When valuing a closely held, private company, it is important to recognize that the process may be more complex than valuing a publicly traded one. While valuation experts apply discounts at both the entity and shareholder levels, this blog will focus on exploring the various types of shareholder-level discounts and their impact on the valuation of closely held companies.
Shareholder-level discounts are applied specifically to the value of an individual shareholder’s interest, accounting for the unique risks and limitations associated with owning a specific ownership interest. These discounts are used in the valuation process to arrive at a more accurate representation of the fair market value of a shareholder’s interest.
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Discount for Lack of Marketability (DLOM)
Selling shares and liquidating funds is not as simple for a private company as for a publicly traded company. In a public company, shareholders can typically sell their shares on a stock exchange and receive the proceeds within a few days. However, this is not the case for closely held companies, where selling shares can be lengthy and complex due to the lack of a readily available market.
The discount for lack of marketability is one of the most frequently applied discounts in valuing closely held companies. This discount reflects the difficulty of selling or liquidating ownership interests in a private company compared to a publicly traded one. The DLOM is used to account for the limited liquidity of closely held company shares and the potential difficulty in finding a buyer.
Additionally, legal and contractual restrictions such as shareholder agreements or transfer restrictions can further limit the marketability of shares in a closely held company, making the application of the DLOM even more relevant.
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Discount for Lack of Control (DLOC)
In closely held companies, the level of control associated with an ownership interest can significantly impact its value. Minority shareholders often face limitations in influencing key business decisions, such as setting strategic direction, hiring or firing management, determining compensation, or approving mergers and acquisitions.
The discount for lack of control is applied to account for the diminished value of an ownership interest that does not have the power to control the company’s operations and decision-making processes. This discount is based on the premise that investors are willing to pay more for an ownership interest that gives them control over the business compared to one that does not.
The DLOC is typically determined by considering factors such as the size of the ownership interest, the company’s governance structure, and the rights and restrictions associated with the interest. For example, a 20% ownership interest in a company with a single controlling shareholder may be subject to a higher DLOC compared to a 20% interest in a company with more dispersed ownership and stronger minority shareholder rights. In shareholder disputes, there may be no DLOC, even for a minority interest, considering the standards of value are different than in other types of valuation engagements such as matrimonial.
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Voting / Non-Voting Stock Discount
In some closely held companies, there may be different classes of stock with varying voting rights. Non-voting stock typically trades at a discount compared to voting stock, as it lacks the ability to influence company decisions. The voting vs. non-voting stock discount reflects the diminished control and influence associated with non-voting shares.
Many valuation reports erroneously conflate the value of voting stock at the minority level, assuming a significant difference between the two. In reality, minority shareholders, even those with voting rights, often have limited practical ability to influence the company’s direction or decision-making processes, as the majority shareholders can outvote them.
It is important to note that the application and size of these shareholder-level discounts can vary significantly based on the specific circumstances of each closely held company. By understanding the role of shareholder-level discounts and collaborating closely with valuation experts, you can ensure that the valuation reports accurately account for the unique characteristics of your clients’ ownership positions, ultimately helping them to make informed decisions.