How to measure a Marketability Discount for a Controlling Interest

The concept that the value of a privately held business can be impaired by marketability limitations “the Discount for Lack of Marketability” “DLOM” is accepted by the courts, IRS, the valuation community, and the marketplace.
The distinction between marketability and liquidity
Marketability has two distinct characteristics: 1) The right or “lack thereof” to offer an investment for sale in a readily available, discernible market (referred to as “marketable” or “non-marketable”) and 2) How quickly the investment can be converted to cash (referenced as “liquid” or “Illiquid”). By way of example if you own 100 shares of McDonalds stock— the shares can be sold at your discretion and cash will be received within approximately three days. Thus the 3-day conversion period from investment to cash is considered liquid. Therefore, a non-controlling interest, hereinafter “Minority Interest” in publicly traded stock is both marketable and liquid (marketable/liquid).
The marketability discount and private equity
What happens when an owner attempts to sell equity owned in a privately held business? The answer–it will typically take months or even years to convert the equity investment to cash. The degree of marketability for private equity is directly related to three key characteristics of the equity:
  1. Whether the interest is controlling or minority
  2. The amount of annual cash distributions
  3. The expected holding period before the equity could be converted to cash (sold).
There are other factors, but these are the most influential. Arguably the single most important factor affecting marketability is whether the private equity interest is controlling or minority. This is intuitive because a controlling interest in private equity typically has the right to sell at their discretion and there exists readily available markets via several venues e.g., business brokers, internet-based markets, etc. (marketable). But despite enjoying the right and ability to sell—even a controlling interest in private equity—typically cannot be converted to cash quickly. So, a controlling interest is marketable but illiquid. We will take a closer look at the discount for lack of marketability for a controlling interest later, but let’s begin our conversation examining the minority interest.
Usually, the prospects for quickly selling a minority interest in private equity are difficult at best. The holder of a minority interest will soon learn there are no readily available markets to sell their investment (non-marketable), nor can the investment quickly be converted to cash (illiquid). So, a minority interest is nonmarketable, illiquid.
Resources available to quantify the marketability discount for minority interests
The marketability discount for a minority interest can be quantified using the restricted stock or IPO studies compiled by researchers. These studies revealed that the value of minority interests in publicly traded stocks can be impaired due to the lack of a readily available market. Restricted stock or letter stock is stock in a publicly traded entity which is identical in all respects to the freely traded stock of a public company except for the fact that it is restricted from trading on the open stock market for a certain period of time. Even though such stock cannot be sold to the public on the stock exchange, it may be sold in private transactions under certain circumstances. These transactions must be reported to the SEC and become matter of public record. Accordingly, empirical data on the prices of private transactions in restricted stock—or letter stocks—can be used for comparison with prices of the same but unrestricted securities eligible for trading on the open market. The restrictions eventually lapse, usually within 24 months up to 1997, and generally within a year since that time except for the “dribble out” provisions, subject to volume limitations. The restricted stock studies revealed that letter stock traded at a 13 to 45 percent discount versus what comparable unrestricted stock in the same company was trading for on the public stock exchange.1 The IPO studies involved tracking the price of stocks several months before they were offered to the public versus the price at which the stock was initially offered to the public. Researchers identified that the private transaction prices were 40 to 72 percent less than the price at which the stock was initially offered to the public.2 The discounts observed from both the restricted stock and IPO studies were derived from observing transactions of minority interests. The marketability of a minority interest in a private business can be compounded by restrictions on the transfer of ownership interests often found in private company buy-sell agreements or shareholder agreements.
So, the restricted stock and IPO studies which were based upon the discounts paid for minority publicly traded stocks can be utilized as a benchmark to quantify a discount for lack of marketability for minority privately equity because the base is the same (that is they are both minority equity interests). However, it is inherently incorrect to rely upon the results of the restricted stock or IPO studies (studies of minority interests) to quantify a marketability discount for a controlling interest (a different base). An impairment of value from marketability limitations for minority interests is different than for controlling Interests. Dr. Shannon Pratt issued the following stern warning, “Extensive empirical studies are available to help quantify the discounts for marketability for minority interests. However, starting with such data and somehow moving from there to a discount for lack of marketability (liquidity my emphasis) for a controlling interest is an unacceptable leap of faith, not grounded in logical connection.”3
Factors that Might Affect the Marketability of a Controlling Interest
Selling a controlling interest in a private company continues to be difficult even in the age of the Internet. However, selling a one hundred percent interest has gotten a lot easier. Arguably, the evolution of the business brokerage profession has enhanced the prospects of selling a privately held controlling interest. Moreover, there are several internet-based sites where business owners can advertise their private businesses for sale. The most well-known “BizBuySell.com” has over 35,000 businesses listed for sale at any given time. However, since we use the three-day conversion cycle from investment to cash as our benchmark the prospects for a DLOM still exist even for a controlling interest. This is especially true if the controlling interest does not have the prowess to distribute cash in the form of dividends/distributions. Factors that affect the size of the DLOM for a controlling interest include:
  1. Whether or not the business is market ready.
  2. Uncertainty with regard to the time it will take to sell.
  3. The ability of the company to pay cash dividends/distributions.
Preparing a small business to be sold is comparable to selling real estate—the business needs to be painted, polished, and generally primed to sell. At a minimum this means the business should have the most recent three years business tax returns, financial statements, and a current year interim financial statement readily available. Any major changes in the performance of the business should be analyzed, documented, and preparations should be made to discuss. Legal agreements, employment information, key customer information, supplier information, etc. should be documented and easily accessible. The less prepared a business is to be sold the more likely there might be a DLOM even for a controlling interest.
Research shows that it takes between six to twelve months to sell a one hundred percent interest in a private business. A recent bizbuysell insight report indicated the median time to sell a business had dropped from 181 days to 171 days.4 Common sense dictates that it would likely take longer to sell anything less than a one hundred percent interest. A conversation with management to ferret out previous offers and current activity in the control interest would assist in determining how long it would take to sell.
It is intuitive that an investment that has the ability to distribute cash would have a smaller DLOM or perhaps no DLOM. A critical step in determining any DLOM for a controlling interest is to analyze the company’s history of dividend/distribution payments. Even if the company has not distributed—the ability to distribute will mitigate the DLOM (distributions can be disguised as excessive officers’ compensation, rent, perquisites, etc.). If a company distributes cash or has the ability to distribute, then the owner of a majority interest has the right to receive a return on their equity during the sales process. Whereas a non-distributing interest must wait until the interest is sold to receive any return on their equity.
Privately held controlling equity interests and DLOM conundrum
Unlike minority interests a controlling interest is marketable but as previously mentioned it is illiquid (i.e., it cannot be converted to cash within three business days like an interest in an actively traded public stock). Real property, while marketable, is also illiquid because, generally, it takes time to convert a parcel of real estate into cash by selling it.
The valuation community lacks consensus on the application of discounts for lack of marketability/liquidity in the valuation of controlling interests. Opponents of marketability discounts generally contend that the lack of marketability is reflected in the pricing of the controlling interest. Proponents believe some discount for lack of marketability/liquidity should be made over and above the applied discount or price multiple based on public markets. They argue that when comparisons are made to liquid public stocks in the application of a valuation method, liquidity may be embedded in the private company value.5 So we are left with the conundrum that private company controlling interests may suffer from illiquidity, but we have no empirical studies to benchmark the magnitude (or even the existence of a DLOM).
The DLOM solution: a logical approach
The solution to this problem lies at the essence of valuation theory—”that is hypothetical buyers and sellers are aware of all material facts, and they are under no compulsion to act.” So, it makes sense that hypothetical market participants (both buyers and sellers) would rely on expected rates of return to ascertain any discount for marketability/liquidity. The biggest factors that will affect the rate of return on a controlling interest are distributions/dividends and the expected holding period until the interest can be sold.
By way of example let us assume it would take Bob two years to sell his 51% interest in HVAC, Inc. Bob is going through a divorce and his valuator (Valerie) has valued a one hundred percent interest in a small [but stable] heating ventilation and air conditioning business “HVAC, Inc” at $1,000,000 (Valerie utilized the private company guideline transaction P/EBITDA market method). Valerie valuator is not certain if a discount for lack of marketability is applicable, and no empirical data exists to benchmark whether such a discount is applicable for a controlling interest. However, Valerie knows the business has averaged distributions of $200,000 annually and based upon a survey of local business brokers it would take Bob two years to sell the entire business for $1,000,000 (and thus his 51% interest). Using the internal rate of return “IRR” function in excel Valerie calculates the rate of return to Bob if she applies a twenty percent discount for marketability to the value of Bob’s fifty one percent interest.
The results of the IRR calculation indicate a 35.61% annualized rate of return for Bob if it took him two years to sell his fifty one percent interest. Is this return reasonable? This question can be vetted by examining rates of return realized by investors over the long haul on similar investments. According, to empirical data the long-term rate of return on the smallest publicly traded stocks is 15.79%.6 A 35.61% rate of return would be exorbitant [for a small, but stable HVAC business] and opposition to the divorce proceeding would object to the twenty percent DLOM. Assume the same facts from above except Valerie Valuator applies no DLOM. By updating the internal rate of return parameters with the expected cash flow amounts the results returned are much different.
The twenty percent [20%] IRR in this second scenario is more in line with the long-term rate of return on small cap publicly traded stocks. The only difference between scenario 1 versus 2 is the valuator recognized no DLOM. This illustrates how critical it is for valuation professionals to calculate rates of return to ensure they do not recognize a DLOM which is unsubstantiated. The IRR methodology is intuitive, and this methodology can be utilized to quantify the illiquidity concerns that affect a control interest.
Conclusion
A discount for lack of marketability is often an inherent characteristic of minority interests in private equity. The restricted stock and IPO studies can be relied upon to quantify the DLOM for minority interests of private equity because the starting base—-a minority interest is the same. But it is inherently incorrect for a valuator to attempt to quantify a DLOM for a controlling interest using the same restricted stock and IPO studies (derived from minority interests) because the control base is a different base than the base of the stocks used to quantify DLOM in the studies. Moreover, the reasons for a DLOM for a control interest are different than the factors that affect the size of the DLOM for a minority interest. The IRR function within excel is a powerful tool that calculates the annualized rate of return of an investment using differing scenarios. By correctly using the IRR function a valuator (or a layperson) can determine if a DLOM is warranted for a controlling interest. The use of the IRR method to identify whether a DLOM provides a definitive answer on whether a DLOM for a controlling interest is appropriate or not. For additional reading on this topic please reference the Quantitative Marketability Discount Model.7
Jim Turner, CPA, CVA, CMEA is the Founder and President of Turner Business Appraisers, Inc a provider of valuations across the country. He can be reach for comments at jim.turner@turnerbusiness.com.
1 Pratt, Shannon, “Valuing a Business, The Analysis and Appraisal of Closely Held Companies, 5th Edition, McGraw-Hill, pp. 430-431.
2 IBID. p.438.
3 Pratt, Shannon, “Business Valuation, Discounts and Premiums, 2nd Edition, John Wiley & Sons, Inc., p. 399.
4 BizBuySell, Insight Report, Q2 2022, https://www.bizbuysell.com/insight-report/
5 Hitchner, James R., “Financial Valuation, Applications and Models, 4th Edition, John Wiley & Sons, Inc. p. 412
6 Kroll, U.S. Cost of Capital, return as of August 31, 2022
7 Business Valuation, An Integrated Theory, 3rd Edition, Mercer and Harms, Wiley, pp. 355-358.
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