control-240px-176859722“The whole is greater than the sum of its parts.” This is a common phrase, but it’s not as common for businesses to realize that this same theory can apply in the valuation of interests in a business.

Controlling Interest is Valuable

A publicly traded business is often purchased for a greater value on a per share basis than the market value of individual shares when it is acquired in the whole by an outside buyer. This is partially due to the fact that the publicly traded shares are all minority interests in the company, and this lack of control results in a diminution of the value of the shares.

For example, imagine there’s a private company with five equal shareholders owning 20 percent each. You might assume that adding each of the 20 percent interests together would equal a 100 percent value of the equity of the company, but that’s not the case. Why? Because each interest, standing alone, isn’t a controlling interest.

It’s important to note that this lack of control means that the interest is less valuable than an interest where you could exercise control. Minority interests in a private company also might be subject to discounts for lack of marketability, because they cannot be readily sold in the marketplace. With a controlling interest, you can do things such as set compensation, determine dividends or other distributions, and affect many other actions that a minority shareholder can’t control.

What About an Interest’s Pro Rata Share?

In this next example, the primary owner would pay a premium to control the business. If the primary owner has, say, 60 percent, and four other owners have 10 percent each, you might be inclined to say that the combined values of these five interests should equal 100 percent of the equity value of the company. However, this would require that the 60 percent owner pay more than the interest’s pro rata share of the entire business’s fair market value on a controlling basis.

Let’s take a look the math.

Suppose the fair market value of this private business on a controlling basis is $1 million. Each 10 percent owner’s interest would be worth $100,000 on a controlling basis (10 percent of $1 million). The 60 percent owner’s interest would be worth $600,000 on a controlling basis (60 percent of $1 million). However, the 10 percent owners would recognize that they lack control and discount their interests accordingly. They might also expect an additional discount, because their interests can’t be readily converted in cash (commonly referred to as a discount for lack of marketability).

For illustrative purposes, let’s assume that the 10 percent interests warrant a combined discount of 30 percent for lack of control and marketability. That would mean their interests are each worth $70,000 on a minority, nonmarketable basis.

Here, the parts, combined, would only be worth $880,000 (4 times $70,000 equals $280,000 plus $600,000). As this example shows, the sum of the parts is significantly lower than the value of the entire business on a controlling basis ($1 million).

A 100 percent shareholder could pay $1 million for a 100 percent interest and possess the same control privileges as — if not more than — the 60 percent control owner. So, the 60 percent isn’t likely to pay more than $600,000 for a 60 percent interest, unless it’s a strategic buyer.

Simple Logic that Makes Sense

In the world of business valuation, the logic of “the whole is greater than the sum of its parts,” makes perfect sense when estimating fair market value.