We are valuing a control interest in a business that pays the control owner a salary. The salary is legitimate, because the control shareholder manages the business, but the company pays her at a quantified above-fair market rate.
How would you handle the valuation of the control interest? (This is only with respect to the excess salary; please ignore any other control considerations.)
- Apply a control premium.
- Increase cash flow to control (add back the excess salary).
- Do neither (no control premium, no add-back).
Also:
- Is there any other information you would need to help you decide what to do?
Please think about your answer and the reasons for it before you read further.
There are really two questions here:
- Should we adjust for control?
- If so, how?
I have found it extremely helpful to visualize control adjustments as the product of three factors:
- Power: the legal authority of the control owner to exercise the prerogative (in this case, to adjust her salary to fair market value)
- Benefit: the economic gain to the control owner (possibly at the expense of minority owners) from exercise of the prerogative
- Probability: the likelihood that the prerogative will be exercised, considering case facts and circumstances
A control owner might have no power to increase her salary if, for example, she is under contract to the company and the minority shareholders have the power to (dis)approve her salary. She might realize no benefit from a salary increase if, for example, the company is cash-flow negative and has no means to fund it. There might be no probability of her increasing her salary if, for example, she wants to sell the company and is thus inclined to maximize earnings and value by keeping it low.
The nice thing about the multiplicative formula is that if any of the three factors is zero, then the value of that control prerogative is also zero. Unfortunately, we cannot always quantify non-zero factors (especially the probability). But this really helps us focus on the factors that drive control value adjustments.
Note that the probability factor has a catch-all “considering facts and circumstances”. One of the big considerations is what the control shareholder intends to do. If it is represented to me that, for example, she is independently wealthy and in a high tax bracket, and for that reason will NOT want salary increases (hoping to reinvest money for capital growth), that is significant. On the other hand, this raises issues of investment versus fair market value, sometimes the line between them is fuzzy, and there can be legitimate differences of opinion.
Back to our example, question (A) is whether or not to adjust for control. In the vast majority of cases, I would do so based on the above information. If there are “facts and circumstances” that indicate otherwise, I would need to assess them. That answers question 4 above. In the three-factor model, the control owner has the legal power to reduce her salary, the benefit to her is quantifiable, and it is highly likely that she would do so (since capital gains are taxed at lower rates than salary income and the interest is to be sold).
Question (B) is how to do so. In this case, I would much prefer to adjust for control by adding back the excess salary. The benefit is known and quantified. This is much superior to guessing at a control premium. In most of my appraisals, I adjust cash flow rather than apply a control premium for this reason. I have specifics on my side.