Control Adjustments - Quantifying a Controlling Interest-Holder’s Diversion of Cash Flow

How to value a non-controlling interest in a private company where the controlling interest-holder materially alters the company’s free cash flow? The valuator has two options:

(1) Rely on the financials provided by the company and do not apply a Discount for Lack of Control (or reduce the DLOC).

(2) Apply Control Adjustments to the company financials and apply a Discount for Lack of Control

The purpose of this article is to explain why option (2) is preferable over option (1). Take for example, a situation where a private company pays certain family member a salary that is far-above the market replacement cost of performing their respective roles. The valuator can either adjust each family-member employees salary to the FMV replacement cost of their role and apply a DLOC as the reduction in free cash flow associated with control is no longer accounted for in the financials OR the valuator can leave the excessive salaries as is, and apply no DLOC as the reduction in free cash flow associated with control is already accounted for in the financials. Here, a Discount for Lack of Control is primarily a measurement for the amount of discretionary earnings that have been diverted from the company into the pockets of others due to the controlling interest-holders policies and actions.

Intuitevely, it may make more sense to say that the best proxy for DLOC is the actual cash flow loss itself. In other words, why adjust earnigns and then compensate for loss with a percentage DLOC when you could bypass all of that and merely say that the excessive compensation = the value that any DLOC would be? There are a couple of reasons.

First, if excessive compensation is ignored and the financials are left in-tact, then the company’s financial performance would likely no longer be compareable to a compareable company sample relied upon in the valaution analysts market aproach estimate, as the market appraoch relies on EBITDA based multiples that likely do not capture such excessive payments (if coming from a credible dataset). It also violates an income approach method as well, as failure to adjust the financials would effectively cause the analyst to ignore a companys ability to generate free cash flow. This is problematic because under the income appraoch, it takes a fact that ONLY applies to a nonn-controlling itnerest and then applies it to the whole company.

The flip-side - See Estate of Adell v. Commissioner of IRS, Tax Court (2014).