Discounts for Lack of Marketability

Discounts for lack of marketability(DLOM) are regularly applied to appraisals of the equity value of closely held firms. Because the dominant income appraisal approach falsely assumes that the purchase of a control equity share in an a closely held firm can be modeled on the purchase of publicly traded fractional minority share of firms traded on public exchanges, certain conceptual problems have to be overcome.

One perceived problem is the difference in liquidity between the equity in closely held firms and minority fractional shares in publicly traded firms. Clearly the latter are much more liquid than the former and so it has been deemed necessary to apply lack of marketability discounts (also referred to as a discount for lack of marketability, or “DLOM”) in valuing the shares of closely held firms.

An entire sub-specialty in the theory of business appraisal has developed and prospered around the issues of just how to develop these discounts. Unfortunately, too much time has been spent on the question of how these discounts should be computed and virtually no time is spent on the question of whether any such discounts should be applied at all. As I shall now show, there is no economic justification for any discount for lack of marketability in the appraisal of control equity interests in closely held small firms.1

Investment Classes and Discounts for Lack of Marketability

The universe of investment opportunities is highly diverse. An investor can choose between marketable securities, real estate, collectibles, closely held businesses, and precious metals, to name the most common forms. Each class of investment has a characteristic level of liquidity. Some, such as marketable securities, are highly liquid. Others are highly illiquid. Informed buyers in all investment classes are aware of the relative liquidity levels of these investments.

The price set to purchase a particular asset within an investment class is based on that asset’s value compared to the value of other assets within that class. If all assets within an investment class have comparable levels of liquidity, liquidity will not be a factor in determining the prices of individual assets within that class.

The only justification for applying a liquidity discount to a particular investment within an investment class occurs if that investment had significantly different liquidity characteristics than other investments within that class. As this is not the case with controlling interests in most closely held businesses, appraisals of such businesses should not be subject to liquidity discounts.

In appraising specific investment opportunities within a particular class of illiquid investments, liquidity is not generally a feature that creates differences in price. When evaluating the price of specific possible investments, buyers and sellers will look for features of these investments that warrant differences in prices. They will ignore common features that do not differentiate one investment alternative from another.

Take the case of real estate. Buyers and sellers negotiating the price of a particular real estate investment do not compare that investment to a common stock or a collectible work of art. Instead, key characteristics of one piece of real estate are compared with that of another. Price differences between alternative possible real estate investment options will be determined by features such as the size and condition of the property, zoning, location, the existence and extent of cash flow, and so forth. The piece of real estate with a better location commands a higher price than one in a worse location.

Similarly, a commercial rental property with several long-term leases will sell at a higher price than a commercial property without tenants. Liquidity, however, will not be a key differentiating factor in pricing individual pieces of real estate, because almost all pieces of real estate are equally illiquid. For these reasons, appraisers of real estate do not consider illiquidity to be a factor in determining value and do not apply lack of marketability discounts to real property appraisals, nor should they.

Analagously, investors in controlling interests in closely held businesses compare a particular potential acquisition with other similar closely held businesses. They will not compare a potential acquisition in a closely held business with the acquisition of a piece of real estate, an art collectible, or marketable securities. They will instead consider the reputation of each business, the size and transferability of its customer base, its historic operating results, the skills and experience of its employees, etc. A closely held business with a well-established reputation and sizable and transferable customer base commands a higher price than a similar closely held business with a lesser reputation and customer base. Those with experienced and highly trained employees command a higher price than a firm with less experienced and talented staff.

If all the potential closely held firms under investment consideration are equally illiquid, this lack of liquidity will have no bearing on their price. Appraisers of closely held businesses should ignore illiquidity in the appraisal of particular businesses for the same reason real estate and art appraisers ignore it. The absence of liquidity has no bearing on prices of particular investments within the class, when all such investments are illiquid.

Of course, current appraisal theory holds that a closely held company in a particular line of business is, in fact, in the same investment class as publicly traded companies in the same line of business. From this standpoint, the equity of a small cabinet maker grossing $75,000 per year is seen as just an illiquid version of the combined value of the common shares of, say, IKEA. Such is the prevailing wisdom in current appraisal practice. However, the similarity of product lines does not define a common investment class. Instead, an investment class is defined by the interplay of buyers' expectations about costs and benefits. An investment market is the same if the buyers seek the same benefits and have similar expectations about costs.

Investor Expectations

There is very little overlap between the expectations of investors in marketable securities and those who acquire equity in closely held businesses. Investors in marketable securities expect and demand a return (in the form of free cash flow) on their investment, combined with liquidity. Investors in closely held businesses have no rational grounds to expect liquidity and, in the case of small, closely held firms, investors often expect returns in the form of compensation rather than free cash flow.

These differences in expectations regarding potential benefits are closely related to the differences in the sacrifices that are expected on the part of investors. Investors in marketable securities do not expect to be obliged to participate in any meaningful way in the operations of a publicly traded company. They are not required to have any special knowledge of the company and may know little about its product lines. Some fairly sophisticated investment approaches depend only on knowledge of the price history of shares and their volatility relative to some broad index.

Furthermore, investors in publicly traded securities often have the ability to diversify their risk. Investors in closely held firms, on the other hand, usually expect to be active in the management of the business. They will ordinarily be very knowledgeable about the business and its product lines. In many cases such investors may be legally required to have professional certifications in order to acquire an ownership interest. In a large number of closely held business investments, the investor expects to work full-time in managing the acquired company.

Investors in closely held businesses seldom have the ability to diversify risk, although mechanisms are available to mitigate it.The key risk mitigation mechanisms available for investments in closely held firms also underscore the differences in investment classes. Specifically, significant differences in sale terms may exist between investments in publicly traded securities and equity in closely held firms. Investors in small, closely held businesses can and often do require sellers to share the risk of investment by financing the acquisition over a reasonable period of time. Often, seller-financed sales call for the sale price to be contingent on retained customers or clients. In contrast, investors in marketable securities bear the full risk of their acquisitions.

Investors in publicly traded securities usually acquire a minority stake in the business (and, in fact, a very small minority stake in the business). Investors in closely held firms usually expect complete or at least controlling interest in the equity of acquired firms.

Because of the restrictions, limitations, and burdens of investments in closely held businesses, there are significantly fewer potential buyers in closely held businesses than in marketable securities. The vast majority of investors in marketable securities would never consider investing in the equity of closely held businesses. Closely held businesses do not provide the free cash flow streams, liquidity, and diversification options that investors in marketable securities demand. The vast majority of investors are not willing or able to perform the management services that equity ownership of closely held businesses often involve.

For all these reasons, closely held businesses represent an entirely different investment market from publicly traded securities, even if there is some overlap in the services or products provided by companies whose shares are acquired.

Restricted Stock Studies

Defenders of discounts for lack of marketability point to restricted stock studies as justification for applying liquidity discounts to closely held shares.2 Restricted stocks are publicly traded equities that cannot be sold until a certain period of time has elapsed. These restricted shares are consistently valued lower than shares of the same company that are not burdened with the sale restriction. This, it is thought, demonstrates that closely held shares should be discounted because they are at least as illiquid as the restricted stocks.

What the restricted stock studies show, however, is that a share of IKEA with a liquidity restriction will have a lower value than the same IKEA stock without the liquidity restriction. The restricted shares are in the same investment class as shares without restriction. Shares of small, closely held cabinetmakers are in different investment classes than the shares in IKEA. Therefore, the restricted stock studies have no bearing on the pricing of closely held companies.

Lack of Control Discounts

The only justification for applying a liquidity discount for a closely held business is if a particular firm has significantly less liquidity than is typical of most closely held businesses in the same sector. Such situations may arise in cases involving the acquisition of non-controlling interests. Having or acquiring a non-controlling interest in a piece of real estate or closely held business can be viewed as an additional impairment to liquidity, beyond the typical illiquidity that comes with owning a controlling interest.

When an investor owns a non-controlling interest in such investments, his or her ability to convert the investment to cash can be thwarted by the owners of the controlling interest. In this case a discount is appropriate; however, this additional illiquidity is usually reflected in the “lack of control” discount, so no further discount is required.3

One problem with applying “lack of control” discounts is that these are notoriously difficult to quantify in any justifiable fashion. The most rational approach to determining a discount would be to compute a differential between the timing on cash flows between the controlling interest equity holder and the non-controlling equity holder. It should not ordinarily be assumed that such a timing differential exists.

In many partnerships or pass through entities, there is little or no timing differences between majority and minority equity holders during the continuing operation of the enterprise. This said, often control equity holders can provide to themselves greater than justified salary, guaranteed payments or other benefits to the detriment of minority equity holders. This is a definite risk of investing in minority equity interest in closely held firms. Of course, this is a risk that minority shareholders in publicly traded securities run as well. It seems to me that in order to apply a lack of control discount, an appraiser ought to be able to justify that circumstances for the particular SC require such a discount. This will not be easy.

Discounts for Income Tax Differences

Another area where discounts have been applied involves income taxes. Here the question involves whether forecast future cash flow used in developing the value of a firm should be reduced for corporate level income taxes. Most closely held smaller firms are organized as pass through entities such as S corporations, proprietorships, partnerships and LLCs.4 However a smaller percentage of these firms are organized as C corporations and are subject to an additional level of corporate tax. Such corporations when selling their assets in an equity transfer will incur a greater level of tax than firms organized under a pass-through structure. In these rarer cases a discount for the higher level of taxes seems reasonable.

Chris Mercer on Discounts

Chris Mercer has written extensively on the topic of appraisal discounts. As I understand it he shares my view that DLOMs should not be applied to control interests in closely held firms. He does hold that they are appropriate in cases where a minority share of ownership is being valued. For more detail on his work click here.

References

1. See my “Liquidity and Investment Class.” The Value Examiner, July /August 2009.

2. See Shannon Pratt’s Business Valuation: Discounts and Premiums, John Wiley & Sons, Inc, New York, 2001, pp. 90-110.

3.  Pratt (2001) discusses these discounts pp. 17-20.

4. According to IRS data in 2012 just under 5% of all business returns were C corporations, the balance were pass through entities.

5.   https://www.irs.gov/uac/SOI-Tax-Stats-Integrated-Business-Data.

 

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