Business valuation methods are used to determine the purchase price in a hypothetical sales transaction where a hypothetical buyer purchases the business from its owner. The price must be adjusted using valuation discounts to reflect the real world circumstances in which a business exists. While the stocks of public companies trade on a public stock exchange, and real estate is marketed on a multi-list service, there is no ready market to buy and sell privately held companies. Also, many owners of private companies who wish to sell their interests do not own a controlling share of the business. Business appraisers have conducted studies to quantify the effects of these realities. Valuation discounts are multiplicative, so they must be considered in order. Minority interest discounts are considered before marketability discounts are applied.

What is a minority interest discount?

Owning a controlling interest in a business confers the prerogatives of control upon the owner. Some of the prerogatives of control include: electing directors, hiring and firing the company’s management and determining their compensation, declaring dividends and distributions, determining the company’s strategy and line of business and acquiring, and selling or liquidating the business. Conversely, owning a minority interest deprives the owner of the prerogatives of control. Minority interests are worth less because minority owners may have little or no say about how the company is operated. Many studies have been done to quantify the discount minority interest owners experience when selling their stock, which may be as great as 50 percent.

Minority interest discounts are assumed equal to the additional price buyers typically pay to buy controlling interests in companies, or control premiums. One of the most common sources of data regarding control premiums is the Control Premium Study published annually by Mergerstat since 1972. Mergerstat compiles data regarding publicly announced mergers, acquisitions and divestitures involving 10 percent or more of the equity interests in public companies where the purchase price is $1 million or more and at least one of the parties to the transaction is a U.S. entity. Mergerstat defines the control premium as the percentage difference between the acquisition price and the share price of the freely traded public shares five days prior to the announcement of the mergers and acquisition transaction. Control premium studies are the source of minority interest discounts.

What is a marketability discount?

Marketability is defined as the ability to convert the business into cash quickly with minimum transaction and administrative costs and with a high degree of certainty as to the amount of net proceeds. For privately held companies, there is no established market of readily available buyers and sellers. All other factors being equal, an interest in a publicly traded company is worth more because it is readily marketable. Conversely, a privately held company is worth less because no established market exists. The “IRS Valuation Guide for Income, Estate and Gift Taxes, Valuation Training for Appeals Officers” acknowledges the relationship between value and marketability, stating, “Investors prefer an asset which is easy to sell, that is, liquid.”

Because it may be costly and time consuming to sell a closely held company, the value must be discounted for lack of marketability. Marketability discounts are based upon longitudinal studies. Several empirical studies have been published that attempt to quantify the discount for lack of marketability. These studies include the restricted stock studies and the pre-IPO studies.

Valuation discounts are significant factors in business appraisals that are used to determine the value of marital property. Individually or collectively, valuation discounts may reduce the enterprise value of a business by a third or more. Understanding valuation discounts is important to lawyers who are representing business owners and their spouses in Pennsylvania divorce proceedings.

Before these issues arise in court or in settlement negotiations, contact one of our family law attorneys for advice and insight.

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