Chapter 13
Valuation discounts

The final piece of the value puzzle is the application of any discounts that might apply to the benefit stream as adjusted by the capitalization rate. Recall once again our example of a 5 percent stake in a midsize trucking company.

Why are discounts needed?
Would you pay the same amount for one share of non-voting stock as you would for one share of voting stock? Do you think a controlling interest in a company should have the same value as a non-controlling interest? Should one share of stock in a privately-held company be worth the same as a share of stock in a publicly traded company? If you answered no to these questions, then you are correct. All shares of stock are not equivalent in nature and therefore are not equivalent in value.

Our calculations in Chapter 11 and 12 give us gross value based on what is assumed to be a controllable, marketable interest in the business. Gross value implies that the shareholder owns and controls the majority of the company and that this interest in the company can be traded for cash in approximately three business days. As you know, this scenario is not exactly realistic. Even if you do maintain control over your business, it is very unlikely that you could redeem your interest for cash in three business days. This is principal reason a valuation discount is in order.

There are levels of value, and discounts vary depending on those levels. The highest level, as we have discussed, is the controlling, marketable value.

Below this level is the controlling, non-marketable level, which based on the assumption that you maintain control of the company but cannot easily trade your interest in the business for cash.

Next is the marketable minority interest – one that can be converted quickly to cash but lacks control over the company.

The lowest level of value is the non-marketable minority interest.

Some people believe that discounts apply only to family-owned limited liability companies for estate planning. Discounts are desirable in these situations because they lower the tax bill. But discounts are part of any valuation process. If discounts were used only for estate planning purposes, courts would not uphold them.

Discounts are the means valuation analysts have of reconciling the particular facts surrounding the interest being valued. Admittedly, the application of discounts is quite subjective, but they are based on actual studies that we will examine in this chapter.

Most common discounts
Based on the discussion above, it should not surprise you that the two most common discounts are the discount for lack of control and the discount for lack of marketability. Minority interest and marketability, though related, are distinctly different concepts. Control is the most important factor of any business interest. The owner of a controlling interest in a company can directly affect the operations of the company, including the appointment of management, the increase or decrease of salaries, the payment of bonuses, and other important operations issues.

The discount for lack of marketability is important because interests in privately held companies are not as easily converted to cash as are interests in publicly traded companies.

As mentioned earlier, the application of discounts is subjective. A number of studies, however, offer guidelines for valuation analysts in applying discounts. Data supporting discounts for lack of control can be found in the Mergerstat Review, an annual report providing control premiums and, thus, implied minority discounts. There are also the Coolidge Study, Securities and Exchange Commission studies and the Quantification of Control Premiums & Minority Interest Discounts model.

To support discounts for lack of marketability, valuation analysts turn to the SEC Institutional Investor Study, the Maher Study, the Emory Studies and the Willamette Management Associates Studies. These studies are either restricted stock studies or pre-IPO studies. Restricted stock studies compare the difference between the values of restricted letter stock as compared to similar unrestricted stock sold on the open market. Pre-IPO studies observe the difference between the prices of private stock before its initial public offering versus the price of the stock following the initial public offering. These studies and models provide a basis on which valuation analysts can support their discount conclusions.

How discounts work
Discounts are applied to the gross value. Typically, the valuator addresses the minority/control issue first and then marketability is addressed. If both a minority and marketability discount are appropriate, the analyst multiplies the gross value by the minority discount and then multiplies that total by the marketability discount.

Thus, a 20 percent discount for lack of control, as illustrated in our hypothetical the example, is taken from the gross value, identified as subtotal. Now, let’s take another 10 percent discount for lack of marketability:

Other discounts — and premiums
While minority and marketability discounts are most important, other discounts include the key person discount, the discount for lack of liquidity and the blockage discount. The key person discount is used to lower the value when one person, usually an owner or manager, is essential to the business and it is virtually impossible for the company to continue operations in his absence.

The lack of liquidity discount is used when the underlying assets of the company are illiquid. This discount is generally used in extreme situations. Otherwise, the discount for lack of marketability handles the illiquidity of the interest being valued.
The blockage discount is used when there are large blocks of minority interests to be transferred. The larger the minority interest owned by one shareholder, the less it is worth because it is an undesirable interest in the company.

There are also some less frequently used – but rather interesting – discounts. For example, discounts have been taken because a trucking company uses proprietary dispatch software that cannot be supported as easily as a commercially available system. Another rare discount specific to the trucking industry is the risk of shutdown by the Department of Transportation.

In general, a valuation analyst takes the gross value and discounts it. There are times, however, when an investor may pay more for an interest than its gross value. This usually occurs when there is some greater benefit to the investor. For example, you would pay more for another trucking company if it would provide you with a terminal in a highly desirable location or a contract with a highly sought-after company. Premiums are usually a result of strategic value rather than fair market value.