When valuing an ownership interest in a privately held business, the value of that interest may differ from its proportionate share of the company's total equity value. A 20% interest in a business, for example, is not necessarily worth 20% of the value of the entire company.
Two factors that may contribute to this difference are lack of control and lack of marketability. A discount for lack of control (DLOC) reflects limitations on an owner's ability to influence or control the business. A discount for lack of marketability (DLOM) reflects the difficulty and uncertainty associated with selling an interest for which no active market exists.
These discounts address different characteristics of an ownership interest and are not automatically applicable. Their use depends on the standard of value, rights and restrictions of the interest, and, in some matters, the applicable legal framework.
Discount for Lack of Control
A discount for lack of control (DLOC) reflects the reduction in value associated with an ownership interest that lacks the ability to direct or influence important business decisions.
Control is not determined by ownership percentage alone. The rights associated with an ownership interest depend on the company's ownership structure, governing documents, and other facts and circumstances.
Depending on the assignment, the analysis may consider an owner's ability to:
- Elect, appoint, or remove management
- Influence business strategy and operations
- Determine or influence distributions
- Set or influence owner and executive compensation
- Approve significant borrowing or capital expenditures
- Sell significant assets
- Amend governing documents
- Cause a sale or liquidation of the business
A minority ownership percentage often indicates a lack of control, but the analysis should focus on the rights actually held by the owner. A minority ownership interest may actually have certain protective or voting rights despite representing a relatively small percentage of the company, while an interest representing a significant percentage of ownership may still lack the ability to control important decisions. A DLOC should therefore reflect the specific rights and limitations associated with the ownership interest rather than its ownership percentage alone.
Discount for Lack of Marketability
A discount for lack of marketability (DLOM) reflects the reduced value associated with an ownership interest that cannot be readily sold because an active market for the interest does not exist.
Shares of a publicly traded company can generally be sold through an active market. An interest in a privately held business typically does not have the same liquidity. Finding a buyer may take time, a sale may involve significant transaction costs, and governing agreements may restrict whether or to whom the interest can be transferred.
Factors relevant to marketability may include:
- Transfer restrictions and rights of first refusal
- Expected holding period
- Historical and expected distributions
- Financial condition and prospects of the business
- Prospects for a future sale or other liquidity event
- Redemption or repurchase rights
- Availability of potential purchasers for the interest
- Costs and uncertainty associated with a sale
The importance of each factor depends on the particular investment. For example, an interest with a history of meaningful distributions and a reasonable path to liquidity may present different marketability characteristics from an interest that pays no distributions and cannot be readily transferred.
How DLOC and DLOM Work Together
DLOC and DLOM address different economic characteristics.
Lack of control concerns what the owner can and cannot influence within the business. Lack of marketability concerns the owner's ability to sell the interest and convert the investment to cash.
Depending on the applicable valuation framework and the characteristics of the interest, one discount, both discounts, or neither may be appropriate.
Where both discounts are appropriate, they should not simply be added together. They are generally applied sequentially to the relevant indication of value. For example, applying a 20% DLOC followed by a 20% DLOM does not result in a 40% combined discount. Because the second discount is applied after the first, the combined effect would be 36%.
More importantly, the analysis should consider whether the factors supporting each discount are distinct and whether a particular risk or limitation has already been reflected elsewhere in the valuation. The objective is to avoid counting the same economic disadvantage more than once.
How Valuation Discounts Are Supported
Determining a DLOC or DLOM requires professional judgment supported by relevant evidence. There is no single percentage that applies to all privately held ownership interests.
Supporting a Discount for Lack of Control
A DLOC analysis begins by evaluating the rights and limitations associated with the ownership interest, including the extent to which the holder can influence or control important business decisions. Depending on the subject interest and available data, market evidence may include pricing relationships between controlling and noncontrolling interests or other market-based indications of the economic benefits associated with control.
Supporting a Discount for Lack of Marketability
Several sources of empirical and quantitative evidence may be considered when analyzing DLOM. Restricted stock studies examine differences between the prices of publicly traded shares and otherwise similar shares that were subject to restrictions on their ability to be sold. Other quantitative methods, including option-based models, may also be used to estimate the effect of limited marketability, depending on the facts and circumstances of the valuation. The marketability of a particular interest may be affected by its expected holding period, distributions, transfer restrictions, the financial condition and outlook of the business, potential liquidity events, and other relevant characteristics. The goal is not simply to select a percentage from a study. The concluded DLOM should be supported by both relevant market evidence and the specific facts of the ownership interest.
Governing Agreements and Ownership Rights
The company's governing documents can be an important part of both DLOC and DLOM analysis.
Operating agreements, shareholder agreements, partnership agreements, and buy-sell agreements may establish rights and restrictions affecting the economic characteristics of an ownership interest. Depending on the assignment, relevant provisions may include voting and management rights, distribution rights, transfer restrictions, redemption or repurchase provisions, rights of first refusal, and other provisions affecting the interest upon death, withdrawal, termination, sale, liquidation, or dissolution. These provisions should be considered together with the company's actual ownership structure and other relevant financial and economic evidence.
Counsel determines the legal interpretation and effect of governing agreements. Our role as valuation professionals is to evaluate the financial and economic implications of the applicable provisions for the ownership interest being valued.
Purpose of the Valuation and the Standard of Value
Whether a DLOC or DLOM applies may depend on the standard of value, the purpose of the valuation, and, in some matters, the applicable legal framework.
Discounts may arise in valuations performed for gift and estate tax planning, shareholder transactions, marital dissolution, shareholder disputes, and other purposes. The appropriate treatment is not necessarily the same in each context.
The standard of value defines the premise under which an interest is valued, including the hypothetical or actual transaction assumed and the market participants involved. Common standards of value include fair market value, fair value, and investment value, and the standard applied can significantly affect whether, and to what extent, discounts for lack of control or marketability are appropriate.
Fair market value is generally defined as the price at which an interest would change hands between a hypothetical willing buyer and willing seller, neither being under compulsion to act and both having reasonable knowledge of the relevant facts. Because this standard contemplates a hypothetical transaction involving the specific interest being valued, discounts for lack of control and marketability are often considered when they reflect the economic characteristics of that interest, such as when a noncontrolling interest in a privately held business is valued under this standard.
Fair value is a distinct standard that is often defined by statute or case law rather than by reference to a hypothetical market participant, and its treatment of discounts varies significantly by jurisdiction and context. In some shareholder oppression or dissenting shareholder proceedings, for example, courts have declined to apply discounts so as not to disadvantage minority shareholders in a transaction they did not choose to enter, while other jurisdictions or contexts permit discounts under a fair value standard. Whether fair value applies, and how it treats discounts, depends on the applicable statute, case law, and the facts of the matter.
Investment value reflects the value of an interest to a particular owner or investor based on that party's specific circumstances, expectations, or synergies, rather than a hypothetical market participant. Because investment value is not necessarily a market-based measure, the applicability and magnitude of discounts under this standard depend on the specific facts and the basis for the valuation.
This is especially important in litigation, where the treatment of control and marketability may vary by jurisdiction and type of claim. Counsel determines the applicable legal framework; the valuation expert evaluates the ownership interest within that framework.
Common Issues in Discount Analysis
A well-supported discount analysis requires more than identifying an ownership interest as "minority" or "private." Common issues that can affect the reliability of the analysis include:
- Assuming a discount applies based solely on ownership percentage
- Applying an average or benchmark discount without considering the specific characteristics of the ownership interest
- Failing to consider the rights contained in governing agreements
- Using market evidence that is not sufficiently comparable to the subject interest
- Double counting risks or restrictions already reflected elsewhere in the valuation, or failing to explain how the available evidence supports the concluded discount
The analysis should connect the concluded discount to the economic characteristics of the interest and the evidence available as of the valuation date.
Our Approach to Minority and Marketability Discounts
Insight Forensic & Valuation Services analyzes discounts for lack of control and lack of marketability as part of valuations of privately held businesses and ownership interests.
Our analysis considers the company's ownership structure and governing agreements, the rights and restrictions associated with the subject interest, relevant market and empirical evidence, and other factors affecting control or marketability. Where a DLOC or DLOM is appropriate, we develop a conclusion based on the specific characteristics of the interest and the applicable valuation framework.
