How to Estimate the DLOM for Controlling Ownership Interests
Willamette Management Author Explains: What You Need to Know About DLOMs
Aaron Rotkowski explains why itâ€™s appropriate to apply a DLOM to a controlling ownership interestâ€”and how to figure itâ€”and why it doesnâ€™t make sense to rely on restricted stock studies and pre-IPO studies to estimate the DLOM for that interest. Find out more.
The discount for lack of marketability (DLOM) is the subject of many articles and studies, butÂ there is a dearth of literature relating to the application of a DLOM to a controlling ownershipÂ interest in a closely held company.
There are at least two reasons why the DLOM for controlling ownership interests is not widelyÂ covered: (1) the discounts are typically much smaller than the DLOM for minority, orÂ non-controlling, ownership interests (and, therefore, have less of an impact on the valuation, allÂ other factors being equal), and (2) analysts value non-controlling ownership interests moreÂ frequently than they value controlling ownership interests.
Because of the lack of coverage this topic receives, many valuation analysts are not properlyÂ trained to select an appropriate DLOM for a controlling ownership interest. In my experience,Â valuation analysts will sometimes use unsupported or erroneous methods to support the DLOMÂ for a controlling ownership interest.Â
For example, valuation analysts sometimes rely on data presented in restricted stock studies andÂ pre-initial public offering (â€śpre-IPOâ€ť) studies to estimate the DLOM for a controlling ownershipÂ interest. This may lead to a selected DLOM that is too large.
Conversely, valuation analysts sometimes ignore the DLOM altogether when valuing aÂ controlling ownership interest in a closely held company. This may lead to a selected DLOM thatÂ is too small.
This article will address the two common errors valuation analysts make when valuing aÂ controlling ownership interest in a closely held company. Specifically, this article will explainÂ why it is typically (1) appropriate to apply a DLOM to a controlling ownership interest and (2)Â inappropriate to rely on restricted stock studies and pre-IPO studies to estimate the DLOM for aÂ controlling ownership interest. The last section of this article will present one methodology valuation analysts can follow to estimate the DLOM for a controlling ownership interest in a company.
Controlling Ownership Interests v. Non-controlling Ownership Interests
Owners of controlling interests are free to sell their shares to a willing buyer. The owner simplyÂ needs to find a buyer and negotiate the transaction terms. A non-controlling owner, on the otherÂ hand, typically faces severe and oppressive restrictions that affect his ability to transfer theÂ subject non-controlling ownership interest.
The issue facing the controlling owner is therefore a matter of liquidity. That is, the owner is freeÂ to sell his shares, but there is no readily available market into which to sell his shares. This is an advantage over the non-controlling owner, who is faced with problems of liquidity and marketability. Not only does a non-controlling owner lack a market or organized exchange to sell his shares, he is typically restricted from selling his shares by agreement or otherwise. Many valuation analysts will therefore refer to the DLOM for a controlling ownership interest as a discount for lack of liquidity.
Using correct nomenclature is important. However, for ease of understanding, this article will not distinguish between â€śDLOMâ€ť and â€śdiscount for lack of liquidityâ€ť as they apply to controlling ownership interests. This article will refer to the discount as a DLOM.
Error #1: Ignoring the DLOM When Valuing a Controlling Ownership Interest
Â In a valuation context, the DLOM, â€śmeasures the difference in the expected price between (1) aÂ liquid asset (that is, the benchmark price measure) and (2) an otherwise comparable illiquid assetÂ (that is, the valuation subject).â€ť
Actively traded public company stock is an example of a liquid asset. It takes approximatelyÂ three days to receive cash from the sale of an actively traded public company stock. This three-day marketing period (or holding period) is often cited as the benchmark for marketability.
The owner of a controlling ownership interest in a private company has the ability to sell hisÂ ownership interest, but he does not enjoy the same market that the owner of public companyÂ stock enjoys. The most significant difference between the marketability of actively traded publicÂ company stock and a controlling interest in a closely held company is the time it takes to convertÂ the asset to cash.
Many textbooks, articles, and courts have argued/accepted that holding period and value areÂ inversely related. That is, as the investorâ€™s expected holding period increases, the value of theÂ underlying asset decreases.
Based on the fact that (1) investors value marketability and (2) studies show that closely heldÂ companies take around six months to eighteen months to sell (compared to three days forÂ actively traded public company stock), the application of a DLOM to a controlling interest in aÂ closely held company is often appropriate.
Although it is widely accepted that it is appropriate to apply a DLOM in the valuation of aÂ controlling ownership interest, there is not a consensus amongst practitioners.Â
According to Financial Valuationâ€”Applications and Models:Â
There has been an ongoing debate as to whether a discount for lack of marketability should be applied or even considered when valuing a controlling interest. The opponents of marketability discounts are fairly consistent in their arguments that the lack of marketability is included in the pricing of the controlling interest.
Proponents of discounts believe some discount should be made over and above the discount rate or price multiple based upon the valuation method employed.
And, according to Z. Christopher Mercer, â€śMy basic question remains: How can an appraiserÂ discount a controlling interest in a business for lack of marketability when the owner(s) maintainÂ control of the cash flows (which determine the value to begin with) while s/he or they wait?â€ťÂ To paraphrase Mercer, the cash flow that accrues to the 100% owner of a closely heldÂ company during the companyâ€™s marketing period will mitigate any DLOM that would beÂ appropriate. The point Mercer makes is theoretically valid, but does not apply equally to allÂ companies.
It seems intuitive that two assetsâ€”one that can be sold in a day and one that takes six months toÂ sellâ€”would have different values. However, to Mercerâ€™s point, the difference in value betweenÂ the two assets may be small if the owner enjoys (1) benefits (monetary or otherwise) during theÂ holding/marketing period, and/or (2) no increase in sale price risk related to the holding/marketing period. These two characteristics do not affect all closely held companies theÂ same way.
To address Mercerâ€™s point, letâ€™s consider a seller that owns his or her home. If (1) the seller livesÂ in the home, (2) there is no opportunity cost to receiving the sale proceeds in months rather thanÂ days and (3) the expected sale price is approximately the same today as it would be in severalÂ months, then the lack of marketability could be very small.
Consider the opposite scenario. Letâ€™s consider a seller that (1) owns a home that he derives littleÂ utility from (e.g., a second home), (2) could invest the sale proceeds in another investment andÂ earn a superior risk-adjusted rate of return, and (3) is selling his home in a declining real estateÂ market. A six-month holding period under this scenario would clearly have a greater detrimentalÂ impact to value than in the scenario outlined in the preceding paragraph.
The home sale example is analogous to the value of a controlling interest in a closely heldÂ company. An example of a closely held company that would warrant a low discountâ€”based onÂ the factors discussed in the preceding paragraphsâ€”is a highly profitable company that operatesÂ in a mature industry and is listed for sale during a strong economy. A closely held residentialÂ construction company listed for sale anytime during 2006 through 2008 is an example of theÂ opposite facts and circumstances.
It is important that the valuation analyst (1) understands the unique, company-specific factors that would have an effect on the DLOM, and (2) does not apply the same discount in each and every assignment. Applying a 0% DLOM to every controlling ownership interest is just asÂ inappropriate as applying a 35% DLOM to every non-controlling ownership interest.
Error #2: Relying on Restricted Stock Studies and Pre-IPO Studies to Estimate the DLOM
When Valuing a Controlling Ownership Interest
There are two distinct types of empirical studies that are used to estimate the DLOM: (1)Â empirical studies used to estimate the DLOM for non-controlling (or minority) ownershipÂ interests, and (2) empirical studies used to estimate the DLOM for controlling ownershipÂ interests.
Empirical studies used to estimate the DLOM for non-controlling ownership interests are basedÂ on data from transactions involving non-controlling ownership interests. These studies generallyÂ fall into two categories: (1) restricted stock studies and (2) pre-IPO studies.
Restricted stock studies compare the price difference between (1) registered shares of publiclyÂ traded companies (i.e., shares that can be freely traded in the open market), and (2) unregistered shares of publicly traded companies (i.e., shares that cannot be freely traded on the open market).
Pre-IPO studies are based on armâ€™s-length sale transactions in the stock of a closely heldÂ company that has subsequently achieved a successful initial public offering of its stock. In a pre-Â IPO study, the DLOM is quantified by analyzing (with various adjustments) the differenceÂ between (1) the public market price at which a stock was issued at the time of the IPO, and (2) the private-market price at which a stock was sold (in an armâ€™s-length transaction) prior to the IPO. In both the restricted stock studies and the pre-IPO studies, the transactions analyzed involve non-controlling ownership interests (except under certain limited circumstances). These studies are appropriately relied on to estimate the DLOM for non-controlling ownership interests.
On the other hand, the studies that are used to estimate the DLOM for controlling ownershipÂ interests are generally based on (1) the cost to sell the subject company, and (2) the inherent risksÂ that accompany that sale.Â
The DLOM for controlling interests and the DLOM for non-controlling interests are separate andÂ distinct concepts. It is not appropriate to use a discount study related to a non-controlling interestÂ to estimate the DLOM for a controlling interest.Â
According to Business Valuationâ€“Discounts and Premiums, using the discount studies in a wayÂ other than what was intended is a common failure of appraisers:Â
[Restricted stock studies and pre-IPO studies] help quantify discounts for lack ofÂ marketability for minority interests. However, starting with such data andÂ somehow moving from there to a discount for lack of marketability for aÂ controlling interest is an unacceptable leap of faith, not grounded in a logicalÂ connection. The rationale for discounts for lack of marketability for controlling Â interests is different from the reasons for discounts for lack of marketability forÂ minority interests.
And, according to CCH Business Valuation Guide:Â Â
There are two broad methods for developing marketability discounts forÂ non-controlling interests in private companies (there is another set of studiesÂ dealing with controlling interests in private companies).One practical reason (and perhaps the most compelling reason of all) these studies are not applicable to controlling ownership interests is that the restricted stock studies and pre-IPO studies involve transactions in non-controlling ownership interests.
For example, FMV Opinions, Inc. examined 573 restricted stock transactions occurring afterÂ January 1, 1980. The FMV Opinions study is unique because study authors make certainÂ underlying data from the study publicly available. Of the 573 restricted stock transactionsÂ analyzed by FMV Opinions, Inc., 85.5%t of the transactions in the FMV Opinions restrictedÂ stock study involved ownership interest of 20% or less. The distribution of the sharesÂ placed in the FMV Opinions study is presented in the chart below.
Only one out of 573 transactions in the FMV Opinions study involved an ownership interestÂ greater than 50 percent. And, based on my firmâ€™s review of that transaction, that transactionÂ involved related parties and may not be indicative of fair market value. No transaction in theÂ study was for 100 percent of a companyâ€™s equity.Â
Furthermore, my colleagues at Willamette Management Associates and I have reviewed theÂ restricted stock studies and pre-IPO studies. Based on our review of these DLOM studies, theÂ underlying transactions studied either (1) primarily involve non-controlling interests, or (2) do not disclose whether the interest transacted was a controlling ownership interest or non-controlling ownership interest. We found no evidence that a meaningful percentage of transactions involved a controlling ownership interest.
Because the underlying transactions in the restricted stock studies and pre-IPO studies involveÂ non-controlling interests, it is appropriate to rely on the restricted stock studies and/or the pre-IPO studies to estimate the DLOM for a non-controlling ownership interest.
This sort of comparison is common in business valuation. Financial analysts will regularly useÂ information provided by one company or transaction to make inferences about a companyÂ subject to analysis. That is the premise of the guideline publicly traded company method in theÂ market approach to business valuation.
In the Guideline Publicly Traded Company Method, the more comparable the subject company is to the guideline (or comparable) company, the more meaningful the method is. Of course, no two companies are perfect for comparative purposes. If the differences between the guideline company and the company subject to analysis are too large, the comparison may not be meaningful.
Â In the same way that certain guideline companies in the Guideline Publicly Traded CompanyÂ Method are not comparable to the company subject to analysis, certain DLOM studies do notÂ apply to all subject interests.Â Â
For reasons discussed in a preceding section of this article, the differences from a marketabilityÂ perspective between the two interests (i.e., a controlling ownership interest and a non-controllingÂ ownership interest) are typically too large for this comparison to be meaningful. The mostÂ significant difference in marketability between controlling ownership interests andÂ non-controlling ownership interests is that owners who enjoy the prerogatives of control are freeÂ to sell their ownership interest whereas non-controlling owners typically are not.Â
Relying on the correct discount study or studies is important because the studies concludeÂ significantly different discounts. The consensus among valuation analysts is that DLOMs for controlling interests are significantly less than DLOMs for non-controlling interests.Â
Current Methodology Commonly Used to Estimate the DLOM for a Controlling
This article focuses on common errors in the application of a DLOM to a controlling ownershipÂ interest. A detailed presentation of the correct way to select a DLOM for a controlling ownershipÂ interest is outside the scope of this article. This section will briefly summarize (1) one commonÂ way valuation analysts estimate the DLOM for a controlling ownership interest, and (2)Â advantages and disadvantages of using that method to estimate the DLOM for a controllingÂ ownership interest.
One of the more common ways analysts estimate the DLOM for a controlling ownership interestÂ is to (1) estimate the costs to sell the subject company, and (2) calculate the costs as a percent ofÂ company value to conclude the DLOM.
According to Business Valuation and Taxes, the five factors must be analyzed in estimatingÂ discounts for lack of marketability for controlling interests are:Â
- Flotation costs (the costs of implementing an initial public offering)
- Professional and administrative costs, such as accounting, legal, appraisals, and management time necessary to prepare the company for a sale or IPO
- Risk of achieving estimated value
- Lack of ability to hypothecate (most banks will not consider loans based on private companyÂ stock as collateral, even controlling interests)
- Transaction costs (payments to an intermediary or internal costs incurred in finding andÂ negotiating with a buyer).
The primary advantage to relying on these five factors to estimate the DLOM for a controllingÂ ownership interest is that it has been accepted by various courts. A second advantage of thisÂ method is that it has been promulgated in books and articles. Third reason analysts rely on thisÂ method is that there is not compelling empirical support for an alternate method to estimate theÂ DLOM for a controlling ownership interest.
However, relying on the cost to sell the subject company to estimate the DLOM for a controllingÂ ownership interest has disadvantages. Valuation analysts that estimate a DLOM for a controllingÂ ownership interest should also understand the disadvantages associated with relying costs to sellÂ the subject company to estimate the DLOM for a controlling ownership interest.Â
First, the value of a company is typically thought to exclude transaction costs. Letâ€™s assume thatÂ the invested capital of a business is worth $100 million, and transaction costs to sell the businessÂ are $5 million dollars. The value of that business is typically thought to equal $100 million, notÂ $95 million. That is, there generally is no relationship between the value of a business (and, byÂ extension, marketability) and the transaction costs to sell that business.
Second, marketability is typically defined as the difference in price an investor will pay for aÂ liquid asset compared to the price he will pay for an illiquid asset. Based on this definition, theÂ transaction costs to sell a controlling interest in an asset are not necessarily indicative of theÂ difference an investor will pay for a liquid asset compared to the price he will pay for an illiquidÂ asset.
Analysts should (1) consider the strengths and weaknesses of whatever method they rely on toÂ estimate the DLOM for a controlling ownership interest, and (2) consider how company-specificÂ factors will affect the DLOM (i.e., should the discount be on the high end of some indicatedÂ range or the low end of some indicated range).
There is no â€śperfectâ€ť method to estimate the DLOM for controlling ownership interests inÂ closely held companies. In fact, the subject receives relatively little discussion relative to theÂ DLOM for non-controlling ownership interests. In spite of this, there are two concepts related toÂ selecting the appropriate DLOM for a controlling ownership interest that are widely acceptedÂ amongst valuation practitioners.
First, the DLOM for a controlling ownership interest is indeed usually appropriate. And second, it is not appropriate to rely on data presented in restricted stock studies and pre-IPO studies to estimate the DLOM for a controlling ownership interest. The financial analyst will produce more a credible and convincing valuation report if he or she is mindful of these two concepts when valuing a controlling ownership interest in a closely held company.
Moreover, the valuation analyst should specifically consider the specific facts andÂ circumstances of the subject controlling interest when selecting a DLOM for a controllingÂ ownership interest in a closely held company.
Aaron M. Rotkowski, CFA, ASA is manager at Willamette Management Associates.Â Aaron has over a decade of business valuation experience. His practice focuses onÂ forensic analysis and dispute resolution, business and stock valuations, and valuations forÂ other purposes. Aaron can be reached at (503) 243-7522 or atÂ firstname.lastname@example.org.