There’s something great about knowing you got a discount. The thought of saving money gives all of us a sense of accomplishment that’s usually greater than the actual monetary savings. As valuation experts, we know that our tax valuation clients also love discounts – maybe even more so!
WHICH DISCOUNTS ARE APPROPRIATE
There are two main discounts that can be taken for valuation purposes: 1) a Discount for Lack of Marketability (DLOM); and, 2) a Discount for Lack of Control (DLOC). (In some circumstances other discounts may be valid, such as a discount for lack of voting (DLOV), key person discount, etc., however, typically these other ‘discounts’ are components of the DLOM or DLOC and are included in these two discounts rather than being identified separately).
- A DLOM is justified based on the lack of a ready market to sell securities of a privately held business. You and I can purchase Apple or Amazon stock on an exchange in an instant and sell just as easily. However, the additional time, the cost to shop, and the cost to market the private securities, suggests that the private security should be sold at a discount when compared to the public security due to this lack of a ‘ready market’ to sell it. (This should not be confused with an illiquid investment. According to section 7.16 of the valuation handbook: “A nonmarketable investment is one that lacks a ready market; an illiquid investment is one in which a market exists, but the investment is not actively traded, or restrictions on the investment prevent access to that market”(AICPA, 2013).
- A DLOC suggests that a minority shareholding would command a lesser price than the same interest with a controlling position because of the inability to make decisions and to generally affect the operations and direction of the business. Section 7.03 of the ACIPA Accounting and Valuation Guide identifies aspects of ‘control’ as:
- “Making investment decisions;
- Appointing management;
- Determining the amount of any special dividends paid; and
- Liquidating, dissolving, selling, or recapitalizing the enterprise”(AICPA, 2013).
A DLOM and/or DLOC can be the most significant input into a valuation, sometimes decreasing the value up to 45% (You can now see why tax valuation clients love these discounts!).
So how do you determine which discount is appropriate and the magnitude of the discount?
HOW DO YOU SELECT THE APPROPRIATE DISCOUNT?
You would think with so much at stake in the selection and application of said discounts, that there would be a robust and stringent system to calculate the discount and to justify its existence. However, from my experience and research as a valuator, it appears to still be one of the most arbitrary parts of a valuation analysis.
I mean, who’s to say that the discount for the lack of a ready market for Company ABC is exactly 24%? How can one argue that an exact numerical discount of 10% perfectly captures the level of value of the control that one investor has compared to another investor that doesn’t have control? Like most questions in finance, there isn’t usually one right answer.
WHAT RANGE OF DISCOUNTS DO YOU TYPICALLY SEE?
Does this mean that we can select the highest discount within this range for every valuation?
The issue of which discounts are appropriate, the method to estimate the discount, and the magnitude of the discount applied have been highly debated over the years. Some authors have stated median averages from studies for a DLOM of 25% to 35% (AICPA, 2012) with a full range of approximately 16% to 45% (AICPA, 2012). Similarly, academics have commented that “in many cases, the discount for lack of control would be minimal”.
Various court cases (arguably the most famous being Commissioner vs. Mandelbaum) define considerations that analysts must make when selecting discounts and have commented on the misapplication of both discounts and double-discounting, especially in gift and estate valuations. Furthermore, academics have prescribed different methods to calculate an estimated discount based primarily on “a function of the duration of the restriction (time) and the risk of the investment (volatility) (AICPA, 2013).
With this level of attention to the selection and application of discounts, a valuator must be very careful in his or her approach. Unlike a sales rep, who has the discretion to offer multiple discounts to clients based on target monthly revenues or the insistence of the client, we as valuators cannot ‘hand out’ discounts.
SUPPORTING THE DISCOUNTS IS THE KEY
From my research and my experience with auditors, most of the time the issue with a discount is not the magnitude of the discounts (as long as it is within the range of reasonable), but the lack of support for the selection and application of discounts. NACVA suggests that “The key to the successful application of discounts in a valuation situation (whether tax related or not) is to properly support and explain the basis for the discount. Traditionally, this is an area where valuators have failed the most” (NACVA, 2015).
That’s not to say that you can apply whatever discount you want as long as you find an article that might allow it. But it emphasizes the need to support the selected discount with a detailed analysis which includes both qualitative and quantitative factors.
The AICPA itself suggests in section 7.31 that “Estimating a discount for lack of marketability is challenging, and none of these methods is completely satisfactory in all respects.” (AICPA, 2013).
Still the debate continues.