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The Valuation Discount Debate

The Valuation Discount Debate

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There is little debate in the valuation profession that interests in closely held businesses are less marketable than shares in publicly traded companies or that minority interests are worth less than controlling interests. Despite these facts, discounts for lack of control and lack of marketability are one of the most contested aspects of any business valuation, not for their applicability as much as their degree.

There have been numerous studies regarding measurement of discounts over last fifty years and while there is some consensus, there are also several studies as well as case law that indicate that discounts must be tailored specifically to the company being valued to avoid being under/overstated and risk the valuation being deemed unreliable.

Revenue Ruling 59-60 defines fair market value and introduces the concept of the “willing buyer -willing seller” as follows:

“The amount at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.”

This ruling implies that fair market value is the most probable price that would be paid in cash or cash equivalents between a hypothetical buyer and a hypothetical seller if the interest was placed on the open market for a reasonable period of time. It is in this open market that several levels of value emerge, depending upon the properties of the underlying subject interest. The differences between these values are recognized as the Discount for Lack of Control (Minority Interest Discount) and the Discount for Lack of Marketability.

The IRS assumes a hypothetical, not actual, sale, therefore the concept of discounts discussed in this article are generally not applicable in an actual transaction, however, the concepts are appropriate as there is an economic basis for the application of these discounts under certain circumstances. Therefore, gaining an understanding of the facts and circumstances of a particular engagement (sale, litigation, tax) is critically important prior to any discussion regarding applicability and levels of discounts.

The two primary discounts are the Discount for Lack of Control (DLOC) and the Discount for Lack of Marketability (DLOM). There are other less common discounts, such as the key person discount, and blockage discount that are not encountered as frequently.

The Discount for Lack of Control (DLOC) is defined as a reduction in the control value of the appraisal subject that is intended to reflect the fact that a minority shareholder cannot control the daily activities or policy decisions of an enterprise; therefore a willing buyer would pay less for this interest than he/she would pay for a controlling interest. It is the quantification of how much less that gives rise to debate.

Most appraisers rely on studies such as Mergerstat to estimate the DLOC; these studies compile data observed in the open market. Unfortunately, the transactions included in the studies each have their own unique attributes, making a true comparison to the subject interest difficult. Additionally, the valuation professional must also consider the impact of an operating agreement (if one exists), the presence of voting and/or non-voting shares, and the distribution of remaining interests. For example, a 2% interest with the remaining 98% ownership split equally would potentially have more control than a 2% interest when the remaining 98% is owned by one individual. The valuation professional must be certain to take into account all factors that may affect the subject interest’s degree of control (or lack thereof) and make a professional judgment as to an appropriate DLOC.

While the DLOC is applied to offset a lack of control, the Discount for Lack of Marketability (DLOM) is used to compensate for the perceived reduction in value of privately held shares which do not provide similar liquidity to shares that are publicly traded. The DLOM also compensates for restrictions on transfers/sales that may be dictated by an operating/shareholder agreement. Although the DLOM is applicable to both minority and controlling interests, it is generally higher for a minority interest.

Similar to the DLOC, the quantification of the DLOM begins with an interpretation of various publications/studies. These studies compile data from the public market, most notably transactional data relative to private restricted stock sales. There are large variances within the data; however, most of the studies conclude that a reasonable DLOM ranges between 25% and 45%. From that point, the valuation professional must again utilize professional judgment to pinpoint an appropriate DLOM for the subject interest. The analyst must be certain to take into account all of the various factors that can impact marketability including the financial condition of the subject interest, restrictions on transfer, degree of control, and dividend history.

As professional judgment is an essential component in the determination of both discounts, the degree to which each valuation analyst applies the discounts varies widely and is highly dependant on the particular facts and circumstances of a given case. Just as an automobile may have three distinct values (retail, trade-in, and private party), all of which may be “right” in a given situation, using any one of the values in the wrong situation yields a meaningless result.

In conclusion, the application of discounts is a tool to ensure that the final conclusion of value makes economic sense. Since there are no specific rules governing applicability, and professional judgment prevails, it is important for the valuator to consider all relevant facts and be able to substantiate the selected discounts. Coordination with attorneys and other advisors is critical for the valuation professional to provide world class service.

Jessica Giresi, CPA/ABV, CFE
609-520-1188
jgiresi@withum.com
Noel Capuano, CPA, CVA, CFF

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The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals.

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