Why Do Control Premium and Illiquidity Discounts Matter in M&A?

In 2017, Diageo, a global leader in beverage alcohol, acquired Casamigos, a super-premium tequila brand, for up to $1 billion. The price was such a high premium over traditional market multiples. Why? The answer lies in the dynamics of control premium and illiquidity discounts — two crucial factors in mergers and acquisitions (M&A) that significantly impact deal pricing.

In the intricate world of M&A valuation, a company’s worth is often more than just its financial metrics. It’s a complex interplay of strategic considerations, market conditions, and investor psychology. Among the critical concepts that shape M&A valuations are control premiums and illiquidity discounts, two factors that can significantly influence the price a buyer is willing to pay for a target company. In this blog post, we’ll delve into the nuances of control premiums and illiquidity discounts, exploring how they function and their implications for effective valuation strategies in today’s competitive market.

Merger and Acquisition: Everything You Need to Know

Mergers and acquisitions (M&A) involve companies combining to become stronger. A merger happens when two similar-sized companies join to form a new one. In an acquisition, one company buys another and absorbs it into its operations. These strategies help businesses grow, gain new technologies, or enter new markets.

The M&A process starts with planning. Companies identify their goals and search for suitable partners or targets. They assess the potential benefits and risks of combining. They exchange information, analyze if the deal makes sense, and sign a Letter of Intent (LOI) to show serious interest. Next is due diligence. It means thoroughly checking the other company’s finances, operations, and legal matters. Both sides dig deep into finances, legal issues, and risks to ensure no surprises. After due diligence, companies negotiate terms and finalize the deal. They agree on price, structure, and how the new combined company will operate. Once everything is settled, they integrate their operations, cultures, and systems to ensure a smooth transition and achieve the desired benefits.

In M&A deals, pricing is crucial. Buyers often pay a control premium, which is extra money for the right to make decisions in the acquired company. On the other hand, sellers might accept an illiquidity discount if their business is hard to sell quickly. These factors ensure a fair price based on control, market conditions, and how easy it is to sell the business.

Control Premium: Why It Matters in M&A

In mergers and acquisitions (M&A), a control premium is the extra amount a buyer pays to gain control over another company. This premium reflects the added value the buyer expects from having the power to make key decisions, such as changing management or redirecting company strategy. Control premiums are typically added when a buyer wants to purchase a majority stake or controlling interest, usually more than 50% of the company’s shares. This majority ownership allows the buyer to make decisions without needing approval from other shareholders, giving them full authority to shape the company’s future.

The size of a control premium varies based on factors like the potential for improving the target company’s performance, the presence of other interested buyers, and the current shareholders’ expectations. Research shows that control premiums in M&A deals usually fall between 10% and 70% above the stock’s market price. However, it is essential to note that the exact percentage varies based on the company’s stock valuation at the time of the transaction.

Buzzacott is a London-based accountancy and advisory firm. The chart above tracks the agency’s observed control premiums in UK take-private deals from 2018 to 2022. It shows that control premiums in M&A deals typically range from 10% to 70% above a company’s market price.

The control premium formula compares the market price per share after an acquisition offer with the price before any takeover news. A higher control premium means the buyer sees extra value in running the business their way. For instance, a company’s stock trades at $50 before a takeover offer. After the news, the stock jumps to $65.

In the above example, the buyer is paying 30% more than the original stock price to take control. The control premium is shown as a percentage to make comparing deals easy. A percentage shows how much extra a buyer pays over the normal stock price. This helps investors see whether the premium is high or low, regardless of the company’s size.

The role of a control premium in M&A valuation is to reflect the additional value a buyer pays to gain full control, enabling strategic decision-making, operational influence, and synergy benefits. Buyers pay this premium to improve efficiency, expand market share, and unlock future growth. For example, Facebook acquired Instagram 2012 for $1 billion — double its estimated value — to control its future and outbid competitors. Control premiums also account for expected synergies, where merging companies create more value together than separately. When Disney bought Pixar in 2006, it paid a premium for Pixar’s creativity and technology, which helped revitalize Disney’s animation success.

The Hidden Impact of Illiquidity on M&A Pricing

When a company is hard to sell, its value drops. Buyers don’t like assets they can’t quickly turn into cash. In mergers and acquisitions (M&A), this issue is called illiquidity. Investors demand a discount if a business has few buyers, complex ownership, or industry risks. They don’t want to invest money in something they can’t easily sell later.

An illiquidity discount is a price reduction applied to a business or asset because it is difficult to sell quickly for its full value. Buyers demand this discount to compensate for the extra risk and time it takes to find another buyer. Illiquidity lowers M&A prices because buyers take on more risk. If a company is small, privately owned, or in a niche market, selling it again could take months or years. Buyers pay less to make up for this uncertainty. They also expect better terms, like seller financing or lower upfront payments, to reduce risk. Sellers must plan for illiquidity. They can attract more buyers by improving financial transparency, reducing business risks, or offering flexible deal terms. The more liquid a company appears, the higher the price it can command in an M&A deal.

To calculate the illiquidity discount using comparable company analysis, we use the EV/EBITDA multiple. Find the median EV/EBITDA multiple from public companies, then apply an illiquidity discount — typically 20% to 30% — to adjust for the difficulty of selling private shares. For example, if the median EV/EBITDA multiple of public companies is 8x and the illiquidity discount is 25%, the calculation is:

The calculation above shows the private company’s estimated EV/EBITDA multiple is 6x after applying the illiquidity discount. Suppose the company’s fair value is based on an 8x EBITDA multiple. However, because the company is illiquid (harder to sell), investors apply a 6x multiple instead.

When a company is hard to sell quickly, buyers see it as risky. This is called illiquidity, and it lowers the price of mergers and acquisitions (M&A). Investors prefer assets they can sell fast, like stocks, over businesses that take months or years to unload. Buyers demand a discount if a company has few buyers, complex contracts, or uncertain cash flow. They don’t want their money stuck for too long. Even strong businesses can lose value in a deal because selling them isn’t easy.

The illiquidity discount reduces the company’s value from $80M to $60M, a $20M drop. This happens because investors want a better deal when buying something harder to sell later.

The Discounted Cash Flow (DCF) method measures illiquidity by adjusting the value of an asset based on how hard it is to sell. Future cash flows are discounted at a higher risk-adjusted rate to reflect the extra illiquidity risk. This rate includes a risk-free base (like government bonds) and a risk premium for market uncertainty. Suppose you are valuing a private real estate investment. The risk-adjusted discount rate (which includes the asset’s risk and market conditions) is 15%, and a similar publicly traded real estate investment trust (REIT) has a liquidity premium of 4% (since it’s easier to sell).

The company’s fair value before any discount is $10,000,000. The new adjusted Enterprise Value is $8,900,000. A higher illiquidity discount means a lower company valuation since investors demand a price cut when an asset is harder to sell.

Decoding M&A Value: The Impact of Control Premiums & Illiquidity Discounts

Control premiums and illiquidity discounts affect the price when valuing a company in mergers and acquisitions (M&A). Buyers must decide if the control is worth paying more, and sellers must accept that a lack of market demand may reduce the price. Getting these numbers right is key to a fair deal.

Control premiums boost value:

· Investors pay more to gain control. If they own most of a company, they can make big decisions — like changing leadership or selling assets. This added power increases the price.

· A majority owner has more say in mergers and deals. They can demand better terms because they don’t need approval from others. This makes control more valuable.

· Businesses with clear control structures attract strategic buyers. They prefer owning a company outright instead of dealing with multiple shareholders. This demand raises the premium.

Illiquidity discounts lower valuation:

· If an investor can’t quickly sell shares, they will pay less. Private businesses face this problem because there’s no stock market to trade them easily.

· Since selling takes time, investors need patience. They often wait months or years to find the right buyer, making their investment less flexible.

· Fewer buyers mean a greater risk of price drops. Investors need a bigger reward (higher returns) to justify holding an illiquid asset, which pushes the price down.

Optimizing Control Premium & Illiquidity Discount with Financial Modeling

When a company buys another business, it’s not just about paying the current market price. The deal often includes extra costs or discounts based on who’s in control and how easy it is to sell shares. These factors — control premiums and illiquidity discounts — shape the final price.

Financial modeling helps businesses find the right balance between control premiums and illiquidity discounts. It shows how much extra value a controlling stake is worth and how hard it is to sell a private company. By testing different scenarios, businesses can make smarter deals, avoid overpaying, and understand risks better. This leads to stronger investments and fairer valuations.

eFinancialModels.com offers industry-specific M&A templates to help you confidently analyze control premiums and illiquidity discounts. Explore our financial models today to make smarter investment decisions and optimize your deal strategy.