Business valuation is a complex process that requires careful consideration of various factors influencing the perceived value of an asset. Two significant aspects that impact the valuation are the Discount for Lack of Control (DLOC) and the Discount for Lack of Marketability (DLOM). Understanding these discounts and their interrelation is crucial for accurately assessing the value of a business or investment.
Discount for Lack of Control (DLOC):
The Discount for Lack of Control (DLOC) is an adjustment made to account for the absence or limitation of control over an asset. Control refers to the power to make decisions and influence the operations, policies, and financial outcomes of a business entity. When an investor holds a minority interest or lacks the ability to exercise control, the value of their ownership stake may be reduced.
The purpose of applying a DLOC is to reflect the reduced liquidity and control rights associated with a minority interest. It recognizes that controlling interests generally command higher prices due to their ability to shape the entity’s strategic direction and make decisions in their best interest.
Lack of control is reflected in the projected cash flows; that is, whether or not control adjustments have been made to the cash flows.
Discount for Lack of Marketability (DLOM):
The Discount for Lack of Marketability (DLOM) is an adjustment applied to account for the illiquidity or limited marketability of an asset. Marketability refers to the ease with which an asset can be sold or converted into cash without significant time, cost, or effort. When an investment lacks a ready market or has significant restrictions on its transferability, it may be subject to a DLOM.
DLOM recognizes that illiquid investments are less desirable to investors who value the ability to readily exit their positions. It reflects the perceived risk and potential costs associated with converting an illiquid investment into cash.
Lack of Marketability is the ability to sell the interest and obtain the cash quickly without loss of value.
Impact on Valuation:
DLOC and DLOM both result in reducing the perceived value of an asset. However, their effects and underlying rationales differ.
DLOC primarily affects the value of ownership interests in closely held companies. The discount reflects the fact that a minority interest holder may not have control over decision-making processes, leading to a lower valuation. The magnitude of the DLOC is influenced by factors such as the level of control of the majority interest holder, the legal and governance framework, and the company’s specific circumstances.
DLOM, on the other hand, impacts the value of both closely held and publicly traded securities. It reflects the risk associated with holding an investment that lacks marketability, potentially resulting in a longer holding period and reduced ability to sell the asset quickly or at favourable terms. Factors affecting DLOM include the size of the investment, the company’s financial performance and prospects, the presence of transfer restrictions, and prevailing market conditions.
Controlling ownership interests in closely held businesses can also suffer from a lack of marketability. 100 per cent ownership interests in public or closely held businesses are not liquid. A majority but less than 100 per cent control position may take longer to sell than a 100 per cent ownership interest. Such an extended selling period reduces the present value of the proceeds from the sale of the majority ownership interest by the time value of money, resulting in DLOM.
Base Value and Adjustment:
The base value is the starting point from which DLOC and DLOM adjustments are made. It represents the value of an asset as if it were freely marketable and under full control. Determining the base value involves utilizing various valuation approaches, such as income, market, or asset-based methods, depending on the nature of the investment.
Once the base value is established, adjustments are applied to reflect the lack of control and marketability. These adjustments are typically derived from empirical studies, industry data, restricted stock transactions, and other market-based indicators. Appraisers may also employ professional judgment and consider the specific circumstances of the investment being valued.
The base from which the discount for lack of control is subtracted is its proportionate share of the value of the total equity (or at least the common equity), taken as a whole, including all rights of ownership control. The base from which the discount for lack of marketability is subtracted is the value of an entity or interest, usually minority interest, that is otherwise comparable but enjoys higher liquidity (that is, can more readily be sold and converted to cash).
Offsetting Effects and Interrelation:
DLOC and DLOM are distinct discounts, but they can offset or interact with each other in certain scenarios. While DLOC reduces the value of a minority interest, DLOM reduces the value of both minority and controlling interests.
In some cases, the lack of control may be offset by the lack of marketability. For example, a controlling interest may have limited marketability due to specific transfer restrictions or a lack of a ready market. Conversely, a minority interest with a high level of marketability may command a premium due to its liquidity.
The interrelation between DLOC and DLOM requires careful analysis and consideration of the specific circumstances, applicable valuation methodologies, and relevant legal and economic factors. Valuation professionals need to be careful in understanding the specific circumstances surrounding those factors and should not apply DLOC or DLOM on valuation results as an uninformed assumption.
Case Laws:
Several important case laws have shed light on the application of DLOC and DLOM. Two notable cases include:
Mandelbaum v. Commissioner: This case emphasized the importance of distinguishing between DLOC and DLOM. It highlighted that the valuation adjustments should be based on the specific factors influencing control and marketability, rather than merely applying a generic discount.
Estate of Gallagher v. Commissioner: This case recognized the need to consider marketability factors specific to the investment being valued. It emphasized that a one-size-fits-all approach to DLOM is inappropriate and that adjustments should be tailored to the circumstances of the asset.
These cases underline the significance of using well-reasoned and supported methodologies when applying DLOC and DLOM, considering both control and marketability factors comprehensively.
Conclusion:
Discount for Lack of Control (DLOC) and Discount for Lack of Marketability (DLOM) are essential considerations in business valuation. While DLOC accounts for the reduced value of a minority interest due to the absence of control, DLOM reflects the impact of illiquidity or limited marketability. The interplay between these discounts, along with the base value and legal considerations, affects the overall valuation outcome. Understanding the nuances of DLOC and DLOM is crucial for accurate and reliable business valuations that reflect the economic realities of the investment being assessed.
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