Investors in the public companies have the luxury of ascertaining the value of their investment at any point of time. It just takes a few clicks of the mouse to get an update about the stock prices. Investors in the private companies do not have the information about the value of their ownership interests readily available. If not available, how the investors in private company determine the value of their ownership? This blog will provide you the insights into the two key components for valuation of privately held businesses, Discount for Lack of Control (DLOC) and Discount for Lack of Marketability (DLOM).
We apply different valuation approaches to reach the final value, however, it is crucial to consider the nature of ownership interest before concluding the final value. The value of an ownership interest in the private business is affected by many factors, such as control and marketability.
What is Control?
Control is whether or not an ownership interest being valued in the closely held company has significant influence over the actions of the subject company. The controllability over the actions in the company will have a significant impact on the value of the ownership as the controlling interest have some privileges not available to the holder of a noncontrolling ownership interest including the following:
- Select the directors and the management;
- Determine management compensation and other perks;
- Declare the dividends/distributions;
- Set investment policies and business course;
- Acquire and liquidate assets
- Liquidate, dissolve, or sell the company;
- Make Acquisitions
- Borrow funds on the behalf of the company.
Did you know the proper valuation of your business is crucial to your success? Learn more.
What is Discount for Lack of Control?
Given the economics of supply and demand, a buyer who wishes to acquire controlling interest in a subject company may have to pay premium as controlling shareholder enjoys control over company’s action. On the other hand, a non-controlling ownership interest typically lacks above stated privileges, therefore a non-controlling ownership interest in the subject company is usually worthless than a controlling ownership interest, on a per share basis.
There is a price premium for control and the price discount associated with a lack of control which is called Discount for Lack of Control (DLOC).
Let’s understand with the help of an example, the control premium is 25%.
DLOC = 1 – (1/ (1+0.25)) = 20%
So, if the control premium is 25%, the DLOC is 20%.
For determining control premiums, data from the acquisitions of public companies are typically used.
If the valuation methodologies used arrives at the value of a controlling ownership interest, in that case a lack of control discount should be applied to arrive at a non-controlling value.
What is Marketability?
The ability of a commodity to be sold and marketed in the market is called marketability. The concept of marketability in investment relates to liquidity of an investment – that is how readily and certainly an investment can be converted into cash.
What is Lack of Marketability?
For the given investments that are otherwise comparable, market participants may apply a downward adjustment or a discount to the value of the one that cannot be converted into cash quickly at the owner’s discretion. That discount rate is called Discount for Lack of Marketability (DLOM).
There is a marketability difference between ownership interest in the stock of publicly traded company as compared to an ownership interest in the stock of privately held company. The investment in privately held securities is not as liquid and have lesser degree of marketability as compared to the otherwise comparable publicly traded company. A rational investor will pay a premium on price for higher liquidity and will demand a price discount for lack of liquidity. Therefore, if an interest in a firm cannot be easily converted into cash, discount for lack of marketability is applied.
The discount of lack of marketability varies with the following:
- An impending IPO or firm sale would decrease the DLOM
- Dividend payments would decrease the DLOM
- A greater pool of investors/buyers would decrease the DLOM
- Contractual restrictions on selling stock would increase the DLOM
- Greater risk and value uncertainty would increase the DLOM.
There are three ways of estimating DLOM:
- Restricted Stock Method: In this method, price of restricted (unregistered) shares of a company is compared with the price of its publicly traded shares (registered). The price difference between both units is considered DLOM.
- IPO Method: In this method, the price of pre-IPO shares is compared to that of post-IPO shares. The percent difference between the two prices is considered the DLOM.
- Option Pricing Method: In this method, the put option price as a percentage of the stock price is considered the DLOM.
The discount rates DLOC and DLOM are multiplicative as they are applied in a sequential process, so the formula for total discount is:
So, if the DLOC is 25%, and the DLOM is 10%, the total discount is:
Total discount = 1- (0.75 * 0.90)
Total discount = 32.5%
If you’re interested in DLOC and DLOM, check out our article on CPA. Click here.
The consideration of discount for lack of control (DLOC) and discount for lack of marketability (DLOM) is very important in any valuation analysis, particularly those involving minority interest in privately held companies. They are generally applicable when controlling equity is converted to a non-controlling and non-marketable value.