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Remember that great Wendy’s ad of 1984, which was also Walter Mondale’s presidential campaign quip? It also applies to business valuation, when we are considering discounts for lack of control and lack of marketability!
I was working with three equal one-third owners of a business. I had valued the business at $X and appraised a 40% combined discount (reflecting lack of control and lack of marketability). Therefore, each business owner’s individual interest was worth (33% X 60% =) 20% of $X. However, they were hung up on the fact that the sum total of their three individual interests was worth only 60% of $X, and one of them asked the captioned question, with a plaintive “where did the rest of the value go?”
This very understandable confusion arose because of the difference between enterprise and shareholder value, a fundamental concept underlying every appraisal. It depends on what interest is being valued and for what purpose.
Enterprise value – the value of the entire business – assumes that all of the shareholders act together and sell 100% of the equity to a third party; in effect, there is one unified block of all the shareholders, just as if there were only one of them. No valuation discounts apply here. The business would be sold for $X, and each 1/3 owner would receive gross proceeds of 33% of $X. Enterprise value is not affected by how ownership is divided; it is irrelevant because all of the interests are sold together in a tidy bundle.
Shareholder value – the value of a specific equity interest – assumes that only a certain (in this case, minority) interest is sold and the rest stay put. Valuation discounts apply to it. The minority interest holder cannot access his or her pro rata portion of enterprise value. Enterprise value did not “go away”; it was unchanged, and the minority seller gave up his or her chance to receive pro rata value because the others were not selling at the same time to the same party. In a minority interest sale, enterprise value is not on the table.
This is the reason I repeatedly urge multi-shareholder businesses to have buy-sell agreements. In the absence of agreement, when one owner wants out, the enterprise versus shareholder value issue rears its head and often leads to costly squabbles.
Every proper business appraisal should address the enterprise versus shareholder value issue at the very beginning, because of its significance (in this case, a big valuation discount).
Valuations play a part in all tax, transaction, and litigation matters. For additional information or advice on a current one, please do not hesitate to call.
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About Western Reserve Valuation Services LLC
Western Reserve Valuation Services LLC, based in Columbus, Ohio, is a leading provider of valuation services and financial opinions relating to corporate finance transactions, corporate tax planning and compliance, succession planning and wealth preservation, employee stock ownership plans (“ESOPs”), financial reporting and portfolio / fund valuations. For more information, visit www.wesresvaluation.com or call (614) 448-3700.
Western Reserve Valuation Services is an affiliate of Western Reserve Partners LLC, a FINRA-member investment banking firm offering financial advisory services relating to mergers and acquisitions, capital raising and financial restructuring. For more information on Western Reserve Partners, please www.wesrespartners.com or call (216) 589-0900.