Measuring the DLOM for a Closely Held Company Controlling Interest

Six Transaction Risks Owners Face Selling a Company that May Explain DLOM (Part I of II)

In this first of a two-part article, Robert Reilly reviews the various models analysts use to estimate the DLOM and factors analysts consider in the DLOM selection. Valuation analysts often value closely held companies for transaction, taxation, financing, accounting, litigation, and other purposes. Depending on: 1) the business valuation approaches and methods applied, and 2) the benchmark valuation data used, the analyst may initially conclude the value of the closely held company on a marketable (as if traded on a stock exchange) basis. In that case, the analyst may have to apply a discount for lack of marketability valuation adjustment to the initial as-marketable value indication in order to conclude the value of a controlling interest (including a 100 percent ownership) in a closely held company. Read Part II here.

Introduction

Valuation analysts (analysts) often value closely held companies for transaction, taxation, financing, accounting, litigation, and other purposes.  Depending on: 1) the business valuation approaches and methods applied, and 2) the benchmark valuation data used, the analyst may initially conclude the value of the closely held company on a marketable (as if traded on a stock exchange) basis.  In that case, the analyst may have to apply a discount for lack of marketability (DLOM) valuation adjustment to the initial as-marketable value indication in order to conclude the value of a controlling interest (including a 100 percent ownership) in a closely held company.

This discussion summarizes the following topics:

1. Various empirical and theoretical models that may be used to estimate the DLOM;
2. Application of the DLOM to the valuation of a closely held company; and
3. Factors to consider in the DLOM selection.

Reasons to Consider the DLOM

In the U.S. public capital markets, investors can quickly sell most publicly traded securities at the last public trade price.  The transactions typically occur at a very small commission cost.

[su_pullquote align=”right”]Resources:

Business Valuation Certification and Training Center

Advanced Valuation: Applications and Models Workshop

On-Demand Webinar: Marketability Discounts Reconciling Differing Approaches/Methods

On-Demand Webinar: DLOM Verification Formula

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By contrast, the population of potential buyers for most closely held companies is a small percentage of the population of potential buyers for publicly traded securities.

In fact, it may be illegal for an individual or an issuer to sell closely held securities to the general public without first registering the security offering with either the:

1. Securities Exchange Commission (SEC), or
2. State corporation commission.

Such a security offering registration is an expensive and time-consuming process.  When valuing a closely held company by reference to publicly traded stock market data, empirical evidence suggests that a DLOM valuation adjustment may be appropriate.

Baseline from Which to Apply the DLOM

In the closely held company valuation, analysts typically apply one or more of the three generally accepted business valuation approaches:

1. Market Approach;
2. Income Approach; and/or
3. Asset-based Approach.

In the typical application of the three business valuation approaches, the resulting value indications are typically concluded on a marketable ownership interest basis.

The amount of any appropriate DLOM depends on the facts and circumstances related to the subject closely held company.  This discussion summarizes the factors that analysts typically consider in the measurement and selection of the DLOM.  Certain engagement-specific factors may also affect the application of any DLOM.

Illiquidity of a Controlling Ownership Interest

The value decrement associated with a controlling ownership interest in a close company is due to the following two factors:

1. The absence of a ready private placement market; and
2. Flotation costs (which would be incurred in achieving liquidity through a public offering).

The owner faces the following transaction risk factors when attempting to sell the close company:

1. An uncertain time horizon to complete the offering or sale;
2. “Make ready” accounting, legal, and other costs to prepare for and execute the offering or sale;
3. Risk as to the eventual sale price;
4. Uncertainty as to the form (e.g., stock or cash) of transaction sale proceeds;
5. Inability to hypothecate the subject equity interest; and
6. Investment banker or other brokerage fees.

Risk factors one through five are summarized below.  A summary of risk factor six—that is, investment banker or brokerage fees—is presented in the “cost to obtain liquidity studies” discussion in Part II of this article of an upcoming QuickRead.

Investment Time Horizon Uncertainty

It may take months (or even years) to complete the offering or sale of a closely held company.  This uncertain (but considerable) time horizon contrasts with the principle of marketability.  The principle of marketability typically implies a short ownership-interest-for-cash conversion period.

“Make Ready” Costs

The business owner may incur substantial costs to:

1. Prepare the close company for sale; and
2. Execute the close company offering or sale.

A study published in 2000 concluded that underwriter costs alone typically represent seven percent of the transaction size in an initial public offering (IPO).[1]  These underwriter costs do not include:

1. Related auditing and accounting fees;
2. Legal costs to draft documents, clear contingent liabilities, and negotiate warranties; and
3. Business owner administrative costs.

In “The Cost of Going Public,” Jay Ritter estimated these “other” transaction costs to be between 2.1 percent and 9.6 percent of the IPO proceeds.[2]

Expected Sale Price Uncertainty

The business seller may not achieve the close company expected sale price because of many factors:

1. Overstatement of the business value on which the expected price is based;
2. Occurrence of company events during the market exposure period that cause the sale price to decrease;
3. Occurrence of market events during the market exposure period that cause the sale price to decrease;
4. Lack of receptivity by capital markets to companies in the subject industry; and
5. Lack of receptivity by capital markets to the subject company.

Expected Sale Proceeds Uncertainty

If the business sale proceeds are in a form other than cash, then the cash-equivalent transaction price may be less than the reported transaction consideration.  Examples of the sale proceeds components that may have a cash equivalency value below face value include the following:

1. Restricted public stock;
2. Seller-provided below-market financing;
3. Future contingency payments; and
4. Future earn-out payments.

Inability to Hypothecate the Ownership Interest

Banks are reluctant to lend based on using a closely held company ownership as the loan collateral.  Accordingly, it is difficult for the closely held company owner to borrow against the expected transaction sale price.

Investment Banker or Other Brokerage Costs

One component in the DLOM consideration in the close company value is the cost to obtain liquidity studies.  These DLOM studies only apply to the analysis of controlling interests in the close company.  Several cost of obtain liquidity studies are summarized in Part II of this article of an upcoming QuickRead.

The seller of a closely held company may incur other costs in addition to the:

1. Underwriter fees; and
2. “Other costs” described above.

The above discussion mentioned six factors that contribute to the close company DLOM.  In order to measure the DLOM, analysts should consider all of the costs to sell a controlling interest in the close company.

Subject Company Risk

Another factor that may affect the close company DLOM is the subject company risk.  Numerous studies conclude that the DLOM size is related to the stock price volatility (one measure for risk).  Numerous studies also attribute company size (another measure for risk) with the DLOM size.

Analysts generally agree that a large closely held company is a “safer” investment than a similar small closely held company, all other factors being equal.  This conclusion is illustrated by comparing the expected rates of return on large-capitalization companies to small-capitalization companies.

Ibbotson Associates makes this comparison in the Ibbotson SBBI 2015 Classic Yearbook:

One of the most remarkable discoveries of modern finance is that of a relationship between company size and return…  The relationship between company size and return cuts across the entire size spectrum…  Small-cap stocks are still considered riskier investments than large-cap stocks.  Investors require an additional reward, in the form of additional return, to take on the added risk of an investment in small-cap stock.[3]

Large companies are perceived as safer investments than are small companies.  This is because greater earnings typically enable the company to:

1. Withstand downturns in the economy and the subject industry; and
2. Capitalize on growth opportunities.

Factors, in addition to size, can also affect the closely held company risk.  The following list includes some of the factors that may affect close company risk:

• Historical financial ratios;
• Historical earnings trends/volatility;
• Management depth;
• Product line diversification;
• Geographic diversification;
• Market share;
• Supplier dependence;
• Customer dependence;
• Deferred expenditures; and
• Lack of access to capital markets.

Each of the above factors should be examined within the context of how they affect the close company owner.  Analysts typically consider how each factor affects the business owner’s ability to sell the close company.

Summary and Conclusion

Analysts often value controlling interests in closely held companies for various transaction, taxation, accounting, financing, and litigation reasons.  Depending on: 1) the valuation approach and valuation method applied; and 2) the benchmark valuation variable date used, the analyst may initially conclude the value of the close company on a marketable (as traded on a stock exchange) basis.

In such an instance, the analyst may need to apply a DLOM valuation adjustment to conclude the nonmarketable value of a controlling (including 100 percent) interest in the closely held company.  This discussion summarized the factors that analysts typically consider in order to measure the DLOM for a controlling (including 100 percent) interest in a closely held company.

 

[1] Hsuan-Chi Chen and Jay Ritter, “The Seven Percent Solution,” The Journal of Finance (June 2000): 1129.

[2] Jay Ritter, “The Costs of Going Public,” Journal of Financial Economics (January 1987): 269–281.

[3] Ibbotson SBBI 2015 Classic Yearbook (Chicago: Morningstar, 2015), 99, 113.

Robert Reilly, CPA, ASA, ABV, CVA, CFF, CMA, CBA, is a managing director of Willamette Management Associates based in Chicago. His practice includes business valuation, forensic analysis, and financial opinion services. Throughout his notable career, Mr. Reilly has performed a diverse assortment of valuation and economic analyses for an array of varying purposes.

Mr. Reilly is a prolific writer and thought leader who can be reached at (773) 399-4318, or by e-mail to rfreilly@willamette.com.