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rial, and such buyers would rarely ever be synergistic. Therefore, it is
imperative to be realistic about the market in which the subject company
is likely to sell.
For a private minority interest, Nath takes both the discount for lack
of marketability and lack of control. In conversation, he has revealed his
own dissatisfaction with the lack of relevant information for calculating
DLOC, since there is still nothing to use other than the traditional ¬‚ip
side of the control premiums that he personally demolished as being valid
premiums to add to a ˜˜minority value.™™
Mercer comes to what probably amounts to a very similar result
through a different path. He does not calculate a discount for lack of
control for private minority interests. Instead, he uses his quantitative
marketability discount model (QMDM) (which we cover in more detail
later in this chapter) to subsume any DLOC, which he feels is automati-
cally included in his DLOM. I agree with Mercer that the QMDM includes
the impact of DLOC because, in the QMDM, one must forecast the spe-
ci¬c cash ¬‚ows to the minority shareholder and discount them to present
value. Thus, by using the QMDM, Mercer does not need a DLOC. Mer-
cer™s position is internally consistent.

Prior Research”Academic
Now that we have summarized the professional literature, we will sum-
marize the results of various academic studies relevant to our topic. The
primary orientation of academic research in ¬nance is on publicly traded
stocks. It is generally not directly concerned with the issues of the valu-
ation profession, which is focused on valuing private ¬rms. Often a
slightly interesting side point in an academic article is a golden nugget
for the valuation profession”if not a diamond.
There are two types of evidence of the value of control. The ¬rst is
the value of complete control. The second deals with the value of voting
rights. Voting rights do not represent control, but they do represent some
degree of in¬‚uence or partial control.11
The academic research falls into the following categories:
1. The article by Schwert focuses primarily on analyzing returns in
mergers and acquisitions during two periods: the runup period,

11. Mergerstat Review does track premiums for acquisitions of minority interests, which make up a
third category of evidence. I am not aware of any academic literature dealing with this

CHAPTER 7 Adjusting for Levels of Control and Marketability 209
which is the time before announcement of the merger, and the
markup period, which is the time period after the
announcement. This is signi¬cant in the context of this book
primarily as providing empirical evidence that is relevant in my
economic components model for the discount for lack of
marketability (DLOM). It could easily belong to the DLOM part
of this chapter, but I include it here with the rest of the
academic articles.
2. The articles by Lease, McConnell, and Mikkelson; Megginson;
Houlihan Lokey Howard & Zukin (HLHZ); and the section on
international voting rights premia all deal with the value of
voting rights and provide insight on the value of control that
¬ts in the de¬nition of fair market value.12
3. The articles by Bradley, Desai, Kim and Maquieira, Megginson,
and Nail are about the value of complete control. In particular,
their focus is on measuring the synergies in acquisitions, which
is a critical piece of evidence to understand in sorting through
the apparently con¬‚icting results and opinions in the
professional literature.
4. The article by Menyah and Paudyal is an analysis of bid“ask
spreads and is primarily related to DLOM, not control. It could
also have been included in section on marketability.

Schwert (1996)
Since business appraisers calculate control premiums and discounts for
lack of control from merger and acquisition (M&A) data of publicly
traded ¬rms, it is important to understand what variables drive control
premiums in order to be able to properly apply them to privately held
¬rms. Schwert™s article has some important ¬ndings.
Schwert™s main purpose is to examine the relationship between run-
ups and markups in M&A pricing. (The runup period is that period of
time before the announcement of a merger in which the target ¬rm™s price
is increasing.) Schwert ¬nds that cumulative abnormal returns (CARs)13
begin rising around 42 days before an acquisition. Thus, he de¬nes the
runup period from day 42 to day 1, with day 0 being the announce-
ment of the merger. The markup period is from day 1 to day 126 or
delisting, whichever is ¬rst. The sum of the runup and markup period is
the entire relevant timeline of an acquisition, and the sum of their CARs
is the total acquisition premium.
Schwert ¬nds that CARs during the runup period for successful ac-
quisitions between 1975“1991 average 25%, with CARs for unsuccessful
acquisitions, i.e., where the bidder ultimately fails to take over the target,
averaging 19%.14 After the announcement date, CARs for successful ac-

12. The HLHZ article is professional rather than academic, but its topic ¬ts in better in our
discussion of academic research.
13. These are the cumulative error terms for actual returns minus market returns calculated by
14. One thousand, eight hundred and fourteen transactions in total, which are later reduced to
1,523 in his main sample.

PART 3 Adjusting for Control and Marketability
quisitions increase to 37%, while for unsuccessful acquisitions they de-
crease to zero.
He discusses two opposite bidding strategies, the substitution hy-
pothesis and the markup pricing hypothesis.
The substitution hypothesis states that each dollar of preannounce-
ment runup reduces the post-bid markup dollar for dollar. The assump-
tions behind this hypothesis are that both the bidder and the target have
private information that is not re¬‚ected in the market price of the stock
and that no other bidder has valuable private information. Therefore,
both the bidder and the target will ignore price movements that occur
prior to and during the negotiations in setting the ¬nal deal price.
The markup pricing hypothesis is that each dollar of preannounce-
ment runup has no impact on the post-bid markup. Thus, the prean-
nouncement runup increases the ultimate acquisition premium dollar for
dollar. The assumption behind this hypothesis is that both the bidder and
the target are uncertain about whether movements in the market price of
the target™s shares re¬‚ect valuable private information of other traders.
Therefore, runups in the stock price could cause both the bidder and the
target to revise their valuations of the target™s stock. Schwert used the
example that if they suspect that another bidder may be acquiring shares,
both the bidder and the target will probably revise their valuations of the
target™s stock upward.
The markup hypothesis re¬‚ects rational behavior of bidders and tar-
gets when they have incomplete information. A different explanation of
the markup hypothesis is that of Roll (1986), who postulates that bidders
are interested in taking over targets regardless of cost (the hubris hy-
pothesis). This would re¬‚ect irrational behavior. Using regression analy-
sis, Schwert ¬nds strongly in favor of the markup hypothesis, while re-
jecting Roll™s hubris explanation as well as the substitution hypothesis.
Had the substitution hypothesis been the winner, this would have
implied that the acquisition premiums that occur in the market would
require major adjustments for calculating fair market value. It would have
meant that the post-bid markups are based on private information to a
particular buyer and seller, who ignore the effects of the pre-bid runup
because they both believe that no other bidder has valuable private in-
formation. This would then be investment value, not fair market value.
With the markup hypothesis being the winner, at least we do not have
that complication.
For professional appraisers, the most important ¬nding in Schwert™s
paper is the impact of competitive bidding, i.e., when there is more than
one bidder for a target, on the cumulative abnormal returns on the tar-
get™s stock. Approximately 20% of the takeovers were competitive (312
out of 1,523), with 80% (1,211 out of 1,523) noncompetitive. Table 4 in the
article shows that the presence of competitive bidding increases the pre-
mium paid by 12.2%.15 This is signi¬cant evidence of the impact of com-
petition that will have an important role to play in calculating D2, the

15. That is, it adds an absolute 12.2% to the premium. It does not increase the premium by 12.2%.
For example, if the average premium with only one bidder is 30%, with two or more
bidders it is 42.2%.

CHAPTER 7 Adjusting for Levels of Control and Marketability 211
component in Abrams™ economic components model of the discount for
lack of marketability due to the absence of competition in thin markets.
We will cover that in detail later in this chapter.

Lease, McConnell, and Mikkelson (1983)
Lease, McConnell, and Mikkelson (LMM) examined all companies with
two classes of common stock outstanding sometime between 1940 and
1978. Both classes of common shares were entitled to identical dividends
and liquidation preferences. In total, 30 companies met the criteria, al-
though never more than 11 companies in any one year. On average, there
were only 7 companies in the population per year.
LMM found a statistically signi¬cant voting rights premium. They
split their population into three categories. Category 1 ¬rms had only
voting and nonvoting common, with no voting preferred stock. Category
2 ¬rms had two classes of voting common”one with superior voting
rights and one with inferior voting rights. Category 3 ¬rms had superior
voting common, either nonvoting or inferior voting common, and voting
preferred. Their results were as follows:

Category Mean Voting Rights Premium

1 3.8%
2 7.0%
3 1.1%

The mean voting premium of the Category 1 and 2 ¬rms is 5.44%.
There is no logical reason why Category 2 ¬rms should have a higher
voting rights premium than Category 1 ¬rms, and the authors labeled
this result ˜˜a puzzle.™™ The relationship should have been the opposite.
There was one large outlier in Category 2. Without it, the Category 2
premium is only 1.9%. However, the authors investigated this outlier
thoroughly and found no reason to exclude it from the data. It had no
distinguishing characteristics.
As to the other puzzling result of a voting rights discount to the
superior common shares in the presence of voting preferred stock, the
authors speculate that there might be some incremental costs borne by
the superior rights shares that are not borne by the inferior rights shares.
However, Megginson (1990) and the HLHZ articles did not ¬nd this re-
sult. Megginson found a 23% premium for Category 3.

Megginson (1990)
The author analyzes 152 British ¬rms traded on the London Stock
Exchange in the 28 years from 1955“1982 that have at least two classes
of common stock, with one class possessing superior voting (SV) power
to the other, for the purpose of explaining the underlying variables that
explain the voting rights premium (VRP) to the SV shares. He labels the
inferior common shares those with restricted voting (RV) power. While
the article does not say so, in one of many telephone conversations that
I had with Professor Megginson, he said that all of the RV shares are
simply nonvoting, even though he was using a more generic terminology.

PART 3 Adjusting for Control and Marketability
A minority of ¬rms in his sample also had preferred shares. His work is
a continuation of that of Lease, McConnell, and Mikkelson in a different
Megginson was hoping for his regression analysis to shed light on
which of three competing hypotheses explain the voting rights premium
to SV shares. Ultimately, the regression results could not shed any light
on the source of VRP. However, his article does provide some information
to determine the magnitude of the control premium that is purely for
control and not for anticipated higher cash ¬‚ows.
Under the ownership structure hypothesis, there is an optimal
amount of stock ownership for insiders”management and directors. If
insiders hold too little SV stock, company performance can be improved
by increasing insider ownership. However, if insiders own too much SV
stock, they can become overly entrenched and immune to forced removal,
lowering the value of all classes of stock in general and restricted voting
(RV) stock in particular.
Under this hypothesis, the voting rights premium is positively re-
lated to insider holdings of SV shares and negatively related to RV shares.
The reason for the former is the entrenchment effect, and the reason for
the latter is that the larger the percentage of RV shares owned by insiders,
the more incentive they have to maximize the value of RV shares.
Some of the more interesting summary statistics from Megginson are
listed below. Pay particular attention to numbers 3 and 4”as they contain
the main information for our analysis below.
1. SV shares represented 38.4% of total common equity but 94.3%
of total voting power.
2. Insiders held 28.7% of SV shares (29.8% for companies with
voting preferred) and 8.6% of RV shares (2.7% for companies
with voting preferred).
3. The mean voting rights premium was 13.3% across all ¬rms,
23% for ¬rms with voting preferred, and 6% for ¬rms that were
subsidiaries of other companies.
4. Forty-three of the 152 ¬rms (28.3%) were taken over during the
sample period. In 37 out of the 43 cases, which is 86% of the 43
¬rms or 24.3% percent of the entire sample of 152 ¬rms, the SV
shares received higher prices than the RV shares by an average
27.6%.16 The existence of signi¬cant tender offer premiums that
go disproportionately to SV shares and whose timing is
generally unknown could possibly explain the VRP, though
Megginson feels the magnitudes of the VRP are too high to be
explained by 28% premiums at unknown times.
5. His regression analysis in logarithmic form17 with the ratio of
the price of SV shares to the RV shares as the dependent
variable found the percentage holdings of insiders of SV and RV

16. It is unclear whether the 27.6% refers to all 43 ¬rms or just the 37 ¬rms where the SV shares
received a premium over the RV shares. Assuming the former instead of the latter changes
the conclusion later in the chapter in Table 7-3, cell D24 from 1.4% to 1.5%.
17. The logarithm of the price variables most closely approximates a normal distribution.

CHAPTER 7 Adjusting for Levels of Control and Marketability 213
shares as the only statistically signi¬cant variables. The former
was positively related and the latter negatively related to the
ratio of prices. Even then, the adjusted R2 was only 11%.

My Conclusions from the Megginson Results. The British VRP of


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