Business Control Premiums: Apply with Caution

By: Joseph B. LaPray and William C. Herber

The American Society of Appraisers defines a control premium as, "The additional value inherent in the control interest as contrasted to a minority interest, that reflects its power of control."(Business Valuation Standard: Definitions, 1997). When a publicly traded company is bought out, the difference between the price per share before the announcement of the buy out and the price per share offered by the buyer of the company is considered the control premium or "acquisition premium". Historically appraisers generally have assumed the "acquisition premium" paid by buyers was for control in order to acquire the following powers:

• Control the policies of the company;
  
• Control the company's resource allocation;
  
• Appoint management and advisors;
  
• Determine management compensation and perquisites;
  
• Make business acquisitions and divestitures;
  
• Determine distributions to owners;
  
• Make asset acquisitions and divestitures;
  
• Register the corporation or partnership's securities for public offerings;
  
• Block any of the above actions.

Information on acquisitions of one company by another is gathered and reported in Mergerstat Review, a publication of the firm of Houlihan, Lokey, Howard and Zukin, familiar to all business appraisers. Several studies of data presented in Mergerstat Review have averaged premiums paid in purchases of companies whose stock is publicly traded. These averages are generally in the range of 30% to 40%. Unwary business analysts may take these averages and simply add 35% to the price per share of a publicly traded stock to determine a "controlling interest value per share". Using such a simplistic approach could result in a serious miscalculation of value.

Acquisition premiums are nothing more than a measurement of the differences between the acquisition price and the prior publicly traded price of the company being acquired. If an acquisition premium measures anything, it measures the net of many relevant factors which may or may not include control and liquidity. Additional factors which may drive acquisition premiums include: acquisition of undervalued or underutilized nonoperating assets, synergistic value, the lottery effect, wherein a company is acquired for a premium by a "greater fool" who pays more than the business is worth (one example is Quaker Oats' acquisition of Snapple), and failure of a company's management to communicate effectively to the stock market that the company is well run and that value is being maximized.

The performance of the market itself must also be considered. With stock prices as high as they have been for the past several years, it could be argued that there is no longer room for a control premium. Another school of thought is that whereas in the past a strategic acquirer may have paid a premium for the target company (in order to gain access to new markets, technologies or certain synergistic benefits), the advent of the information age has changed this. These benefits are now available for the public to discover and therefore, to some degree, they are built into the stock price. In other words, if an acquisition premium is to be applied in a specific case, there should be some reason supported by evidence in similar transactions observed in the marketplace. One example illustrating the above factors which are sometimes mistaken for a "control premium" is found in Woolworth Corporation's 1996 acquisition of Eastbay, Inc.

Eastbay, Inc. was a publicly traded company which marketed athletic footwear, apparel, equipment and licensed and private label products through catalogs. On November 29, 1996 the closing price for Eastbay's stock was $19 per share. On December 2, 1996 Woolworth Corp. announced that it had agreed to buy Eastbay for $24 per share, implying a "control premium" of 26.3% over the $19 pre-announcement price. However, one of the conceptual flaws of control premium studies is that each transaction is unique and many different factors may be at work in a specific acquisition. In the case of Eastbay, 57.9% of the company's shares were held by three individuals, two of whom were co-chairmen of the board and the third was chief executive officer and president. These three individuals together received annual remuneration of $1,069,726 or approximately .9% of the company's $117,639,000 annual sales for 1996. At $19 per share, Eastbay's price/earnings multiple was 12.3. Woolworth paid $24 per share or a price/earnings multiple of 15.6 for control of Eastbay. However, if Woolworth could fold Eastbay's operations into its existing businesses and eliminate the management compensation paid to Eastbay's executives, the price/earnings multiple Woolworth paid drops to 14, or a control premium of only 13.8%, little more than half of the 26.3% nominal premium. Woolworth could afford to pay a premium for control of Eastbay because after the purchase it could reduce management compensation and the savings would drop to the bottom line. Not all businesses offer such easy savings to potential buyers.

Another possible explanation for the premium Woolworth paid for Eastbay's stock is the outstanding growth record for Eastbay's business. Eastbay's five year compound annual sales growth rate was 30.6% and its compound annual rate of net income growth had been 44.5%. Sustaining this growth would require additional capital, and by acquiring the company Woolworth could provide this capital and realize the benefits of Eastbay's growth potential. In contrast, most businesses do not demonstrate the growth potential offered by Eastbay and therefore offer less reason for a buyer to pay an acquisition premium.

In some cases a company will pay an acquisition premium in order to develop strategic synergies with the operations of the acquired company. Eastbay had a mailing list of proven customers which would be difficult for a competitor to reproduce. This mailing list may have been regarded as an underutilized asset which Woolworth could develop in conjunction with some of its other businesses. Before an analyst calculates a "controlling interest value per share" by simply tacking on a 35% control premium, it is wise to consider if the company being valued has any underutilized assets which might attract a premium-paying buyer.

It is clear from the evidence that the acquisition premium involves factors other than "control". The simple fact of "control" contributes to a greater or lesser degree in each company's purchase. These other considerations can range from very quantifiable efficiencies (through owners compensation or duplication of services between companies), to less quantifiable synergies and other factors. Detailed, in-depth studies of individual transactions are necessary to determine whether or not valuation adjustments for control are necessary when appraising a business ownership interest based on comparison with public market data.

Business valuations are as unique as individuals: simply because one company's stock attracted an acquisition premium does not mean that another company's stock will also merit a premium. The most recent Houlihan, Lokey, Howard and Zukin Control Premium Study (3rd quarter 1998) indicated that 20 of the 58 domestic transactions reported sold at discounts rather than at premiums. This study reflects an overall mean premium of 10.3% and median premium of 10.9%; well below the 30%-40% cited in past studies. To make a convincing case for application of a control premium, an analyst or appraiser must stay abreast of market conditions and also look beneath the surface as opposed to routinely applying an average.

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