Imagine being offered the chance to purchase a 10% ownership interest in Expert Painting Professionals, LLC (EPP), the local painting company in your city. EPP has a strong reputation around town and is actively involved in the community. EPP is closely-held and Sally, the sole owner, wants to raise additional funds to expand her business to nearby cities. She plans to sell a small portion of her business so she can retain control. You have known Sally for a long time, and you find her to be a smart and savvy business owner and you believe her expansion plans are possible with your investment.
The company generates over a million dollars a year in revenue and its profit margins are at the higher end of the industry range. The company is run efficiently with few discretionary expenses passing through the business.
Sally explains that your investment will be used to open a new location in a nearby city. She needs the funds to rent space, hire painters, and buy the necessary equipment. Sally further explains that she wants to reinvest all future profits back into the business to fund more locations. She will not distribute profits to any owner, except for an amount to cover the respective portion of business taxes. She plans to pay distributions once the firm is established throughout the state but provides no definitive time frame.
Going over the operating agreement, Sally states that since she owns 90% of the business, she will have complete control to make whatever decisions she feels are necessary. She can set management compensation and perquisites, determine distributions, buy or sell business assets, and determine when to sell a location or the entire business, just to name a few.
Furthermore, in the operating agreement, she wants to restrict how and when you can sell your interest in the business. She includes a clause in the agreement restricting the transferability of your interest in the business to favor her first. This means that if you want to sell your 10% interest in the business, you must first give her the right of first refusal to buy your shares. She will have thirty (30) days to respond, and if she declines to purchase your shares, then you can offer the shares to outside investors that must be approved by her.
Given the facts above, it is now your job to determine what you will pay for a 10% interest in EPP.
Let’s revisit some important facts:
1. Distributions – As an owner, you won’t receive a distribution of profits, except maybe an amount equaling your tax burden. This means you won’t see any cash from your investment for an indefinite period. And the decision to pay distributions is up to Sally.
2. Control – Sally has stated that she will have complete control to make whatever decisions about the direction of the business she deems necessary. You cannot control how the company spends its money, who it hires, what assets is buys or sell, or when you receive a distribution.
3. Illiquid – Liquidity is the ability to sell something and convert it to cash in a timely manner. Given the restrictions on transferability, it may take up to 30 days before Sally’s agrees to purchase your interest. If she doesn’t buy your interest than it may take even longer to find a suitable investor to buy your interest because there is no active market for your ownership interest. Therefore, you cannot liquidate your interest quickly, whereas a liquid publicly traded stock can be sold immediately, and the cash can be received within three days.
This story is intended to highlight two primary issues business appraisers encounter when valuing a minority interest – issues related to marketability and control. When matters of marketability and control are lacking, appraisers will reduce the value of a minority interest by applying a Discount for Lack of Marketability and a Discount for Lack of Control.
When applied, the combined discounts for lack of marketability and control can reduce the value of a minority interest in a business between 5% and 60%.
Below are the definitions provided by the International Glossary of Business Valuation Terms:
• Discount for Lack of Marketability – an amount or percentage deducted from value of an ownership interest to reflect the relative absence of marketability.
• Discount for Lack of Control – an amount or percentage deducted from the pro rata share of value of 100% of an equity interest in a business to reflect the absence of some or all of the powers of control.
Discount for Lack of Marketability (DLOM)
A DLOM is intended to capture two important factors impacting the value of a minority interest: liquidity and marketability. Sometimes these terms are used interchangeably but they reflect some important differences. Liquidity refers to the ability of being able to quickly convert your asset into cash with little to no price disruption. Marketability refers to the speed and ease with which you can sell a particular asset.
For comparison purposes, a publicly traded stock that has a large number of shares outstanding and is actively traded on a daily basis is highly marketable (easy to buy or sell) and is also liquid (meaning a transaction will not disrupt the price at which it trades).
For our purposes let’s understand that when something is marketable, it can be transacted with speed and ease, without impacting the price of the security.
The main takeaway is investors value liquidity.
The reason to apply a DLOM is that ownership in a closely held company has a small percentage of the population of buyers as compared to a publicly traded business. In fact, it is typically illegal to sell closely held shares in a business to the general public without first registering those shares with the Securities and Exchange Commission (SEC) or state authority, which is an expensive and time-consuming process.
Additionally, it is hard for owners of a closely held business to pledge their securities as collateral for a loan as banks are generally unwilling to lend on such types of securities. For these reasons, a DLOM may be applied to a minority interest.
Typically, the application of marketability is not an either/or proposition, but instead there are degrees of marketability stretching along a spectrum. Various factors that impact the degree of marketability include:
• Whether the company is publicly traded or privately held;
• The company’s dividend policy;
• Historical financial performance;
• The ability to transfer ownership interests; and,
• Holding period.
The above list illustrates some of the characteristics appraisers use to assess the marketability of an interest.
Back to the Case: When buying a 10% interest in EPP, an investor would find the interest lacking marketability. Sally stated that she will not pay a dividend for the foreseeable future which defers the financial benefit of ownership and reduces the marketability of the interest. Also, the operating agreement has restrictions on how and when you can transfer your shares, making it very hard to quickly turn your ownership interest into cash. Transferability is further reduced because the company’s shares are not publicly traded, and your holding period is indefinite. Considering all these factors, a business appraiser would discount the 10% interest in EPP for a lack of marketability.
Discount for Lack of Control (DLOC)
A DLOC is generally applied when an interest in a closely held business lacks elements of control. Non-controlling interests in a closely-held business are typically less valuable than a controlling interest, all else equal.
The following list provides examples of ownership control :
• Elect directors;
• Appoint or remove management;
• Determine management compensation and perquisites;
• Set policy and change the course of business;
• Make acquisitions, merge, recapitalize, or spin-off;
• Declare and pay dividends; and,
• Change the articles of organization or bylaws.
The above list demonstrates the valuable rights the controlling owner of an entity possesses. Depending on the situation, the minority interest may not completely benefit from the control factors possessed by the owner. For example, the business may be profitable, but the dividend policy set by the owner precludes dividends from being paid, negatively impacting the minority owner.
A buyer contemplating the purchase of a minority, non-controlling interest in a business would consider these disadvantages stemming from a lack of control. Therefore, it is reasonable to expect a buyer purchasing a non-controlling interest in a business to pay a price that is a discount from an equivalent pro rata share.
Back to the case: As we see with Sally, she has complete control of the company whereas the 10% interest owner would not have the ability to make controlling decisions. Sally can make decisions such as setting the dividend policy, selecting or removing management, dissolving or recapitalizing the business, and acquire or merge with another company. These factors can be detrimental to a minority interest and must be carefully considered when contemplating the purchase.
It is common for business appraisers to consider marketability and controlling factors when appraising minority interests in closely held businesses. The combined discounts can range between 5% to 60% (or more) depending on the interesting being valued. Therefore, discounts for lack of control and marketability can have meaningful impacts on the value of an ownership interest.