Application of Discounts to the Fair Value of Rollover Equity
A question Intrinsic often fields in completing valuations for financial reporting involving a controlling transaction is whether it is appropriate to apply discounts for lack of control (DLOC) or discounts for lack of marketability (DLOM) to rollover equity granted to the sellers. We find that in many cases neither are applicable, but this can vary based on the deal-specifics and the legal rights of the minority owners. Below are some factors that play into the need (or lack thereof) to apply each type of discount.
Discount for Lack of Marketability
To distill the concept, a DLOM is the difference in value between a liquid and illiquid business interest. As we most often see rollover in the context of a private equity transaction, where a controlling stake is not inherently more marketable than a minority stake, it does not make sense to discount the basis of rollover as less marketable than the stake owned by a PE fund. This is particularly true where there are tag along and drag along clauses and pari passu preference that allow a rollover holder to receive equal liquidity at the time of a PE exit. For this reason, we rarely see traditional DLOMs applied to rollover in our valuation engagements.
Discount for Lack of Control
A DLOC is often more interesting as it pertains to a typical private equity transaction. Rollover is structured as a minority interest with limited or no ability to influence corporate governance or strategy. Extensive research exists on the topic of how a minority stake might be worth less on a per share basis than that of a controlling shareholder with the ability to influence company decisions. Two pieces of guidance for valuation professionals caught our attention for their differences and ambiguity on the topic: Appraisal Foundation’s The Measurement and Application of Market Participant Acquisition Premiums and EY’s Business Combination (ASC 805) guide.
The Appraisal Foundation suggests that if economic benefits of new stewardship are instrumental to the pro-forma business being worth more to a new, controlling shareholder than under prior ownership, a control premium may be present. When a market participant buyer can i) substantially reduce the cost of capital and/or ii) achieve material synergies, then the business would be worth more post-acquisition. Either argument is hypothetical and requires careful consideration of not only the specific operations of buyer and seller but also other market participant acquirers for the business. The presence of synergies or lower cost of capital may indicate the need to apply a discount for lack of control to a minority stake, according to this literature.
Interestingly, the EY guidance suggests the existence of a premium paid per share in a majority acquisition does not necessarily mean a discount for lack of control is applicable to a minority interest. If the benefits of the new, lower cost of capital or synergies are shared amongst the majority and minority ownership groups, this indicates the presence of an acquisition premium. An acquisition premium does not require an application of a DLOC to determine the fair value of the rollover granted.
The conversation amongst investors, valuation professionals and accountants regarding appropriate discounts to rollover is picking up in light of recent publications, particularly that from the Appraisal Foundation. Intrinsic enjoys taking in the opinions of various thought leaders on the topic and using those to support our clients’ needs in financial reporting valuations.
Appraisal Foundation: https://appraisalfoundation.sharefile.com/share/view/sa5378ae8f7541ba9