Share valuation is an important factor when calculating taxation liabilities. Trevor Slack argues against control premiums when valuing shares and businesses.
As published on 16 January 2019 in Taxation https://www.taxation.co.uk/Articles/2019-01-15-339098-control-premiums-when-valuing-business-and-shareholdings
The use and misuse of control premiums in fiscal valuations was covered deftly in Andrew Strickland’s article, ‘Time to change the music’ (see Taxation, 30 January 2014, page 8)). However, there still seems to be a stark divide in the valuation community, HMRC and the courts over this issue.
For unquoted shares, the guidance from HMRC (tinyurl. com/jhmee6p) is that it will consider whether ‘the holding… would give control of a company’. Indeed, the department has a propensity to do so in the inheritance tax and capital gains tax (and gifting) arenas. For inheritance tax (forms IHT205 and ITH400), there are separate places for declaring controlling and non-controlling shareholdings, implying that HMRC views them differently (tinyurl.com/ybfb4p5q). In Marks v HMRC (TC1086), the parties’ experts both agreed a 30% control premium was appropriate and the First-tier Tribunal agreed.
In Foulser v HMRC (TC4413), capital gains tax was levied on the value of a gift of shares when a 40% control premium was argued for, and 35% was given by the First-tier Tribunal. In Netley v HMRC (TC5904), another gifting case, the First-tier
Tribunal noted that if the value of a 100% interest is represented, it ‘therefore commands a premium compared to the valuation of a minority interest’.
To put another brick in the wall against control premiums, this article considers the legal context and structure of corporate control, and how that affects the basis of a control premium.
● The arguments for including a control premium when valuing shares are usually flawed.
● Control premiums from public company studies should not be inferred to private companies.
● Most companies are managed optimally, at least most of the time.
● Corporate governance theory and the exercise of control.
● Shareholders own shares, not corporate assets.
● Institutional frameworks affect the value of control.
● Without proof to the contrary, the addition of a control premium should be the exception rather than the rule.
The market value of a private company is based often on the share prices of public companies. Usually, however, no individual shareholder controls a public company, so a control premium may be added to arrive at the value of a 100% stake in such a business. Based on observed premiums in takeovers and/or voting rights studies, the average control premium is about 30%.
However, the case for the automatic addition of a control premium is wafer thin. One of the most important reasons is that a control premium is an outcome of a valuation, not a determinant of value. To explain why, perhaps we should first recap some of the benefits of control and how they are measured. We then go back to the origins of companies and the sources of control. From there, we look at how public companies are structured and some of the theories about how they are managed. Against this backdrop, we discuss why there should be a reluctance to robotically add control premiums in business valuations.
Benefits of control
The market capitalisation of a public company is the product of, first, the price at which small parcels of shares are traded and, second, the issued capital. When a public company is the subject of a takeover, the offer price per share may be, and often is, higher than the market price of the shares. Often, this price difference is seen as the value of control.
Such a premium may be paid when the buyer is able to increase value by interventions such as:
● Changing management, strategy and/or tactics;
● Addressing operational or financial inefficiencies;
● Direct access to cash flows; and
● Tax planning.
Through such actions and options, control can pave the way for optimum business value to be realised. Thus, a control premium is said to bridge the gap between optimum value and the ‘status quo’ value of a target company.
There are two main approaches to establish a market-based control premium:
● Takeovers; and
● Voting rights shares.
When a quoted company is taken over, it reveals the shares’ worth to the buyer over the quoted price. A sample of takeover studies found average premiums of between 14% and 35%.
Three points were also highlighted.
● Average excess returns of 20% to 30% when the takeover was announced.
● Control premiums of 9% in the 1960s, 35% in the 1970s, and 30% between 1980 and 1985.
● On average, corporate control is worth 14% of the equity value of a firm, ranging from 4% in Japan to more than 65% in Brazil.
A critical aspect of takeover studies is that a wide range of premiums goes into these average figures. Further, the studies can cover long timespans and many industries.
This makes it difficult to infer that the average reflects or is relevant to a given company in a specific industry at a particular point in time.
From a statistical stance, a small sample with a big standard deviation does not let us infer much beyond the very little.
Isolation of voting rights shares
The second approach uses the price difference between two classes of a public company’s shares that have the same, or similar economic rights. However, one class of shares has voting rights and the other does not. The value of control can be inferred if there is a price premium for shares with voting rights.
Examples from studies based on different voting rights show that:
● The average premium for the voting stock is 3.79%; and
● Voting stock traded at an average premium of 7%.
But the relevance of voting rights studies to control value can be hard to see. This is because most business valuations involve shares that already have voting rights and, by definition, control value should already be embedded. Thus, adding a control premium to the price of a voting share would be double counting at the least. At worst, it is doubtful that control is being observed and measured in such studies. A voting right is one of the checks and balances between the agents and shareholders of a public company. When voting rights are not given, it is the loss of a check and balance that is being priced, not the loss of control, which arguably was not there in the first place.
Origins of companies
The idea of a company can be tracked back to ancient Rome in the forms of corpus, collegia and publicani. These bodies were formed to serve society at large, including subcontracting government tasks. From these roots, the company became a legally separate entity that carried on a business and acted like an individual. However, a key difference between company owners and individuals is that the liability of the former is limited if the risks do not pay off, whereas the latter suffer the full consequences.
In the marketplace, resources are moved between buyers and sellers by way of the price mechanism. However, to make their products, most companies will move their resources by a command-and-control structure. In doing so, they can be seen to do business through a ‘nexus of contracts’, either explicit or implicit. It is through this web of connections that capital providers, employees, customers, suppliers, government and society at large interact with companies.
The nexus of contracts itself has a nexus in the company board. Line managers derive their authority from their ability to enter into contracts, but their authority comes from, and vests in, the board. As we will see next, this vesting is needed for public companies to work efficiently.
Sources of control
Public companies have many shareholders, most with small holdings, and this sets them apart from private companies. Further, most of what these investors know about public companies can be limited to public information. It therefore seems a big ask of shareholders to bring deep insight into public company decision making.
This makes it difficult, if not impossible, for a public company to twin a good decision-making process with shareholder consensus.
Thus, there is a structural disconnect between a public company’s ownership and its control. This means specialist managers are brought in to use efficiently a public company’s resources for its activities. The managers provide their time and skill to earn salaries and benefits. The capital providers bear risk in exchange for the returns on the activities. Control arises from how these two groups engage with each other.
Indeed, it seems a catch-22 to argue that shareholders could:
● Oversee and/or approve management decisions; but
● Still be the ones to bring management to account when things go wrong.
Corporate governance theory
There has been much debate, particularly in the US, on how corporate governance is organised and delivered. Three of the main theories are:
● Shareholder primacy;
● Managerialism; and
● Director primacy.
These are discussed below.
Shareholder primacy argues that shareholders own and control a public company, with the board’s actions being just a fringe benefit. However, a public company is a separate legal entity and its shareholders do not conduct its business or own its assets. Legally, shareholders are the last in line after all other claims have been met.
At best, they have only a limited range of transactions put to them for approval. So, even at a basic level, public company shareholders are not the prime movers of corporate activity.
Managerialism argues that top management controls the company and, largely, is free to carry out their pet projects. This leaves the board as figureheads and shareholders as small beer. However, this model is inconsistent with the fact that when there is a conflict between the chief executive officer (CEO) and the board, it is the latter which prevails as a matter of law. This is also the case in many non-Western countries. So, even if it might not happen in practice, this legal position is still the baseline for control.
Director primacy argues that, ultimately, the board rather than the shareholders and management controls the corporation. Director primacy agrees with shareholder primacy in that shareholders benefit from the board’s actions and duties, but it should not be seen as fringe. Even if it is delegated, it is the board that hires the factors of production, namely capital, material and labour. At a company’s inception, at least one director must be responsible for the company and be authorised to do business. This can happen without any significant share capital or factors of production.
At the other end of the scale – consider any global giant – it is the CEO and the board who are held out as the leaders, and who receive the glory for success or the blame for failure. It is difficult to think of examples in which an investor is portrayed in this manner, even active ones such as the US financier Carl Icahn. So, the board is accountable for shareholder wealth maximisation, and controls how it is delivered. Thus, thanks to the insights of law professor Stephen Bainbridge, director primacy appears to be the model that best describes how corporate control works, both functionally and legally.
The implication for control premiums is that it is the directors who operate the business, not the investors. At best, shareholders can be asked to approve the big deals. And although investor capital is put at risk in acquisitions, that is what investors sign up for.
Although a buyer can bypass a target’s board during an acquisition, the target’s board will usually make a recommendation to the shareholders whether to approve it, or not. Thus, in practice, deal prices are not established by investors, but by their agents – the board.
Although the acquisition of a public company often has a premium to the quoted price, it is not always so. There are many instances of deals at the quoted price, or even at discounts to it. To quote US business magnate Warren Buffett: ‘The banker’s focus will be on describing “customary” premiums-to-market price that are currently being paid for acquisitions – an absolutely asinine way to evaluate the attractiveness of an acquisition…’
The good, the bad and the average
An important aspect of control premium studies is that the public companies that are typically taken over are the subpar performers. This is because buyers are more likely to act on real differences between status quo value and optimal value. This creates a risk of inferring subpar performance biases in the studies on to companies that are performing well.
In the UK, there are about 2,000 public companies and more than three million private ones. However, the number of public company takeovers each year is only a few hundred. This seems thin ground for making general inferences about the value of millions of private companies. This is especially so if the takeover sample contains mostly subpar companies, with poor cash flows. Also in the mix could be top performers that have been acquired because of their distinguishing strengths. However, the top performers may have been bought for buyer-specific reasons that cannot be generalised. To say it all averages out is just too big a call.
Another latent aspect of control premium studies is that the share prices of buyers often fall after an acquisition announcement – the so called ‘winner’s curse’. This is more likely to be the case when the takeover is friendly rather than hostile. If a buyer offers a premium to a friendly target but the buyer’s share price falls, it signals that investors think they are overpaying.
There can be many factors in a takeover that do not lend themselves to generalisation but which can lead to a premium being paid. These include factors such as:
● Distress (such as a pressured buyout of a superior competitor);
● Repurposing assets for different products or markets;
● Unequal negotiation strengths;
● The CEO’s ego.
All these factors should be seen as separate to the value increasing actions listed earlier. When a deal has unique factors, isolating the value of pure control seems infeasible. And sure, the definition of control could be extended to include any factor that takes the takeover price above the quoted price. However, it would be impractical to relate how much of each factor is present in study averages and the company being valued.
The case for a control premium is also driven by the assumptions of the valuation method used. The discounted cash flow (DCF) method turns on whether optimal cash flows are used. If they are, a premium should not be added.
However, a control premium could be considered if suboptimal cash flows are used. If they are, it assumes that the status quo is subpar. It also means that the valuer already knows how much better the company could be run. This raises the question: why resort to control premiums if optimal cash flows are known?
Another reason not to automatically add a control premium is to avoid circular reasoning – also known as the ‘Nath hypothesis’. This posits that, if more value could be obtained from public companies with a change of control, they should all be taken over. This leads to the illogical conclusion that soon there would be no more public companies left because they would all be taken over.
The fact that public companies have not all been taken over leads to an argument that liquid stock markets offset the lack of shareholder control. It is on this basis that illiquidity discounts can offset control premiums in private company valuations. In
Netley, the First-tier Tribunal considered that ‘such an approach involves too broad a brush’.
However, if shareholders vote with their feet over subpar performance, it should lead to a new, lower share price. This lower share price could make a public company ripe for takeover when buyers are available to address the subpar performance. How much of a control premium such buyers would pay for the privilege is another thing, and in any event its very existence will not be proven until a takeover happens.
Private benefits of control
Private benefits are a diversion of corporate resources for the improper gain of specific individuals. Sometimes, buyers of controlling stakes might pay a premium to obtain private benefits. By design, the effects of such benefits on the value of a company are unobservable. However, whether these will be on offer is driven by institutional frameworks, which include the:
● Relative development of the capital markets;
● Level of legal rights and regulatory controls;
● Special interest groups (such as labour unions); and
● National culture.
The price of such a control premium should therefore fall as investor and stakeholder protection rises. Thus, if there are any private benefits of control to be had in developed economies, they should be only a small portion of corporate value. This makes it a brave call to add a control premium based on private benefits when valuing companies in developed markets.
Public versus private company divide
For a public company there is a clear separation of ownership and control. This article argues that control does not reside with the shareholders of a public company. Accordingly, observations of share price differences in takeovers are not measures of control premiums, but are of other factors that should not be generalised.
In contrast, however, ownership and control are often equivalent in private companies where they are both held by the same individual/s or related groups. There is then at least a basis for applying control premiums in the context of a private company.
However, having a necessary condition does not make it sufficient. First, this is because no control premium data emerges from private company transactions. Second, the structural differences between public and private companies mean the inference bridge is broken.
Control premiums in valuation seems to be a conflated concept. Corporate control lies with the board of directors, while ownership rights lie with investors. In private companies, ownership and control are often one and the same and, while aligned, they are still separate. But in public companies investors need agents for efficiency. However, in no way does agency imply that public companies tend to underperform and are always in need of new owners to come in and fix them. If anything, having an agent means that public company investors do not actually want control, and this makes it hard to accept they like paying for it in a takeover.
Thus, the market for control rests with directors, so control premium arguments should focus on directors’ behaviour and motives, not investors’.
Even if the agency bridge can be crossed, using the averages observed in takeover and voting rights studies seems a woolly way to value control. At the least, this is due to problems with small sample sizes containing wide ranges of premiums across time and industry. The concerns are compounded by a mix of biases, winners’ curses and factors unique in buyers that do not carry well into generalisations.
To assume that public companies and private companies all harbour untapped control value seems misplaced. The default position should be that ‘number of shares times price’ equals the market value of a public company’s equity. Although there might be a basis for applying a control premium for private companies, the means for proper observation and measurement is missing. Adding a control premium as a matter of practice seems unsupported. Unless there is clear proof to the contrary, such an addition should be the exception rather than the rule.