Valuation Advisor: Discounts help determine value

The valuation of privately held firms, including those in the A/E/P and environmental consulting industry, will usually involve discounting to arrive at a concluded value of the subject interest. Readers who have been through the valuation process in the past are at least familiar with the terminology. For those who have not, a primer is in order. To place a value conclusion on a privately held business interest, we must determine the level at which the valuation will be done – a control interest basis or a minority interest basis. An owner of a 51 percent or more interest is considered a “control” owner and a holder of 49 percent or less is considered a “minority” owner. In the context of fair market value, these two levels of ownership are significantly different. It would be easy to assume that the value of a minority interest in a privately held firm is equivalent to the pro rata value of 100 percent interest, but that is not the case. Issues of control and marketability must be taken into account. The other contributing factor a valuation professional takes into consideration to determine discounts is the actual methodology employed in the appraisal process. The various approaches to value can produce results on a different basis.

• Asset approach – Under an asset approach, no individual shareholder owns the corporation’s assets at the individual level; shareholders with a majority position and voting control have the ability to control the corporation and the accumulation or disposition of the assets. Therefore, the control shareholders have access to the equity in the assets – and asset-based methodologies produce values at the control level.
• Income approach – Depending on the appraiser’s decision as to the level of normalizing adjustments to the financial statements, income approach methodologies can produce a value indication at the control or minority interest level. If “control” normalizing adjustments are made, the value indication is at the control level. The opposite is true if the only normalizing adjustments made are those applicable to what a minority interest holder could affect.
• Market approach – The transaction data used in a market approach methodology will have a direct correlation to the level of value produced. Transactions involving privately held companies are representative of a control interest; public company data is representative of minority interests.

Let’s now take a look at discounts.

• Discount for lack of control – A discount for a minority interest is taken from a control-level value indication to account for the lack of control associated with a minority shareholder. Empirical evidence suggests that the size of the minority interest discount is based on control premium, resulting in implied discounts of about 25 percent. To develop the appropriate discount for a subject interest properly, an appraiser should consider several factors that could increase or decrease the discount. Factors include non-voting interests, extreme lack of consideration of minority shareholders, an interest insufficient to stop corporate action or elect a director, the existence of put rights and the presence of enough minority owners to block certain actions or have a meaningful input on the election of directors.
• Discount for lack of marketability – This type of discount is meant to account for the lack of liquidity (or marketability) of stock that is not traded on public exchanges. There’s a market of readily willing buyers and sellers for publicly traded stocks. That market is able to consummate transactions in a short period of time and the proceeds are usually available within three business days. In contrast, closely held shares – which are economically impaired due to lack of access to active markets – have a small market. Studies point to the existence of discounts on sales of restricted shares of publicly traded companies and discounts on sales of closely held shares compared to prices of subsequent IPO offerings of the same company’s shares. In all, the studies suggest a range of discount from about 10 to 35-plus percent. As with discounts for lack of control, the appropriate discount for a subject interest depends on multiple factors, including transfer rights, dividends or the lack thereof, the prospect of selling the firm, the existence of a market for the block of shares being valued, put rights, the existence of a buy-sell agreement, stability of earnings, etc.

Multiple considerations need to be taken into account when valuing a privately held company, its many moving parts and the discounting appropriate for the subject interest. What shareholders should take away from this brief discussion is that every decision made within a firm, from financial to corporate governance, will have an implication on the final value conclusion. The valuation of privately held firms, including those in the A/E/P and environmental consulting industry, will usually involve discounting to arrive at a concluded value of the subject interest. Readers who have been through the valuation process in the past are at least familiar with the terminology. For those who have not, a primer is in order. To place a value conclusion on a privately held business interest, we must determine the level at which the valuation will be done – a control interest basis or a minority interest basis. An owner of a 51 percent or more interest is considered a “control” owner and a holder of 49 percent or less is considered a “minority” owner. In the context of fair market value, these two levels of ownership are significantly different. It would be easy to assume that the value of a minority interest in a privately held firm is equivalent to the pro rata value of 100 percent interest, but that is not the case. Issues of control and marketability must be taken into account. The other contributing factor a valuation professional takes into consideration to determine discounts is the actual methodology employed in the appraisal process. The various approaches to value can produce results on a different basis.

• Asset approach – Under an asset approach, no individual shareholder owns the corporation’s assets at the individual level; shareholders with a majority position and voting control have the ability to control the corporation and the accumulation or disposition of the assets. Therefore, the control shareholders have access to the equity in the assets – and asset-based methodologies produce values at the control level.
• Income approach – Depending on the appraiser’s decision as to the level of normalizing adjustments to the financial statements, income approach methodologies can produce a value indication at the control or minority interest level. If “control” normalizing adjustments are made, the value indication is at the control level. The opposite is true if the only normalizing adjustments made are those applicable to what a minority interest holder could affect.
• Market approach – The transaction data used in a market approach methodology will have a direct correlation to the level of value produced. Transactions involving privately held companies are representative of a control interest; public company data is representative of minority interests.

Let’s now take a look at discounts.

• Discount for lack of control – A discount for a minority interest is taken from a control-level value indication to account for the lack of control associated with a minority shareholder. Empirical evidence suggests that the size of the minority interest discount is based on control premium, resulting in implied discounts of about 25 percent. To develop the appropriate discount for a subject interest properly, an appraiser should consider several factors that could increase or decrease the discount. Factors include non-voting interests, extreme lack of consideration of minority shareholders, an interest insufficient to stop corporate action or elect a director, the existence of put rights and the presence of enough minority owners to block certain actions or have a meaningful input on the election of directors.
• Discount for lack of marketability – This type of discount is meant to account for the lack of liquidity (or marketability) of stock that is not traded on public exchanges. There’s a market of readily willing buyers and sellers for publicly traded stocks. That market is able to consummate transactions in a short period of time and the proceeds are usually available within three business days. In contrast, closely held shares – which are economically impaired due to lack of access to active markets – have a small market. Studies point to the existence of discounts on sales of restricted shares of publicly traded companies and discounts on sales of closely held shares compared to prices of subsequent IPO offerings of the same company’s shares. In all, the studies suggest a range of discount from about 10 to 35-plus percent. As with discounts for lack of control, the appropriate discount for a subject interest depends on multiple factors, including transfer rights, dividends or the lack thereof, the prospect of selling the firm, the existence of a market for the block of shares being valued, put rights, the existence of a buy-sell agreement, stability of earnings, etc.

Multiple considerations need to be taken into account when valuing a privately held company, its many moving parts and the discounting appropriate for the subject interest. What shareholders should take away from this brief discussion is that every decision made within a firm, from financial to corporate governance, will have an implication on the final value conclusion.