One of the most common issues we see in the registered investment advisory world is the discrepancy in understanding the different levels of value and how they coincide with various valuation approaches. For example, a controlling shareholder that is selling the business to a single controlling buyer faces an entirely different set of valuation metrics than an employee buying a 10% stake. In fact, where most mistakes with valuation methodology and logic occur are in simply matching valuation methodologies with the transaction.
Take the simple example of two identical RIAs with $300 million AUM. A single owner owns one and the other has four equal owners. Does the sum of the value of the four individual owner’s interests equal the value of the 100% owner? Conceptually, it seems obvious that if you were going to sell the firm then it doesnʼt matter how many owners there are; however, if you are going to sell 25% of the firm then the other ownership matters a great deal. The reason for the difference being that the 25% owner just simply doesnʼt hold the same power to influence management, pay dividends, approve a material long-term lease, or approve/block a merger agreement. As such, the cash flows potentially available to this 25% owner might be severely restricted.
So imagine buying into an investment advisory firm and owning a 25% interest. The founder, who has been running the firm like his own personal checkbook, owns the remaining 75%. He shows you the profits that the company can generate or even profits they generated in the prior year of $400k. However, after you buy-in, he starts compensating himself at double the rate as before and taking bonuses, joins a country club, and leases a new car through the company. Now the $400k in profits is $100k, and he decides to reinvest the profits back into the company’s growth. As you can quickly see, the value of your interest is nowhere near the same pro rata share as is his. This is why value is rarely a single point estimate but rather will work up and down a continuum based on the rights of the buyers and sellers.
If you want to maximize the value of your interest, whether you are a controlling shareholder or a minority shareholder, then simply negotiate to protect your rights and preferences. Items like rights of first refusal, buy/sell agreements, restrictive covenants, and liquidation preferences all enable minority shareholders to protect themselves. Now, the difficult part is often matching the valuation methodology to the level of rights held.
So, if you have some aspects of control and no ability to sell your shares, your interest is worth one value; however, that same interest might be worth a whole lot more to you if you could sell at anytime to anyone. Navigating these waters is why simply applying a market multiple ensures one outcome, a winner and a loser – you just wonʼt know which one you are until its too late.