Valuation Discounts for Closely Held Businesses

Introduction

When valuing closely held businesses, valuators must account for the reality that ownership interests in private companies possess different characteristics than publicly traded securities. Three critical valuation discounts address these differences: Discount for Lack of Marketability (DLOM), Discount for Lack of Control (DLOC), and Discount for Lack of Voting Rights (DLOV). These discounts ensure that business valuations accurately reflect the practical limitations and risks associated with private company ownership interests.

Discount for Lack of Marketability (DLOM)

Definition and Purpose

DLOM represents the reduction in value applied to ownership interests that cannot be readily sold or converted to cash. Unlike publicly traded securities that can be liquidated within days through stock exchanges, closely held company shares lack a ready market, making them inherently less valuable due to their illiquidity.

Key Characteristics

· Affects both minority and controlling interests, though to different degrees

· Typically ranges from 25% to 40% for minority interests

· May range from 0% to 20% for controlling interests

· Reflects the time, cost, and uncertainty involved in selling private company shares

Calculation Methods

Restricted Stock Method: Compares the trading prices of restricted shares of public companies to their freely tradeable counterparts. The price differential provides empirical evidence for marketability discounts.

IPO Method: Analyzes the difference between pre-IPO transaction prices and post-IPO trading prices to quantify the marketability discount.

Option Pricing Method: Uses financial models to value the "put option" that marketability provides, treating marketability as the ability to sell shares immediately.

Discount for Lack of Control (DLOC)

Definition and Application

DLOC reflects the reduced value of minority ownership interests that lack the ability to control key business decisions. Controlling shareholders can influence management, declare dividends, approve major transactions, and direct corporate strategy, while minority shareholders have limited influence over these critical decisions.

Calculation Framework

The relationship between control premium and DLOC is expressed as:
DLOC = 1 - [1/(1 + Control Premium)]

Example Calculation

If market data indicates a control premium of 20%:

· DLOC = 1 - [1/(1 + 0.20)]

· DLOC = 1 - [1/1.20]

· DLOC = 1 - 0.83 = 0.17 or 17%

Factors Influencing DLOC Size

· Degree of minority shareholder rights and protections

· Concentration of ownership among other shareholders

· Company governance structures

· Legal framework and shareholder agreements

· Size and significance of the minority interest

Typical DLOC ranges from 15% to 25% for minority interests, though it can extend from 5% to 40% depending on specific circumstances.

Discount for Lack of Voting Rights (DLOV)

Definition and Scope

DLOV applies when ownership interests carry limited or no voting rights compared to other share classes. This discount recognizes that non-voting shares are inherently less valuable than voting shares due to the holder's inability to participate in governance decisions.

Application Scenarios

· Multiple share classes with different voting rights

· Preferred shares with limited voting privileges

· Special voting arrangements in family-owned businesses

· Trust structures with restricted voting rights

Quantification Approach

Studies of public companies with voting and non-voting share classes typically show DLOV ranging from 2% to 5%, though this can vary based on:

· Extent of voting rights restriction

· Influence of controlling shareholders

· Specific rights and privileges of the non-voting shares

· Market conditions and investor preferences

Practical Application in Business Valuations

Sequential Application of Discounts

When multiple discounts apply to the same ownership interest, they should be applied sequentially (multiplicatively) rather than additively:

Example: For a minority, non-marketable interest:

· Base value: $1,000,000

· Apply DLOC of 20%: $1,000,000 × (1 - 0.20) = $800,000

· Apply DLOM of 30%: $800,000 × (1 - 0.30) = $560,000

· Total discount: 44% (not 50%)

Key Considerations for Valuators

Case-Specific Analysis: Each discount must be determined based on the specific facts and circumstances of the subject company and ownership interest. Mechanical application of generic discount ranges without proper analysis violates professional standards.

Supporting Documentation: Discount determinations require thorough documentation including:

· Analysis of comparable transactions and market data

· Assessment of company-specific factors

· Consideration of legal and contractual restrictions

· Evaluation of shareholder rights and protections

Market Evidence: Where possible, discount determinations should be supported by:

· Control premium studies from comparable transactions

· Restricted stock studies for marketability discounts

· Voting/non-voting share price differentials

Common Valuation Contexts

These discounts frequently appear in:

· Estate and Gift Tax Valuations: Reducing taxable values for transfer tax purposes

· Divorce Proceedings: Determining fair value of business interests

· Shareholder Disputes: Establishing buy-sell prices for ownership interests

· Financial Reporting: Fair value measurements for accounting purposes

Professional Standards and Best Practices

Valuation professionals must:

· Conduct individualized analysis for each discount application

· Consider the interrelationship between different discounts

· Document the rationale and supporting evidence for discount levels

· Stay current with market studies and legal precedents

· Apply professional judgment rather than relying solely on rules of thumb

Conclusion

DLOM, DLOC, and DLOV represent essential tools in the business valuator's toolkit for accurately valuing closely held company interests. These discounts ensure that valuations reflect the economic reality of private company ownership, including liquidity constraints, control limitations, and voting restrictions. Proper application requires careful analysis, professional judgment, and thorough documentation to produce credible and defensible valuation conclusions that serve the needs of various stakeholders in closely held business transactions and disputes.

reachout to abhi.yadav@whitecrownconsulting.com