(An excerpt from Skoda Minotti’s How a Company is Valued e-book)
Investors in publicly-traded companies have the luxury of knowing the value of their investment at virtually any time. An internet connection and a few clicks of a mouse are all its takes to get an up-to-date stock quote. Of all U.S. companies, however, less than 1% are publicly-traded, meaning that the vast majority of companies are privately-held. Investors in privately-held companies do not have such a readily available value for their ownership interests. How are values of privately-held businesses determined, then? Each month, this eight blog series will answer that question by examining a key component of how ownership interests in privately-held companies are valued. If you would like to download our full e-book, which includes all of the blogs in this series, you can do so here .
Discounts for Lack of Control and Lack of Marketability
Before a final conclusion of value can be rendered, the nature of the ownership interest being valued must be considered. The value of an ownership interest is influenced by many of its characteristics, including marketability and control, which can have a meaningful impact on the concluded value of an ownership interest.
Control – Whether or not the ownership interest being valued has control over the subject company can have a meaningful impact on its value. Controlling owners have the ability to:
- Elect directors or appoint management;
- Set levels of management compensation and other perks;
- Determine cash dividends/distributions;
- Set company policies or business course;
- Purchase or sell assets; and
- Determine when and how to sell the company.
The ownership of a non-controlling interest in a company does not have the ability to unilaterally direct the items above, which generally makes it less valuable than a controlling ownership interest.
The impact of lack of control on the value of an ownership interest is typically reflected in one of two ways:
- Benefit Stream – The benefit streams used in the income and market approaches are not adjusted for control-related items (such as overcompensation of officers or discretionary expenses of the owners that are run through the company), so the resultant values are deemed to be non-controlling in nature
- Discount for Lack of Control – If the valuation methodologies applied arrive at the value of a controlling ownership interest (such as the Adjusted Net Asset Method or income/market-based approaches that include adjustments for control-related items in the benefit stream), a lack of control discount can be applied to arrive at a non-controlling value.
Marketability – There are certain marketability differences between an ownership interest in a privately-held company and an ownership interest in the stock of a publicly-traded company. An owner of publicly-traded securities can sell that holding on virtually a moment’s notice and receive cash, net of brokerage fees, within several working days.
This would not be the case with an ownership interest in a privately-held company. Consequently, liquidating a position in a privately-held company is a more costly, uncertain and time-consuming process than selling the stock of a publicly-traded entity. An investment in which the owner can achieve liquidity in a timely fashion is worth more than an investment in which the owner cannot sell the investment quickly. Privately-held companies sell at a discount that reflects the additional costs, increased uncertainty and longer time commitments associated with selling these types of investments.
- Controlling Ownership Interests – Controlling owners have the ability to arrange for the sale of a company at their discretion. Typically, there is still some risk associated with identifying potential buyers and negotiating a deal, as well as the value of the company changing during that time period, which is not encountered when selling the stock of a publicly-traded company. As a result, discounts for lack of marketability for controlling ownership interests (if any) are lower in comparison to those applied to non-controlling ownership interests.
- Non-Controlling Ownership Interests – The lack of marketability discounts associated with non-controlling ownership interests are significantly higher than those applicable to controlling ownership interests. Data sources frequently used to compute lack of marketability discounts for non-controlling ownership interests in privately-held entities are as follows:
- Empirical Studies – Restricted stock studies, pre-IPO studies, and long-term equity anticipation securities (LEAPS) studies are often used to estimate the discount for lack of marketability for privately-held companies.
- Option Models – Theoretical option-based models are used to estimate the discount for lack of marketability based on the estimated holding period and volatility of an investment. These models assume that the cost to purchase a put option relates directly to the measurement of the discount for lack of marketability.
- Qualitative Factors – Qualitative factors specific to the company being valued are also typically considered, such as those identified in Bernard Mandelbaum, et al. v. Commissioner.
It is not unusual in the valuation of a non-controlling ownership interest in a privately-held company for the resultant value to be 50%-80% of the value of the company on a controlling, fully-marketable basis. Therefore, the consideration of discounts for lack of control and lack of marketability are important in any valuation analysis, particularly those involving non-controlling ownership interests in privately-held companies.