Valuation discounts

What Are Valuation Discounts?

Valuation discounts are reductions applied to the theoretical or pro-rata value of an asset or business interest to reflect specific characteristics that make it less desirable or less valuable than a comparable, freely traded asset. These adjustments are a crucial component within the broader field of valuation in financial analysis. They acknowledge inherent limitations such as a lack of control or marketability, which can significantly impact an asset's market value compared to its intrinsic value if these limitations did not exist. Common scenarios where valuation discounts are applied include the appraisal of private company shares, minority interest stakes, or illiquid assets within an investment portfolio.

History and Origin

The concept of valuation discounts has evolved alongside the increasing complexity of financial markets and the need for fair and accurate appraisals of assets not actively traded on public exchanges. A significant foundational document in U.S. valuation practice is the Internal Revenue Service's (IRS) Revenue Ruling 59-60. Issued in 1959, this ruling provided guidelines for valuing shares of closely held corporations for estate and gift tax purposes. It articulated key factors that appraisers must consider, implicitly acknowledging that non-publicly traded interests often require adjustments to their value due to characteristics like limited salability and lack of control. While not explicitly defining "valuation discounts" as a term, the ruling's emphasis on considering marketability and control laid the groundwork for the formalization and widespread application of such discounts in subsequent decades.⁵

Key Takeaways

• Valuation discounts reduce the theoretical pro-rata value of an asset or business interest.
• They compensate for factors such as limited marketability, lack of control, or specific asset characteristics.
• Common types include the Discount for Lack of Marketability (DLOM) and the Discount for Lack of Control (DLOC).
• These discounts are crucial in valuing private companies, minority interests, and certain illiquid assets.
• Proper application of valuation discounts requires careful consideration of the asset's specific facts and circumstances.

Formula and Calculation

Valuation discounts are typically expressed as a percentage reduction from an initial, unadjusted value. While there isn't a single universal "formula" for valuation discounts themselves, they are applied as a component of the overall asset valuation process.

For instance, if a business interest has an initial pro-rata value determined by a comparable analysis or discounted cash flow (DCF) model, the discount is applied as follows:

Where:

• Adjusted Value = The final value after applying the discount.
• Unadjusted Value = The value derived before considering illiquidity or control issues (e.g., as if the interest were freely traded or a controlling interest).
• Discount Percentage = The determined percentage for the specific valuation discount (e.g., 25% for a lack of marketability discount).

For example, if an unadjusted pro-rata value of a private company share is $100, and a 20% valuation discount for lack of marketability is deemed appropriate, the adjusted value would be:

When multiple discounts are applicable (e.g., a discount for lack of control and a discount for lack of marketability), they are typically applied sequentially, not simply added together, which results in a slightly smaller combined discount than a simple sum.

Interpreting Valuation Discounts

Interpreting valuation discounts involves understanding why an asset or interest is worth less than its pro-rata share of a larger, more liquid, or controlled entity. The size of a valuation discount reflects the degree of impairment to an asset's immediate saleability or the power of its owner. A higher discount implies greater limitations or risks. For example, a significant discount for lack of liquidity indicates that converting the asset to cash quickly would likely incur a substantial price reduction or take a considerable amount of time. Similarly, a large discount for lack of control suggests that the owner has minimal influence over key operational or strategic decisions, which can deter potential buyers seeking active management. The appropriate discount percentage is subjective and determined by market evidence, empirical studies, and the specific facts and circumstances of the asset being valued, including its capital structure and associated risk premium.

Hypothetical Example

Consider XYZ Corp., a privately held manufacturing business. Its founder, Ms. Chen, owns 100% of the equity. She decides to gift 15% of the company's shares to her son. A business appraiser determines the total enterprise value of XYZ Corp. to be $10 million. Therefore, a pro-rata 15% interest would initially appear to be worth $1.5 million.

However, since this 15% represents a minority interest in a private company:

1. Lack of Control: The son, as a 15% owner, cannot dictate business operations, declare dividends, or initiate a sale of the company. A Discount for Lack of Control (DLOC) is applied. Let's assume the appraiser determines a DLOC of 10%.
2. Lack of Marketability: Shares in a private company are not easily sold like publicly traded stocks. There's no active exchange, and finding a buyer can be time-consuming and costly. A Marketability discount (DLOM) is applied. Let's assume the appraiser determines a DLOM of 25%.

The calculation would proceed sequentially:

• Step 1: Apply DLOC
  $1,500,000 (Pro-rata value) × (1 - 0.10) = $1,500,000 × 0.90 = $1,350,000

• Step 2: Apply DLOM to the control-adjusted value
  $1,350,000 (Control-adjusted value) × (1 - 0.25) = $1,350,000 × 0.75 = $1,012,500

After applying both valuation discounts, the fair market value of the 15% interest for gift tax purposes is determined to be $1,012,500, significantly less than the initial pro-rata value of $1.5 million. This reduced value can result in lower gift tax liabilities for Ms. Chen.

Practical Applications

Valuation discounts are widely applied in several financial contexts to accurately reflect the true economic value of assets or interests:

• Estate and Gift Tax Planning: A primary application is in reducing the taxable value of gifts or inheritances involving closely held businesses or real estate. By applying valuation discounts such as the Discount for Lack of Marketability (DLOM) and Discount for Lack of Control (DLOC), the fair market value of transferred interests can be lowered, potentially reducing the overall tax burden for the grantor or estate. Thi⁴s is a common strategy in family wealth transfer.
• Private Equity and Venture Capital: Investors in private equity and venture capital deals routinely account for valuation discounts. The illiquid nature of private investments means that these firms often apply discounts when valuing their portfolio companies, especially for minority positions, to reflect the difficulty and time required to exit the investment. Recent reports indicate that private equity firms are facing increased scrutiny and challenges in overcoming doubts about their valuations, particularly amid higher interest rates that increase borrowing costs for acquisitions.
• ³ Mergers and Acquisitions (M&A): In certain mergers and acquisitions (M&A) scenarios, particularly those involving partial ownership stakes or non-controlling interests, buyers may seek to apply discounts to the value of the target company or its assets to reflect the limitations inherent in such interests. Conversely, premiums may be paid for controlling interest.
• Litigation and Shareholder Disputes: When shareholders are disputing the value of a business interest (e.g., in divorce proceedings, partnership buyouts, or dissenting shareholder actions), valuation discounts become a critical factor in determining a fair settlement or award.
• Financial Reporting: While publicly traded companies rarely apply these specific discounts to their own market-traded shares, private companies or assets held by public companies might require fair value measurements that incorporate valuation discounts for financial reporting purposes, especially under fair value accounting standards.

Limitations and Criticisms

Despite their widespread use, valuation discounts are not without limitations and criticisms. One significant challenge lies in the subjective nature of determining the appropriate discount percentage. Unlike market prices for publicly traded securities, there is no universally agreed-upon formula or direct observable market for these discounts, leading to potential discrepancies in appraisals. Critics argue that analysts may rely too heavily on empirical studies (such as restricted stock studies) that may not perfectly align with the specific characteristics of the asset being valued, potentially leading to over or understatement of the discount.

Ac²ademic research, while acknowledging the existence of a marketability discount, highlights that only a portion of this discount may be attributable to pure illiquidity; other factors like risk, expected growth, and holding periods also play a role. Fur¹thermore, some court cases have provided varying guidance on acceptable discount levels, adding to the complexity and lack of definitive standards. The application of multiple discounts, such as a Discount for Lack of Control (DLOC) and a Discount for Lack of Marketability (DLOM), also presents challenges in ensuring they are applied appropriately and not cumulatively, as sequential application is the accepted practice. Misapplication or overly aggressive use of valuation discounts can lead to disputes, particularly in tax contexts, where the Internal Revenue Service may scrutinize valuations that appear to be solely aimed at minimizing tax liabilities.

Valuation Discounts vs. Marketability Discount

While often used interchangeably by the public, "valuation discounts" is a broader term, and "marketability discount" is a specific type of valuation discount.

In essence, a marketability discount is one of several tools under the umbrella of valuation discounts. When an appraiser refers to "valuation discounts," they might be considering a marketability discount alongside a discount for lack of control, or other specific discounts relevant to the asset being appraised. The confusion often arises because the lack of marketability is one of the most common and significant reasons for applying a valuation discount, especially for private equity and closely held business interests.

FAQs

Q1: What are the most common types of valuation discounts?

A1: The two most common types are the Discount for Lack of Marketability (DLOM), which accounts for the difficulty of selling an asset quickly, and the Discount for Lack of Control (DLOC), which reflects the diminished value of a non-controlling interest that cannot influence key business decisions.

Q2: Why are valuation discounts important for private companies?

A2: Valuation discounts are especially important for private company shares because, unlike publicly traded stocks, they lack immediate liquidity and often represent minority interest stakes with limited control. Applying these discounts helps determine a fair market value for transactions like sales, gifts, or estate transfers.

Q3: Can valuation discounts be applied to publicly traded stocks?

A3: Generally, standard valuation discounts like DLOM and DLOC are not applied to publicly traded stocks because they are actively traded on exchanges (implying marketability) and individual shares represent a minority interest where control is irrelevant. However, a "restricted stock" of a public company (which cannot be freely traded for a period) might be subject to a marketability discount.