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Business Valuations

The Role of Control and Marketability Discounts in Business Valuation

Lukasz Kustra

Summary

  • Discounts, in the context of business valuation, refer to downward adjustments to the calculated value of an interest in a company to reflect certain inherent limitations or risks.
  • The two main types of business valuation discounts are lack of control of the interest being valued and marketability of the ownership interest being valued.
  • Valuation experts can determine the appropriate discounts to reflect the true value of a minority ownership interest.
The Role of Control and Marketability Discounts in Business Valuation
Andriy Onufriyenko via Getty Images

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In the complex world of business valuation, discounts play an important role in determining the fair market value of a fractional interest in a company. While the concept of discounts may seem straightforward, their application and significance can vary significantly depending on factors such as control and marketability. In this article, we delve deep into the world of discounts, exploring their nuances and implications in business valuation.

The Essence of Discounts

Discounts, in the context of business valuation, refer to downward adjustments to the calculated value of an interest in a company to reflect certain inherent limitations or risks associated with either the ownership interest or the marketability of the interest. These discounts serve as a means to provide a more accurate representation of the value of the interest in the eyes of a potential investor or buyer.

Discounts for Lack of Control

One of the primary factors contributing to discounts in business valuation is the lack of control of the interest being valued. When an owner holds either a minority or non-controlling stake in a company, such as an interest representing less than 50% of the total ownership of the company, they often lack the ability to influence key decision-making processes, leading to a discount in the perceived value of their ownership interest. This lack of control can significantly impact the valuation of the specific shareholder’s interest in the company, as it reflects the reduced ability of the minority shareholder to dictate the company’s strategic direction. This includes the lack of ability to influence major decisions made by the company, such as the appointment of key management, determination of the compensation and benefits paid to shareholders, decisions regarding the capital structure of the company, or other strategic or operational decisions, whether those controlling the business have been able to exert financial control by taking excess compensation and the payment of distributions and dividends.

To determine the discount for lack of control, valuation experts consider various factors. These factors include the company’s governance structure, voting rights associated with the ownership interest, historical decisions made by management, and the likelihood of future decisions that could impact the value of the interest.

The discount is usually expressed as a percentage reduction from the pro-rata value of the total calculated value of the company. Discounts for lack of control can range widely depending on the specific circumstances of the interest being valued. Discounts sometimes can fall in the range of 10% to 40%, depending on the level of control exerted by the minority interest holder. Empirical studies, such as the FactSet Review, which is a comprehensive publication that provides detailed analysis and statistics on merger and acquisition activity, help to provide information concerning publicly reported premiums for control and implied minority interest discounts. These reflect differences in value before, and after, a controlling transaction was announced. Between 1980 and 2022, the FactSet Review suggests an average control discount of approximately 25% for the transactions reported. The FactSet Review is one of many studies that business valuation professionals rely on to derive discounts for lack of control.

Discounts for Lack of Marketability

Another aspect influencing discounts in business valuation is the marketability of the ownership interest being valued. A lack of marketability discount is applied to account for the fact that certain ownership interests in a company may be less liquid and more challenging to sell or transfer. Unlike publicly traded companies, which can be easily bought or sold on stock exchanges, closely held businesses may lack a readily available market for selling the ownership interest being valued. The limited liquidity of certain interests can make it more challenging for investors to quickly convert their ownership stake into cash. As such, discounts for lack of marketability reflect the risk associated with the time, effort, and uncertainty involved in finding a buyer and executing a sale of the ownership interest.

Factors influencing marketability discounts include the offering size of the ownership stake, the company’s financial performance, including the company’s dividend-paying ability and history, the attractiveness of the company and its industry, the prevailing market conditions that impact the company, any existing restrictive transfer provisions, and prior transaction history (if any).

Restrictive transfer provisions are typically outlined in the shareholder or operating agreement of the company being valued. These agreements may include provisions that impose restrictions on the transferability of ownership interest, such as rights of first refusal, buy-sell agreements, drag-along rights, or other limitations on the sale of interest to external parties without the consent of the existing shareholders of the company.

A right of first refusal allows existing shareholders to have the right to purchase any interest being sold before it can be sold to third parties. This type of provision can restrict the ability of the owner to sell their interest freely on the open market at a negotiated price. Potential buyers may be discouraged by the uncertainty of whether their offer will be accepted or if the existing owners will exercise their right to purchase the interest. As a result, the marketability of the ownership interest is reduced, leading to a decrease in the value of the interest being sold.

Buy-sell agreements are contractual arrangements that govern the purchase and sale of ownership interests. While buy-sell agreements may provide clarity regarding the transfer of ownership interests, they can also introduce limitations and restrictions that may warrant a discount in business valuation. This may involve complex procedures, valuation methodologies, or dispute resolution mechanisms that can prolong the sale process or lead to disagreements among the shareholders. These agreements may impose restrictions that prevent shareholders from transferring or selling their ownership without the consent of the company or existing shareholders. Alternately, buy-sell provisions may require the buy-out of shares under certain circumstances.

Drag-along rights allow majority shareholders, or certain specified shareholders, to force minority shareholders to sell their interest alongside them in the event of a sale of the company. With the existence of drag-along rights, when a majority shareholder decides to sell their interest in the company, they have the right to require minority shareholders to sell their interest on the same terms and conditions as the majority shareholder. Drag-along rights effectively strip minority shareholders of their ability to control the timing and terms of a sale transaction. When majority shareholders exercise drag-along rights, minority shareholders are compelled to sell their interest regardless of their own preferences or investment goals. This loss of control over the sale process reduces the attractiveness of the ownership interest and may warrant a discount.

After gathering information on specific issues relating to the subject company and analyzing the interest, experts will typically employ a variety of methods and approaches to research marketability discounts to apply to the ownership interest being valued. These include analyzing transactions in restricted securities markets or private transactions involving similar assets, use of various quantitative models, empirical studies, as well as the expert’s professional judgment and experience involving similar interests.

The marketability discount is expressed as a percentage deduction from the pro-rata interest being valued, after accounting for any control discounts. Similar to control discounts, marketability discounts may vary widely, sometimes ranging from 5% to 40%, depending upon the specific circumstances of the valuation.

Applying Multiple Discounts

In practice, both control and marketability discounts are often applied together in fair market value valuations of closely held businesses. The combined effect of these discounts helps to adjust the valuation of minority ownership interests to reflect their reduced marketability and control relative to freely traded and controlling interests. Please note that discounts are typically not applied under fair value measurement because fair value represents the price that would be obtained in an arm’s length transaction between market participants at the measurement date, assuming both parties are knowledgeable, willing, and able to transact. When applying these discounts, it is important to understand that they reduce the value of an interest sequentially rather than simultaneously.

For example, let’s assume the value of a 100% interest in the business is Y.

Suppose the discount for lack of control is 20%. This means a minority interest (which lacks control) is worth 80% of the pro-rata share of the total value, or (Y × (1 – 0.20).

Now, you would apply the discount for lack of marketability. Suppose the discount for lack of marketability is 30%. This means the value, after accounting for the lack of marketability, is 70% of the value after applying the discount for lack of control, or (Y × (1 − 0.20) × (1 − 0.30)).

Meaning, for a business worth $1 million, a discount for lack of control of 20% and a discount for lack of marketability of 30% would conclude a value of $560,000 [($1,000,000 × (1 – 0.2) = $800,000 × (1 – 0.30)].

The rationale behind the multiplicative application is to recognize the compounding effect of these discounts. When you apply discount for lack of control first, you reduce the base value to reflect the lack of control. Then, the discount for lack of marketability is applied to the already reduced value to account for the lack of marketability. This method accurately reflects the sequential nature of these value adjustments, as each discount impacts the value independently and cumulatively.

Real-World Scenarios

To make this concept more tangible, consider the following real-world scenario. Imagine a thriving family-owned bakery, Sweet Treats, which has a loyal customer base and strong financials. Suppose Bob, one of the minority shareholders owning 20% of the company, decides to sell his stake in Sweet Treats. Bob’s stake is significant, but he can’t influence key decisions about new product lines or expansion plans because he holds a non-controlling interest. His lack of control leads to a discount on his stake’s valuation, reflecting the reality that Bob’s influence over the company’s strategic direction is limited.

Next, consider the marketability of Bob’s 20% stake in Sweet Treats. Unlike shares in a publicly traded company, which can be sold quickly and easily on the stock market, finding a buyer for a stake in a closely held family bakery is much more challenging. Potential buyers know that selling this stake in the future will be difficult, leading to a marketability discount. This discount reflects the risk that buyers take on due to the lack of liquidity.

Now, add in restrictive agreements within the bakery’s shareholder agreement. Suppose the agreement includes a right of first refusal, meaning existing shareholders have the option to buy Bob’s stake before any outside buyer. This provision can deter potential buyers who may be unsure if their offer will be accepted or if an existing shareholder will step in to purchase the stake. The agreement might also include drag-along rights, allowing majority shareholders to force minority shareholders to sell their stakes if a majority shareholder sells their interest. These restrictions further reduce the marketability of Bob’s stake, leading to additional discounts.

A Nuanced Approach to Discounts

Determining the appropriate level of discounts requires careful analysis and the application of various methodologies. Valuation experts use a combination of approaches to assess the appropriate discounts for lack of control and marketability. The assessment of factors such as lack of control and marketability plays a crucial role in assessing an accurate value of an ownership interest held in a company. Understanding and applying these discounts appropriately is essential for providing comprehensive and accurate assessments of business value.

By carefully analyzing governance structures, financial performance, market conditions, restrictive agreements, and employing a combination of empirical data, quantitative models, and professional judgment, valuation experts can determine the appropriate discounts to reflect the true value of a minority ownership interest. This nuanced approach ensures that valuations accurately capture the inherent limitations and risks associated with the ownership interest, providing a realistic representation of its fair market value.

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