Articles

The Application of Valuation Discounts by By Sharon F. Foote, ASA, CFE


Posted on October 08, 2014 by Scott Bouchner

“How large a discount can I get when valuing my business?” This is a question often posed by business owners. They are referring to the most commonly applied valuation discounts, referred to as the discounts for lack of control (also known as a minority interest discount) and marketability. Many people believe that these discounts are automatically applied. In actuality, these discounts must be supported by both the facts and circumstances of the particular valuation and comparison to the body of empirical data currently recognized in the valuation community for quantifying valuation discounts.

 

The valuation of a controlling interest versus a minority interest in a closely-held business is not likely to have the same value, depending on the circumstances. Because of the inherent differences between a controlling and a minority interest, the value of a minority interest is not equal to its pro-rata portion of the enterprise’s value. This results from the application of lack of control and marketability discounts. For example, a 10 percent interest in a business valued at $1 million is not necessarily worth $100,000. After applying discounts, it may be worth considerably less.

 

A discount for lack of control reduces the value in order to reflect the minority interest’s inability to control the business’s management and policies. When quantifying this discount, the valuator must consider several factors, including voting rights, the level of control and accompanying benefits of the minority interest, the contractual agreements in place between the company’s owners, and relevant jurisdictional law. Many factors can affect the degree of control an owner has over the operations of a corporation, partnership or limited liability company. If any of the elements of control are unavailable to the ownership interest being scrutinized, the value attributable to control should be reduced accordingly.

 

The lack of marketability discount reflects the effort an investor would have to put forth to sell an ownership interest. Investors usually consider the liquidity of an interest – that is, how long it will take to convert to cash. Investments such as publicly-traded stocks are highly liquid, since investors can, under ordinary circumstances, sell their shares and receive the proceeds in cash in just a few days. Shares in privately-held companies are much more illiquid, compared to publicly-traded securities, and typically warrant significant discounts from their indicated “marketable” price. Therefore, the market will require a discount for that lack of liquidity. Factors affecting a privately-held business interest’s marketability include – transfer restrictions, dividend-paying policy, size of the block of stock, and whether the owner possesses elements of control.

 

The application of valuation discounts depends on the level of value (see the chart below) indicated by the methods utilized by the valuator. If the valuation analyst values the company using a method that results in a marketable controlling interest, discounts for lack of control and lack of marketability may be appropriate. However, if the valuation methodology used produces a marketable minority value, no discount for lack of control would be warranted, but a discount for lack of marketability may be applicable.

 

Valuation chart

Source: Traditional Levels of Value (www.mercercapital.com)

 

The valuator must apply appropriate valuation discounts to adjust the level of value indicated in the valuation method(s) to the level of value required for the particular valuation engagement. Failure to properly apply discounts may result in a substantial inaccuracy in the value conclusion.

 

The example below reveals the potential advantage of making certain that applicable discounts are considered. For example, if a company’s 100 percent value has been estimated at $10,000,000, and a 20 percent minority interest is being valued, the discount for lack of control and discount for lack of marketability can be calculated as illustrated in the example below.

 

$10,000,000 100% Controlling Interest Value
$ 2,000,000 20% Pro-rata Value (before discounts)
($   500,000) Less: DLOC (25%)
$ 1,500,000 Minority, Marketable Value
($   300,000) Less: DLOM (20%)
$ 1,200,000 Minority, Non-Marketable Value

 

In this hypothetical example, the total reduction of value through the discounts amounted to $800,000. This reduction was 40 percent of the pro-rata value. By reducing the pro-rata value of the minority interest using the discounts, the taxable amount is lower and may generate tax savings for gift and estate tax purposes, just by considering the inherent characteristics of a minority ownership interest.

 

The application of appropriate valuation discounts should be left to the professional judgment of the valuator. A qualified business appraiser is able to support discounts to withstand scrutiny by the IRS and correctly value the ownership interest, providing significant benefits to the client.

 

About the Author: Sharon Foote, ASA, CFE, is a manager in the Business Valuation and Litigation Support practice of Berkowitz Pollack Brant. For more information, call (305) 379-7000 or e-mail info@bpbcpa.com.