Why Privately-Held Businesses Receive Valuation Discounts – Part 1

Privately-held businesses are generally entitled to receive two types of valuation discounts. One is the discount for lack of marketability (DLOM) and the other is the discount for lack of control (DLOC). This blog post will focus on the DLOM, which is available for most privately-held business valuations, whereas the DLOC, as the name would indicate, is only available for a minority ownership stake within a privately-held business. We will explore the DLOC in more detail in a future blog post.

So to begin the discussion of the DLOM, you may be wondering why a private company equity interest would be worth less than its apparent market value. The answer lies in the source of information used to value a share in a business. Many valuation techniques use publicly available information to assign value to a subject entity. Over time, publicly available information has been accumulated in various databases, studies, and reports to help determine the implied value of a business enterprise. Nearly all public company information is derived from stock exchanges, which inherently makes the company’s shares highly marketable. An owner of public company stock can easily sell their holding and convert it to cash via computer or phone.

The owner of a privately-held stock, however, does not have the luxury of being able to sell their holding on a public market. This is where the marketability difference between private and publicly-traded equities exists. The time and effort required to convert a private equity interest into cash is not necessary at the owner’s discretion, and accordingly, the valuation receives a downward adjustment. In addition to the inherent fact that there is not an open market for privately-held equities, below are some other factors which impact the marketability of privately-held stock or equities:

• Finding a willing buyer. Significant time could be incurred to simply find a willing buyer, particularly for a small equity interest.
• Restrictive agreements. Many holders of privately-held stocks are subject to agreements which provide heavy restrictions on to whom the equity can be sold. These agreements can also dictate the value between such parties.
• Transactional costs. Depending on the block of interest being exchanged, the expenses associated with the transaction can be significant. This is best exemplified by a sale of the entire equity interest in a business. These transactions typically incur legal fees, investment banker fees, due diligence costs, and other professional services fees. All of these costs add up and contribute to the discounted value.

Both the marketability discount and the control discount have enabled privately-held owners to transfer an ownership interest in the business at a discounted value and potentially receive favorable tax benefits. This is the reason privately-held business owners use gifting in connection with their estate planning years in advance of a third-party sale of their company. This technique allows the owner to utilize less of their lifetime estate tax credit by 1) transferring the stock before it appreciates further, and 2) using the discount for lack of marketability.

If you would like to learn more about private company valuation discounts, particularly the role they play in estate planning or gifting, please contact your Kreischer Miller relationship professional or any member of our team.

Brian J. Sharkey is a director with Kreischer Miller and a specialist for the Center for Private Company Excellence. Contact him at Email. 

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