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Discount for lack of control

What Is Discount for Lack of Control?

A discount for lack of control (DLOC) is a reduction applied to the value of a minority ownership interest in a business, reflecting the fact that this interest does not convey the power to direct the company's policies and management. This concept is a core element within the broader field of business valuation. Unlike a controlling shareholder who can influence strategic decisions, appoint management, and dictate dividend policies, a minority shareholder lacks this ability, which diminishes the value of their stake on a per-share basis compared to a controlling stake.

History and Origin

The concept of control, and thus the discount for lack of control, has been implicitly understood in financial markets for centuries, as controlling interests have always commanded a premium. However, its formal recognition and systematic application in valuation methodologies gained prominence with the evolution of modern financial accounting standards and the increasing need for fair value measurements in various contexts, including litigation, tax, and mergers and acquisitions.

A significant turning point in the formalization of fair value measurements, which inherently consider the presence or absence of control, was the issuance of Accounting Standards Codification (ASC) Topic 820, "Fair Value Measurement," by the Financial Accounting Standards Board (FASB). ASC 820 provides a framework for measuring fair value and expands disclosures. It defines fair value as the "price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."8 Under ASC 820, the application of control premiums and non-controlling interest discounts (which include DLOC) is allowed when a market participant would consider them appropriate.7

Key Takeaways

  • A discount for lack of control (DLOC) reduces the value of a minority ownership interest in a business.
  • This discount reflects the inability of a minority shareholder to influence significant corporate decisions.
  • DLOC is applied in various valuation scenarios, including for tax, litigation, and transactional purposes.
  • Its application is rooted in the principle that control itself holds inherent economic value.
  • The magnitude of the DLOC can vary based on factors such as the company's governance structure and the rights of minority shareholders.

Formula and Calculation

The discount for lack of control is not calculated with a single, universal formula but rather is determined judgmentally based on market data, empirical studies, and the specific characteristics of the subject interest. It is typically expressed as a percentage reduction from the pro-rata value of the controlling interest.

For example, if a controlling interest in a company is valued at $100 per share, and a 20% DLOC is deemed appropriate for a minority interest, then the minority interest would be valued at $80 per share.

The calculation of the discounted value can be represented as:

Minority Interest Value=Pro-Rata Controlling Value×(1DLOC Percentage)\text{Minority Interest Value} = \text{Pro-Rata Controlling Value} \times (1 - \text{DLOC Percentage})

Where:

  • Minority Interest Value is the estimated value of the non-controlling ownership stake.
  • Pro-Rata Controlling Value is the value of the ownership stake assuming it had controlling rights.
  • DLOC Percentage is the determined discount rate, expressed as a decimal.

Valuation professionals often refer to various studies and databases that track control premiums—the inverse of a DLOC—observed in actual transactions to inform their assessment. These studies analyze transactions where a controlling interest was acquired and compare the price paid to the pre-transaction market value of the non-controlling shares.

Interpreting the Discount for Lack of Control

Interpreting the discount for lack of control involves understanding its implications for both buyers and sellers of business interests. A higher DLOC suggests a significant disadvantage for minority shareholders due to limited corporate governance rights. Conversely, a smaller DLOC might indicate that the non-controlling interest still possesses certain protections or rights that mitigate the lack of full control.

In practical terms, the DLOC reflects the economic reality that owners of non-controlling interests cannot unilaterally initiate significant corporate actions such as selling assets, incurring debt, or declaring dividends. These actions can materially affect the cash flow and profitability of the business, and therefore, the value of an investment in it. The discount quantifies the reduced marketability and influence inherent in a minority position.

Hypothetical Example

Consider a private company, "Alpha Innovations Inc.," valued at $10 million on a controlling interest basis. A potential investor, Sarah, is interested in acquiring a 15% minority stake. As a minority shareholder, Sarah would not have the power to make executive decisions, such as appointing the board of directors or selling the company.

A business valuation expert determines that a 25% discount for lack of control is appropriate for Alpha Innovations, based on the company's operating agreement and comparable market transactions for minority interests in similar private companies.

First, calculate the pro-rata value of Sarah's 15% stake assuming control:
( \text{Pro-Rata Value} = $10,000,000 \times 0.15 = $1,500,000 )

Next, apply the 25% discount for lack of control:
( \text{DLOC Amount} = $1,500,000 \times 0.25 = $375,000 )

Finally, subtract the DLOC amount from the pro-rata value to arrive at the fair market value of Sarah's minority interest:
( \text{Minority Interest Value} = $1,500,000 - $375,000 = $1,125,000 )

Therefore, Sarah's 15% minority stake in Alpha Innovations would be valued at $1,125,000 due to the discount for lack of control, reflecting the reduced influence and liquidity of a non-controlling position.

Practical Applications

The discount for lack of control is a critical consideration in several practical financial and legal contexts.

  • Estate and Gift Tax Valuations: When gifting or inheriting shares of a closely held business, the IRS often requires a valuation that considers DLOC. This can significantly reduce the taxable value of the gifted or inherited shares.
  • Mergers and Acquisitions (M&A): While control premiums are more commonly discussed in M&A, the inverse—the discount for lack of control—is implicitly relevant. Acquirers are typically paying a premium to gain control, which implies a pre-existing discount on the non-controlling shares.
  • Shareholder Disputes and Litigation: In cases of shareholder oppression or disputes over the buyout of minority interests, courts often rely on DLOC analyses to determine the fair value of the shares in question.
  • Financial Reporting: Under certain accounting standards, particularly for private equity investments or non-controlling interests in subsidiaries, fair value measurements may incorporate DLOC to reflect the market reality of such stakes. The Financial Accounting Standards Board (FASB) provides guidance on fair value measurements in its Accounting Standards Codification Topic 820. This st6andard mandates that when measuring fair value, an entity must consider characteristics that market participants would take into account when pricing the asset or liability.
  • [5Employee Stock Ownership Plans (ESOPs)](https://diversification.com/term/employee-stock-ownership-plans-esops): Valuations for ESOPs, which typically hold minority interests in a company, almost always apply a discount for lack of control to accurately reflect the value of the shares held by the plan participants.

The application of DLOC reflects the principle that the ability to direct a company's operations, strategic direction, and distribution of profits holds tangible economic value. Academic research, such as a paper published by the National Bureau of Economic Research (NBER), has explored the "control premium," which is the inverse of the DLOC, examining individuals' willingness to pay for control. This re4search suggests that agents may incur costs to avoid delegating and that studies inferring beliefs from choices may overestimate results on overconfidence if the control premium is not accounted for.

Lim3itations and Criticisms

Despite its widespread use, the discount for lack of control (DLOC) faces several limitations and criticisms. One primary concern is the subjective nature of its determination. Unlike publicly traded stocks with readily observable prices, the valuation of private company interests and the appropriate DLOC require significant professional judgment and reliance on empirical data from sometimes dissimilar transactions.

  • Lack of Direct Observability: DLOC is not a directly observable market input. It is typically inferred from control premiums observed in transactions involving publicly traded companies or through studies of private transactions. Critics argue that these studies may not perfectly translate to every unique private company situation.
  • Varying Methodologies: There is no single universally accepted methodology for quantifying DLOC. Different valuation experts may use different approaches, leading to a range of potential discount percentages for the same interest. This can lead to disputes in legal and tax contexts.
  • Impact of Shareholder Rights: The specific rights granted to minority shareholders by a company's articles of incorporation or shareholder agreement can significantly impact the justifiable DLOC. If minority shareholders have strong protective provisions, the discount might be lower, but assessing the value of these provisions is complex.
  • Size and Industry Factors: The applicability and magnitude of DLOC can also be influenced by the size and industry of the company. A minority interest in a highly illiquid, small private company might warrant a higher DLOC than a similar interest in a larger, more established private firm with clearer exit strategies.
  • Double-Counting Concerns: In some valuation models, care must be taken to avoid "double-counting" the lack of control. For instance, if a valuation methodology already inherently captures the lack of control in its inputs (e.g., through higher discount rates for less liquid or less controllable assets), applying a separate DLOC could lead to an undervaluation.

The Federal Reserve Bank of San Francisco has also discussed the broader topic of corporate governance and its impact on firm value, noting the ongoing debate among scholars about how various governance mechanisms affect a company's worth., These 2d1iscussions highlight the complexities in valuation, including factors like control and minority interests.

Discount for Lack of Control vs. Discount for Lack of Marketability

The discount for lack of control (DLOC) and the discount for lack of marketability (DLOM) are both important concepts in business valuation, often applied together, but they address distinct characteristics of an ownership interest.

FeatureDiscount for Lack of Control (DLOC)Discount for Lack of Marketability (DLOM)
What it addressesThe absence of power to direct or influence the management and policies of a business.The inability to quickly convert an asset into cash at its fair market value due to an absence of a ready market.
Reason for discountMinority shareholders cannot control major corporate decisions (e.g., dividends, asset sales, strategic direction).Private company shares, or restricted shares of public companies, lack a public trading market.
Impact on ValueReduces the value per share based on the diminished influence and decision-making power.Reduces the value per share based on the time and cost associated with selling the interest.
ApplicabilityPrimarily to minority (non-controlling) interests.Applicable to both controlling and non-controlling interests in illiquid companies or restricted shares.
ExamplesInability to appoint a majority of the board of directors, dictate operational changes.Takes time and expense to find a buyer, lack of public trading venue.

While the DLOC reflects a lack of operational and strategic power, the DLOM reflects the liquidity constraint inherent in selling a private company interest or restricted shares. For example, shares in a private company might be difficult to sell quickly, regardless of whether the interest is controlling or non-controlling. Therefore, a minority interest in a private company would typically be subject to both a DLOC and a DLOM.

FAQs

Why is a discount for lack of control applied?

A discount for lack of control is applied because a minority ownership interest in a company does not confer the power to make significant business decisions or influence company operations. This lack of control reduces the value of the interest compared to a controlling stake, which commands a premium due to its decision-making power.

Is the discount for lack of control always used in valuations?

The discount for lack of control is typically applied when valuing a non-controlling interest in a business, especially a private one. However, its application depends on the specific purpose of the valuation and the context, such as tax, litigation, or transactional purposes. It would not be applied when valuing a controlling interest.

How does marketability differ from control in valuation?

Marketability refers to the ease and speed with which an asset can be converted into cash at its fair value. Control refers to the ability to direct the management and policies of a business. An interest might be marketable (easy to sell) but still lack control, or vice versa. The discount for lack of marketability accounts for illiquidity, while the discount for lack of control accounts for the absence of decision-making power.

Can a controlling interest also be subject to a discount?

A controlling interest would not typically be subject to a discount for lack of control. However, a controlling interest in a private company can still be subject to a discount for lack of marketability because even a controlling stake in a private entity may be difficult to sell quickly on an open market.

Who determines the appropriate discount for lack of control?

The appropriate discount for lack of control is typically determined by a qualified business valuation professional. This professional considers various factors, including the characteristics of the company, the nature of the ownership interest, industry data, and empirical studies on control premiums and discounts.