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Implied Minority Discounts in Statutory Fair Value: The Doctrine That Just Won't Die

Authors:
  • Sutter Securities Financial Services, San Francisco

Abstract

This presentation discusses and critiques court decisions in Delaware that applied the now-rejected assumption that market prices of shares always include a minority discount.
© 2010, Business Valuation Resources, LLC
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TC-Questions@BVResources.com
Implied Minority Discounts in Statutory Fair
Value: The Doctrine That Just Won’t Die
Gilbert E. Matthews
MBA, CFA | Sutter Securities Incorporated
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Introduction
The points I will be discussing are:
Levels of value
The ambiguity of the phrase “control premiums”
The statistical bias in acquisition premium studies
Current views on IMD
How to test whether or not IMD exists in a given situation
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Control Premiums and Levels of Value
The “levels of value” model is familiar to valuation experts from
numerous articles and, particularly, from books by authors such as
Shannon Pratt and Chris Mercer.
The levels of value chart in Pratt’s Valuing a Business shows five
levels of value for publicly traded companies:
Synergistic (strategic) value
Value of control shares
Market value of freely traded minority shares
Value of restricted stock
Value of non-marketable shares
The latter two levels are not relevant in a Delaware appraisal because
marketability discounts are not permitted under Delaware law.
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Mercer’s Levels of Value
Mercer presents a revised levels of value diagram in his Integrated
Theory of Business Valuation that shows Marketable Minority Value
overlapping Financial Control Value.
SCP = Strategic Control Premium
FCV = Financial Control Value
FCP = Financial Control Premium
MID = Minority Interest Discount
MMV = Marketable Minority Value
Source: Z. Christopher Mercer and Travis W. Harms, Business
Valuation: An Integrated Theory, 2nd Edition (Wiley, 2007), p. 71.
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Mercer’s is a coherent and useful levels-of-value concept.
Strategic Control Value (“SCV”)= Pratt’s “synergistic value” =
the company’s value to a party that could achieve synergistic
benefits if it had control.
Financial Control Value (“FCV”) = value without anticipated
synergies, but including “the ability of a specific buyer to
improve the existing operations or run the target company
more efficiently.”
Marketable Minority Value (“MMV”) = Pratt’s market value of
freely traded minority shares.
.
Mercer Clarifies the Levels of Value
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Most Public Companies Trade at FCV
Mercer points out that public market prices may exceed Strategic
Control Value at a level he calls “Apparently Irrational.”
We have all seen numerous examples of this, such as the “dot.com”
bubble in the late 1990s.
Mercer says :
[U]nless there are cash flow-driven differences between the
enterprise’s financial control value and its marketable minority
value, there will be no (or very little) minority interest discount.
Since most public companies are not taken over,. . . the
marketable minority and financial control value of most public
companies approximate each other.”
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What Level of Value Is Used in a Delaware
Appraisal?
Under Delaware case law, a company must be appraised on an
“as-is” basis – as a going concern based on the way it is being
managed at the time of the valuation – a concept called “operative
reality.”
Hamermesh & Wachter call it “warts and diamonds.”
Going-concern value based on operative reality does not include
potential benefits such as cost savings that an acquirer may
achieve, such as eliminating the costs of being a public company,
reducing excessive management compensation, or running the
business differently.
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Delaware Appraisal Value Should Be Marketable
Minority Value
Delaware appraisal value (going-concern value) generally should
equal MMV.
Where there are any potential cost savings available to an
acquiror, the going-concern value of the company being
appraised would be lower than FCV.
When market prices are depressed and shares trade below their
going-concern value, then the going-concern value of a company
under Delaware appraisal law would be higher than MMV.
When the Court calculates going-concern value based on “warts
and diamonds,” it arrives at MMV.
The company is valued as a going concern as it is being run by
existing management.
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Adding IMD Changes the Level of Value
The guideline company method calculates MMV.
When the Court decides to adjust for IMD, the Court attempts to
exclude synergies and then determines the IMD by reference to
testimony as to premiums paid in acquisitions.
By adding IMD to MMV, the Court arrives at FCV, which includes
cost savings that a financial acquirer may achieve.
Thus, the Court’s going-concern DCF valuations arrive at a different
level of value than its guideline company valuations adjusted for IMD.
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Multiple Meanings of “Control Premium”
Courts have used “control premium” with 3 different meanings.
Meaning #1: FCP = difference between FCV and MMV = the inverse
of minority interest discount.
Meaning #2: SCP = difference between SCV and FCV.
The use of SCV is impermissible in a Delaware appraisal
(except, inexplicably, in valuing subsidiaries of holding
companies).
Meaning #3: the difference between acquisition price (SCV when
SCV>FCV) and MMV, which is the sum of Meanings #1 and #2. This
is the observable number measured in control premium studies.
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Clarifying Meanings of “Control Premium”
It would be helpful if the Court, authors, and expert witnesses shared a
common language based on a commonly-shared conceptualization.
The “control premium” ambiguity could be avoided if experts
used the levels-of-value model and the financial community’s
newer, more precise terminology.
Clear testimony could help the Court in at least two ways:
Distinguishing between FCP and SCP by using the word
“Strategic” or “Financial” as appropriate, rather than just
“Control Premium.”
Using the phrase “Acquisition Premium” to describe Meaning
#3: the difference between acquisition price and MMV.
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“Acquisition Premium”
The premium used in control premium studies is the Acquisition
Premium, i.e., the difference between acquisition price paid and MMV .
As noted earlier, the acquisition premium is the only premium that
is directly observable in the market.
Acquisition price is usually SCV, but it equals FCV when SCP = 0.
Since the SCP must be excluded in a Delaware appraisal, it
becomes necessary for experts and the Court to estimate (or
speculate) as to the unallowable portion of an Acquisition
Premium attributable to synergies (the SCP).
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Average Premiums Are Not Meaningful
Average premiums paid in acquisitions are not useful to the Court.
Average premiums paid in acquisitions are statistically biased,
because data used in calculating average acquisition premiums
includes a substantial built-in upward bias.
These premiums are computed in relation to target companies’
market prices prior to announcement of the relevant transaction.
The databases consist primarily of those companies which
acquirers believe to be worth more than market price.
Thus the universe of guideline transactions includes companies
which were undervalued in the market but necessarily excludes
companies that acquirers consider overvalued.
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The Fallacy of Average Premiums
Thousands of companies are publicly traded, but only a small portion of
them are acquired in any specific year.
Professor Bradford Cornell wrote in 1993:
The fact that most companies do not receive takeover bids at
premiums above market price indicates investors believe that the
shares of those companies are not worth significantly more than
market price [emphasis in original].
Professor Richard Booth wrote in 2001:
[I]t is not necessarily the case that actual market price is always
less than fair market price. If it were, then there would be no
such thing as a fair market price.
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The Courts Have Relied on Flawed Data
The Chancery Court’s belief that guideline companies suffer from an
IMD, as well as the Court’s quantifications of IMDs, have generally
been based on expert testimony as to average acquisition premiums.
The Court, therefore, has relied on data that is seriously flawed
and statistically unreliable.
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Investment Bankers Misuse Average
Acquisition Premiums in Fairness Opinions
The Courts have been further misled by the fact that many investment
bankers include average acquisition premiums as one of several
measures in arriving at fairness opinions, even though the method is
not statistically valid.
The use of average acquisition premiums as a measure of value has
been mistakenly accepted by many in the financial community.
My review of all published fairness opinions in cash acquisitions during
the 12 months from September 2007 through August 2008 (179
fairness opinions in 160 transactions) shows that just over half (90) of
the fairness opinions used average premiums paid as a standard of
fairness!
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Experienced Firms Seem Less Likely to Use
Average Premiums in Fairness Opinions
This widespread use by investment bankers of the premiums paid
method gives a façade of respectability to the reliance on average
acquisition premiums.
However, the more fairness opinions a firm issued in the 12-month
period reviewed, the less likely they were to use a premiums paid
analysis. The premiums paid method was used by:
78% of 40 firms issuing one fairness opinion
68% of fairness opinions by firms issuing 2 to 4 opinions
25% of fairness opinions by firms issuing 5 or more opinions
In my view, this is evidence that the firms with the most experience in
fairness opinions seem to be less likely to use the unsound premiums
paid method.
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Valuation Experts’ Views of IMD
The presumption of an IMD was first questioned by Eric Nath in a 1990
Business Valuation Review article.
Nath posited that the freely traded market prices of a company already
had incorporated the company’s financial control positives or negatives
and thus reflected control value.
His theory stimulated a great deal of debate and was generally
opposed in the 1990s. But the position of other commentators
gradually shifted, and Nath’s position is now widely accepted.
Pratt implicitly agreed with Nath in Business Valuation Update in 1999:
Valuation analysts who use the guideline public-company
valuation method and then automatically tack on a percentage
“control premium’” . . . had better reconsider their methodology.
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Mark Lee’s Valuable Insights
Mark Lee wrote in Business Valuation Update in 2001:
If there is no M&A market available to sell a company at a
premium to its stock market value, then there is little or no
acquisition premium, much less a “theoretical” premium based on
an average of acquisitions of dissimilar companies.
Lee pointed out, “Factors influencing the stock market often do not
coincide with those affecting the M&A market.”
He illustrated the fact with a diagram (on the next slide) showing that
the stock market and the M&A market are separate markets, albeit with
some overlap.
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Mark Lee’s Diagram
Acquisition Value
Exceeds Market Value
If A Buyer Exists
______________________
Acquisition Value
Equals Market
Value
______________________
Acquisition Value
Is Less than
Market Value
M&A Market
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The Diagram If All Market Prices Included
IMD
If all market prices included IMD, then the M&A market in Lee’s
diagram would hover over the market like the dot on an “i” instead
of overlapping it.
M&A
Public
market
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Mark Lee’s Valuable Insights continued
Lee further wrote in 2004 that “the acquisition value of a company may
be equal to or below its market value,” explaining:
While a company may be viewed as very attractive to a
purchaser of a minority interest in the public market, the company
as a whole may be perceived as too risky at its publicly traded
market price.
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IMD Is No Longer Accepted by Valuation
Experts
In addition to Nath, Hamermesh & Wachter, Pratt, Lee, and me, others
have expressed their views that publicly traded shares usually do not
include IMD.
Mercer in his 2004 book discussed his past disagreement with Nath.
He wrote that he has changed his view and now concurs with Nath.
Philip Clements and Philip Wisler wrote in their book Fairness
Opinions in 2005:
The control value of a company may not differ greatly [from] and
may even be below its publicly traded minority share value.
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The Courts Have Relied Upon Authors Who
No Longer Support IMD
In accepting IMD, the Delaware courts were following Weinberger’s
injunction to make their valuations in accordance with accepted
financial practice.
When Pratt wrote in 1996 that the guideline company method “usually
requires some adjustment from the publicly traded minority stock value
equivalent to account for control,” that was the then-accepted view of
the financial community.
In contrast, Pratt’s 4th Edition of Valuing a Business (2000) included
his 1999 BVU comment that warned analysts not to automatically add
percentage control premium to guideline company valuations.
However, some of the IMD decisions since 2000 have cited experts’
older books containing positions that the authors had modified in later
books before those decisions were rendered.
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The Courts Have Relied Upon Authors Who
No Longer Support IMD continued
In Agranoff (2001), for example, the Court cited Pratt’s 1996
view. The Court in 2001 was apparently was not aware of Pratt’s
changed view.
Pratt further clarified his revised position in Business Valuation
Discounts and Premiums (2001). After an extensive discussion of
various articles and seminars regarding the issue of whether market
prices reflect control value, Pratt quoted Lee’s 2001 article and
concluded,
In any case, it is obvious that, given the current state of the
debate, one must be extremely cautious about applying a control
premium to public market values to determine a control level of
value.
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Valuation Experts No Longer Support IMD
Mercer’s 1st edition of The Integrated Theory of Business Valuation
in 2004 presented the modified levels-of-value diagram that showed
MMV overlapping FCV.
Thus, although earlier Pratt and Mercer citations supported pre-1999
decisions regarding IMD, since then neither has held that publicly
traded shares customarily include implied minority discounts.
Nonetheless, the Court, in its 2005 Andaloro decision, continued
to cite Pratt’s 1996 thinking in support of an IMD adjustment. Yet
the Vice Chancellor cited Pratt’s 4th Edition (2000) in the same
decision when discussing discounted cash flow!
Most leading valuation experts now concur that market prices of
actively traded shares usually do not include IMD.
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IMD Should Not Be Imputed Unless There Is
Evidence to the Contrary
The default assumption should be that no IMD should be imputed
unless there is specific data that indicates otherwise.
Without evidence that the prices of guideline companies
include minority discounts, there is no reason to adjust for IMD.
However, because the market is sometimes inefficient, IMDs
may arise.
The analyst must make a decision in any guideline company
analysis whether or not an IMD is applicable.
When applicable, an IMD must be quantified based on an
appropriate analysis.
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How to Test for IMD and, If Appropriate,
Quantify It
In determining whether IMDs are present, the valuation expert must
consider the relation between market multiples and transaction
multiples.
1. If there are no recent guideline transactions, market prices of
guideline companies are probably not at levels that are
attractive to acquirers, making IMD moot.
2. Quantify an IMD (if any) by comparing the average multiples of
guideline companies with average multiples of guideline
transactions.
3. If available, examine data for relevant transactions in which
large minority interests are acquired.
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How to Test for IMD and, If Appropriate,
Quantify It continued
4. Estimate the adjustments to be made to multiples of guideline
transactions to eliminate any synergistic benefits excludable in a
Delaware appraisal.
5. An example of a transaction with evidence of synergies is a
merger of competitors or related businesses.
6. An example of a transaction with little evidence of synergies is a
purchase by a financial buyer who does not own a competitor or
related business.
7. Adjustments are required for transactions that were priced at
earlier dates under different market conditions.
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Addendum:
Overvaluation of Subsidiaries
The use of a Strategic Control Premium is impermissible in a Delaware
appraisal except, inexplicably, in valuing subsidiaries of holding
companies.
In three cases in the 1990’s, the Court permitted acquisition premiums
to be added in valuing subsidiaries of holding companies.
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Addendum:
Overvaluation of Subsidiaries
The use of a Strategic Control Premium is impermissible in a Delaware
appraisal except, inexplicably, in valuing subsidiaries of holding
companies.
In three cases in the 1990’s, the Court permitted acquisition premiums
to be added in valuing subsidiaries of holding companies.
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Harris v. Rapid American Corp. (1992)
The Chancery Court valued each subsidiary based solely on
guideline companies.
The Delaware Supreme Court concluded that the Chancery Court
had effectively “treated Rapid as a minority shareholder in its wholly-
owned subsidiaries” because market prices of guideline companies
“do not reflect a control premium.”
The Supreme Court reasoned was that the inherent value of the
parent holding company included control value of its 100%-owned
subsidiaries.
On remand, Chancery Court applied “control premiums” to the three
subsidiaries that were the average premiums paid in acquisitions in
the subsidiaries’ respective industries, i.e., acquisition premiums.
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LeBeau v. M.G. Bancorporation (1998)
M.G. Bancorp was a bank holding company with two bank subsidiaries.
The Court of Chancery, following Rapid American, added a control
premium to the guideline company valuation.
I wrote in BVU in 1998:
This reasoning leads to the absurd conclusion that a business
conducted through a subsidiary is entitled to a control
premium, but an identical business conducted through a
division is not! The application of a control premium at a
subsidiary level, when such premium is not permitted at the
parent level, is an anomaly that is difficult to justify. [Emphasis
added]
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Hintmann v. Fred Weber, Inc. (1998)
An acquisition premium applied in Hintmann to a single operating
subsidiary.
I wrote in BVU in 1998:
If [Weber] Industries had not been a holding company, but had
owned FWI as a division, Rapid-American would not have
applied and there would have been no control premium added.
This elevates form over substance.
Hintmann is unique in applying IMD to a DCF valuation. Few, if any,
experts would consider it proper to add a control premium to a DCF
calculation.
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Adding a Control Premium to a Subsidiary’s
Value Seems to be Contrary to the Statute
In adding average acquisition premiums to the going-concern value
of subsidiaries, the courts effectively award a Strategic Control
Premium.
Using a Strategic Control Premium appears to be contrary to the
appraisal statute’s mandate that “the Court shall determine the fair
value of the shares exclusive of any element of value arising
from the accomplishment or expectation of the merger or
consolidation.”
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Bibliography
William J. Carney & Mark Heimendinger, “Appraising the Nonexistent: The Delaware Courts’ Struggle
with Control Premiums,” 152 U. Pa. L. Rev. 845 (2003).
Philip J. Clements and Philip W. Wisler, The Standard & Poor’s Guide to Fairness Opinions
(McGraw Hill, 2005).
Bradford Cornell, Corporate Valuation (McGraw Hill, 1993).
Lawrence A. Hamermesh & Michael L. Wachter, “The Short and Puzzling Life of the ‘Implicit Minority
Discount’ in Delaware Appraisal Law,” 156 U. Pa. L. Rev. 1 (2007).
Hamermesh and Wachter, “The Fair Value of Cornfields in Delaware Appraisal Law,” 31 J. Corp. Law
119 (2005)Richard A. Booth, “Minority Discounts and Control Premiums in Appraisal Proceedings,” 57
Business Lawyer 127 (2001).
M. Mark Lee, “Control Premiums and Minority Discounts: the Need for Economic Analysis,” Business
Valuation Update, August 2001, p. 4.
Lee, “The Discount for Lack of Control and the Ownership Control Premium,” in The Handbook of
Business Valuation and Intellectual Property Analysis, Robert F. Reilly and Robert P. Schweihs,
eds. (McGraw Hill, 2004).
Gilbert E. Matthews, “Delaware Court Relies on Comparable Acquisition Method: LeBeau v. M.G.
Bancorporation, Inc.,Business Valuation Update, March 1998
Matthews, “Delaware Court Adds Control Premium to Subsidiary Value: Hintmann v. Fred Weber,
Inc.,” Business Valuation Update, May 1998.
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Bibliography page 2
Matthews, “Fairness Opinions: Common Errors and Omissions” in The Handbook of Business
Valuation and Intellectual Property Analysis Robert F. Reilly and Robert P. Schweihs, eds.
(McGraw Hill, 2004).
Matthews, “A Review of Valuations in Delaware Appraisal Cases, 2004–2005,” Business Valuation
Review, Summer 2006
Matthews, “Misuse of Control Premiums in Delaware Appraisals,” Business Valuation Review,
Summer 2008
Z. Christopher Mercer and Travis W. Harms, Business Valuation: An Integrated Theory,Second
Edition (Wiley, 2007).
Eric Nath, “Control Premiums and Minority Interest Discounts in Private Companies,” Business
Valuation Review, June 1990.
Nath, “The Tale of Two Markets,” Business Valuation Review, September 1994
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Shannon P. Pratt, “Control Premiums? Maybe, Maybe Not – 34% of 3rd Quarter Buyouts at Discounts,”
Business Valuation Update, January 1999, pp. 1-2.
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ResearchGate has not been able to resolve any citations for this publication.
Article
Full-text available
In statutory appraisal cases, Delaware Courts sometimes apply premiums that are based on questionable reasoning. They commonly adjust guideline company valuations for an ‘‘implicit minority discount’’, they apply acquisition premiums to subsidiaries, and they often rely upon average premiums in acquisitions as a basis for calculating control premiums. This article discusses the flaws in the reasoning underlying these adjustments.
Article
Full-text available
The Delaware Court of Chancery decided an unusually high number of appraisal cases during 2004 and 2005. In an appraisal, the Court looks at a company as it exists at the date of the transaction— the ‘‘operative reality.’’ Actions planned by a third-party acquiror before a change of control are normally excluded in a Delaware appraisal, but should be taken into account in second-stage mergers. The Court used discounted cash flow as its primary valuation methodology. This may reflect the fact that cases involving profitable companies with good comparable companies are easier to settle. In applying the comparable company method, the Chancery Court has been applying control premiums, even in a case in which no testimony supported a control premium. The appraisal valuations in 2004–5 did not display a tendency in favor of either petitioner or respondent.
Article
The "implicit minority discount," or IMD, is a fairly new concept in Delaware appraisal law. A review of the case law discussing the concept, however, reveals that it has emerged haphazardly and has not been fully tested against principles that are generally accepted in the financial community. While control share blocks are valued at a premium because of the particular rights and opportunities associated with control, these are elements of value that cannot fairly be viewed as belonging either to the corporation or its shareholders. In corporations with widely dispersed share holdings, the firm is subject to agency costs that must be taken into consideration in determining going concern value. A control block-oriented valuation that fails to deduct such costs does not represent the going concern value of the firm. As a matter of generally accepted financial theory, on the other hand, share prices in liquid and informed markets do generally represent that going concern value, with attendant agency costs factored or priced in. There is no evidence that such prices systematically and continuously err on the low side, requiring upward adjustment based on an "implicit minority discount."Given the lack of serious support for the IMD in finance literature, this Article suggests that the Delaware courts may be relying on the IMD as a means to avoid imposing upon squeezed-out minority shareholders the costs of fiduciary misconduct by the controller. Where either past or estimated future earnings or cash flows are found to be depressed as a result of fiduciary misconduct, however, or where such earnings or cash flows fail to include elements of value that belong to the corporation being valued, the appropriate way to address the corresponding reduction in the determination of "fair value" is by adjusting those subject company earnings or cash flows upward.This approach to the problem of controller opportunism is more direct, more comprehensive in its application, and more in keeping with prevailing financial principles, than the implicit minority discount that the Delaware courts have applied in the limited context of comparable company analysis. The Delaware courts can therefore comfortably dispense with resort to the financially unsupported concept that liquid and informed share markets systematically understate going concern value.
The Standard & Poor's Guide to Fairness Opinions
  • J Philip
  • Philip W Clements
  • Wisler
Philip J. Clements and Philip W. Wisler, The Standard & Poor's Guide to Fairness Opinions (McGraw Hill, 2005).
Control Premiums and Minority Discounts: the Need for Economic Analysis
  • M Mark Lee
M. Mark Lee, "Control Premiums and Minority Discounts: the Need for Economic Analysis," Business Valuation Update, August 2001, p. 4.
The Discount for Lack of Control and the Ownership Control Premium
  • Lee
Lee, "The Discount for Lack of Control and the Ownership Control Premium," in The Handbook of Business Valuation and Intellectual Property Analysis, Robert F. Reilly and Robert P. Schweihs, eds. (McGraw Hill, 2004).