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Windeye Partners frequently performs valuations of minority interests or shareholdings in businesses. When valuing a minority interest or shareholding in a company, discounts for lack of control and for lack of marketability may need to be considered, as well as what standard of value should be used for the valuation.
It is commonly recognized and that an ownership interest in a private business enterprise lacking control will sell at a lower price than an equivalent controlling ownership interest. When control is not conveyed with the sale of an ownership interest, a downward adjustment to the preliminary indication of value may apply. This is commonly referred to as a Discount for Lack of Control (“DLOC”) but also known as minority discount. In some instances a premium (as opposed to a discount) for control may be applied when valuing a controlling ownership interest.
A controlling position in a private business enterprise is typically worth more on a pro-rata basis than a non-controlling minority position for many reasons,
including the rights of controlling owners to do any or all of the following:
• Elect management/directors
• Select and/or remove management
• Set dividend/distribution policies
• Establish compensation and benefits
• Set business strategies and goals
• Acquire and liquidate assets
• Self-dissolve, or recapitalize the entity
• Revise organizational documents
• Establish or change buy-sell agreements or clauses
• Cause the entity to become publicly traded
A non-controlling interest holder cannot cause these actions to occur.
To quantify a Discount for Lack of Control a common approach is to consult studies of premiums paid in acquisitions of public companies, which many believe indicates the implied discount for lack of control. However, other academics and valuation professionals believe that there is little or no control premium present in public companies and that acquisition premiums instead represent synergy values or discounts imposed on poorly run companies.
Marketability is defined as the ability to convert an ownership interest into cash within a short period of time. This lack of marketability may cause the ownership interest to be less valuable than an equivalent ownership interest that is marketable. When an ownership interest lacks certain elements of marketability an adjustment from the preliminary indication of value may be applicable. This is commonly referred to as a Discount for Lack of Marketability (“DLOM”).
The standard for marketability is publicly traded stocks that enjoy significant trading volume on a major stock exchange. Owners of these stocks can know the value of their interests on a minute-by-minute basis, and can buy or sell these stocks at a moment's notice with the proceeds (net of fees) delivered in a matter of days.
A privately held business enterprise does not enjoy such marketability. Liquidating a position in a privately held entity is more costly and time consuming. Fees may need to be paid to a business broker and other marketing costs may be incurred. Time is required to find a buyer, negotiate a price and draw up the necessary legal documents. In some cases the purchase price is paid over a period of years.
In some cases, more onerous restrictions are placed on the ownership of privately held enterprises through by-laws or shareholder agreements. These can include rights of first refusal, giving existing owners the right to purchase an ownership interest before it is sold to an outside party, and in some cases, an outright ban on the transferability. For these reasons, the marketability of a minority interest is important to estimating its value.
The estimation of a Discount for Lack of Marketability is difficult and subject to ongoing debate among valuation professionals and the courts. Methods used include empirical market studies (Restricted Stock, Pre-IPO Stock, IPO Flotation Costs) and quantitative methods (discounted cash flow, put option analysis) and a valuation analyst will often consider several of these before arriving at a conclusion.
Factors that can impact the marketability of an equity ownership interest in a business enterprise were identified in the Mandelbaum Tax Court decision in 1995. The Estate of Mandelbaum court considered various studies on the lack of marketability as benchmarks and adjusted the benchmark discounts using nice factors affecting marketability. However these adjustments are by definition subjective.
In order to determine the value of a business or a business interest we must first have a definition of the meaning of value.
A commonly used definition or Standard of Value is Fair Market Value as defined by the U.S. Internal Revenue Service in IRS Revenue Ruling 59-60: “the price at which the subject equity ownership 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 under no compulsion to sell, both parties having reasonable knowledge of relevant facts.” In addition, the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and the market for such property under the Fair Market Value standard.
However, for business valuations that deal with shareholder disputes under state laws the standard of value is Fair Value. While about half of U.S. states have adopted the Model Business Corporation Act which includes a definition of fair value, the definition in other states may vary somewhat. It is important to note that under the fair value standard a discount for lack of control is normally not allowed for a minority interest and similarly with a discount for lack of marketability as these would disadvantage a minority holder versus a majority holder. Nevertheless, in New York State the situation is somewhat unclear as courts have accepted a discount for lack of marketability on a minority interest in certain disputes such as the AriZona Ice Tea case in 2014.