

of the value of a sing le share, he cannot necessarily calculate the value of

the entire company just by multiplying that f‌igure by the total sha res out-

standing — if the value of a publicly-traded share is $10, and the company

has 1 million shares outstanding, it may or may not have a $10-million total

668 james l. horvath & tim dunham

en bloc value. The valuator will have to apply additional premiums, where

appropriate, to the initial price or calculation.

The most common discount or premium adjustments made to a specif‌ic

shareholding, or that impact the value of a particular interest in a business

include the following:

control premiums; •

minority discounts; •

minority interest premiums;•

marketability and liquidity discounts;•

key-person discount; •

blockage discount;•

restricted stock discount, and •

portfolio discount.•

B. CONTROL PREMIUMS

In the case of a corporation, there are generally two types of control. De jure

control, meaning control t hrough ownership of more than 50 percent of a

corporation’s voting shares, and de facto control, which refers to situations

where a shareholder controls the af fairs of a company t hrough ownership

of 50 percent or less of the voting shares. De facto control is typically evident

in the case of publicly-traded companies with widely held share ow nership

where the “majority” of the shareholders are passive investors and not or-

ganized in an effort to inf‌luence the management or business operations

of the entity.

Typically, the value of a controlling interest is equal to a rateable portion

of the intrinsic value of the corporation. Why rateable value? T he control-

ling shareholder ca n generally direct the utilization of the company’s re-

sources, the day-to-day operations of the business, the timing of investment

returns through dividends, mergers, and liquidating events, t he compos-

ition of the company’s f‌inancing, and in cases where management or other

services are provided, the disposition of cash f‌lows through remuneration

and other benef‌its. As a consequence, they are in a position to ensure t hat

their percentage claim on t he earnings and va lue of the company is secure

and will not be attr ibuted to some other shareholder v ia the above control-

ling mechanism.

In the majority of cases, a shareholder with, say, 51 percent of the vot-

ing shares is able to enjoy all the same benef‌its as a shareholder with a 100

percent interest — without having to put up the other 49 percent of the eq-

uity. The controlling shareholder in a situation such as this most typical ly

receives the applicable pro rata portion of the company’s “value.”