Business value and control premium

The concept of control premium in business valuation is this: to obtain control of a business the investor usually has to pay the per-share price that is higher than what a single share of the company stock sells for.

Why would an investor seek a controlling share of a company? Because with control come a number of important benefits. If you own, say 50.1% of the outstanding stock, you can elect yourself to the company’s board of directors. You can hire the executives you believe will run the company the way you want. You can decide on the dividend payouts, define the firm’s financing strategy, exit or enter markets, merge or acquire other businesses. In short, if you own a controlling stake in the company, you are the boss.

Now let’s take a look at what it takes to get a controlling share in a company. Public company investors usually hear about a tender offer open for a certain time and stating the terms and price per share that the acquirer is willing to pay for a controlling share of the firm.

Note that public company investors need an incentive over and above the current share market price to part with their stock. After all, they can easily sell the shares should they choose to do so without any tender offers. If the offer price is uninspiring you can get a handful of investors to sell but you will likely not gather the required 50.1% of the company stock to control it.

To motivate a sufficient number of investors to take the tender offer, the acquirer needs to raise the price above the market just before making the acquisition bid. The difference between the market price per share and the tender offer price is the control premium.

If the control premium is sufficiently high, you can entice enough smaller investors to hand over their stock and forgo the potential future dividends and appreciation as company value increases. In addition, the control premium also must cover the capital gains tax expense the investors will have to pay.

What does the control premium mean when valuing a business? The entire business enterprise value is generally higher than the current sum of individual shares.

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