Clifton Gunderson
 

Business Valuation 101: What to Look for in a Valuation Report

Valuation is Always About the Future

Standards of Value

Purpose of the Valuation

Level of Control

Valuation Approaches

Discounts for Lack of Control and Lack of Marketability

Common Errors

 
 

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Business Valuation 101: Discounts for Lack of Control and Lack of Marketability

When an interest being valued lacks certain elements of control and marketability, two discounts are generally appropriate. They are commonly referred to as the discount for lack of control and the discount for lack of marketability. The net asset value method under the Asset Approach and the transaction method under the Market Approach do not consider any non-controlling interest discount issues based on the assumption that the assets or the company itself could not be sold without a controlling equity interest. The capitalized cash flow method under the Income Approach does not consider any discount for lack of marketability issues.

There are a number of books devoted entirely to these discounts. The focus here is on the broad concepts and a general discussion of the topics.

    Discount for Lack of Control

    A discount for lack of control represents a reduction from the pro rata share of the value of an entire business to reflect the absence of the power of control. The concept of the discount for lack of control and control premiums can be validated by analyzing the transactions on the stock exchanges that involve the purchase of both non-controlling interests and controlling interests of the common stock of various companies.

    The value of control is dependent on the shareholder's ability to exercise any or all of a variety of rights typically associated with control. Listed below are several common prerogatives of control.

    • Elect directors and appoint management.
    • Determine management compensation and perquisites.
    • Set policy and change the course of business.
    • Acquire or liquidate assets.
    • Select people with whom to do business and award contracts.
    • Make acquisitions of other companies.
    • Liquidate, dissolve, sell out or recapitalize the company.
    • Sell or acquire treasury shares.
    • Register the company's stock for public offering.
    • Declare and pay dividends.
    • Change the articles of incorporation or bylaws.
    • Block any of the above actions.

    Obviously, many factors can impact the degree of control a shareholder has over the operations of a corporation or limited liability company. When any of the control elements are not available to the ownership interest being considered, the value attributable to control must be reduced accordingly.

    The concept of the discount for lack of control has been validated by analyzing the transactions on the stock exchanges which involve the purchase of both non-controlling interests and controlling interests of the common stock of various companies.

    Discount for Lack of Marketability

    Marketability relates to the liquidity of an investment. Investments such as publicly traded stocks are highly liquid in that an investor can, under normal circumstances, sell their stock and obtain cash proceeds within three working days. Shares of stock in privately held companies are, in comparison to publicly traded securities, highly illiquid and usually warrant large discounts from their stated "marketable" price.

    Investors greatly prefer liquidity to a lack of liquidity and will require a higher rate of return to offset the lack of liquidity. When valuing privately held companies, it is a common and accepted practice to apply a discount for lack of marketability.

It is important to keep in mind that the discount for lack of control reflects the inability of a non-controlling shareholder to compel liquidation and/or to realize a pro rata share of a company's net asset value and other prerogatives of control. The discount for lack of marketability reflects the lack of a ready market for the shares of a closely held corporation and the inability to convert the investment into cash in three working days.

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