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Discounts - Control and Liquidity


When valuing equity interests in privately held businesses, perhaps the greatest impact on the ultimate valuation comes from the application of control and liquidity discounts. There are several techniques for assessing the value of an equity interest (broadly, the income, market and asset-based approaches) and each of these can be modified by control and liquidity discounts. Because investors are risk averse, any characteristic that increases the risk of holding or owning a property (such as lack of control or lack of marketability) will decrease the value of the property to the investor. This is the rationale behind applying discounts. If the owner or potential owner of an equity interest does not have the ability to make control decisions, the risk of the ownership is increased because the owner will be subject to control decisions made by another. The owner will not have the ability to make decisions that increase or even simply maintain the value of the property to the owner. Similarly, if an equity interest is not easily marketable, the owner faces a high degree of risk in the form of a lack of liquidity. The owner may not be able to quickly sell the interest for fair value in the event of a forced liquidity event.

These two discounts are termed a Discount for Lack of Control (DLOC) and a Discount for Lack of Marketability (DLOM). In many cases both of these discounts are applied to an equity interest although it is possible that only one or the other may apply to a particular equity interest. When applying both of the discounts, the effect is multiplicative rather than additive, and convention is to apply the DLOC first and then the DLOM. This convention makes sense because it is possible that controlling interests and non-controlling interests may be subject to a DLOM. Therefore an equity interest may require no DLOC, but still require a DLOM.

The IRS and US courts have accepted the application of control and marketability discounts. Numerous extant decisions embrace the existence of discounts, however, there is great variation as to the amount of an appropriate discount. Empirical studies have been conducted to quantify the mean and median discounts. For example, Mergerstat has shown that average control discounts range from approximately 20% to approximately 35% depending on the year studied and exclusion parameters for outlier observations. Most of the studies that have looked at marketability discounts have studied the difference between prices of publicly traded vs. restricted stocks or have looked at stock transactions before and after an IPO. These studies produce a wide range of implied marketability discounts. Average marketability discounts range from 20% to 40% depending on the study. However it is important to realize that there is a great range of discounts within each study. For example a restricted stock study published by Bruce Johnson in 1999 produced an average marketability discount of approximately 20%, but the range was between - 10% and 60%. The large ranges in such studies highlight the fact that the discount applied in any given valuation are case specific. While an average or a median discount can be informative, additional interest - specific analysis may be warranted.

Craig J. McCann

Eddie O'Neal