Every accountant, attorney, or advisor guiding a privately held business owner eventually runs into the same question: “What is the business really worth?” The word “really” suggests a bit of skepticism and proposes the need for a framework. This series dissects that structure: the anatomy of a valuation that the opposing side of the table will respect rather than tear apart. Part II examines what exactly is being valued.
In Part I, we built the structure of a defensible valuation: triangulated methods, normalized earnings, a documented discount rate, a terminal value that respects common sense. Now comes the question that unravels more valuations than any spreadsheet error ever will, and at this point it sounds almost too basic to ask: What, exactly, is being valued? That answer is rarely precise. Is it 100% of the equity, with full control, ready to be sold to a strategic buyer?[1] Is it a 25% interest held by a sibling who cannot sell to anyone outside the family without approval? Is it a limited partnership interest in an entity whose agreement restricts transfers for another decade?
These are radically different assets, with different degrees of complexity, even when they sit inside the same company. A dollar of value at the enterprise level does not translate into a dollar in every holder’s hands. The bridge between these different values is built from premiums and discounts. It is here where the IRS concentrates its fire power. It is here where the opposing side of the table disagrees with you. It is also here where we, valuation professionals, earn our keep.
Values change depending on what specifically is being sold. Think of it as owning a house. There are three ways you can own the house. At the top level, you own the whole house. You decide who lives there, when to renovate, whether to rent it out, and when to sell. And when you decide to sell, there is a ready market of buyers. That is a controlling interest (fully own) in a marketable company (sells fast).
One level down, you own 20% of the house, but your co-owner holds the other 80% and makes every decision; the paint color, the tenants, the mortgage, whether to sell at all. You just receive your slice of whatever they decide to distribute. Your consolation is that your 20% can at least be sold readily to someone else. That is a minority interest (20% ownership) that is still marketable (sells fast).
At the bottom level, you own that same powerless 20%, but now the co-ownership agreement restricts transfers, and the realistic buyer pool is unknown. You cannot steer the asset and you cannot exit it. That is a minority (20% ownership), non-marketable interest (hard to sell). This is the position most family-business shareholders actually hold.
Same house at every level. Same bricks, same square footage. But the value of your piece changes depending on how much you own and how easy it is to sell. A business valuator’s job is to defend the value of what you are selling.
The Small-Company Risk Premium Debate
Before we reach the interest-level discounts, one enterprise-level premium deserves its own discussion, because it is genuinely contested inside the profession: the size premium. The empirical observation is old and robust on its face; over long periods, small public companies have delivered higher returns than large ones. Higher returns mean higher risk. Higher risk means higher expected return. Higher expected return means higher discount rates. And—to finish this charade—higher discount rates mean lower valuations.
Even though the paragraph above can make you a bit dizzy, if you give it a minute, the logic is straightforward. So why the debate? Researchers argue about the integrity of the available data. Sometimes you cannot find the perfect comparable. Or there is a gap for the revenue level of the subject company. Or the only available transactions are from five years ago. So how do you move on in the valuation process? If you are a good scout, you do three things.
First, you disclose the debate rather than pretending the number is gospel; credibility is built by acknowledging what is contested. Second, you identify the specific study, decile, and data year relied upon, so the reviewer can trace the number to its source. Third, you make sure you avoid double-counting (e.g., if the size premium already captures certain small-company risks, they cannot be counted again in the company-specific premium).
The size premium is a judgment call supported by data. What it can never be is a plug that is hard coded to give the impression you did your homework. And that is just enough blood in the water for sharks to smell it.
The Discount for Lack of Control (DLOC)
Let’s start this section with a thought experiment: two people, each own stock in the same profitable company. One owns 51%, the other owns 49%. Their ownership differs by 2%. Their power differs by 100%. The 51% holder decides who runs the company, what everyone is paid, whether profits are distributed or reinvested, and whether the company gets sold. The 49% holder decides … to hope the 51% holder is reasonable.
The DLOC prices that difference. A minority holder cannot set strategy, compel distributions, hire or fire management, or force a sale. When the underlying valuation was built on a control basis, a minority interest in that same company must be discounted to reflect its powerlessness.
Evidence for the size of the discount traditionally comes from control premium data. When public companies are acquired, buyers historically pay premiums over the pre-announcement minority trading price, and the implied minority discount can be derived from those premiums. The data is imperfect (acquisition premiums bundle control with synergies), and a careful report states it. The direction, however, is not in dispute; the absence of control reduces the value of the interest being purchased.
The Discount for Lack of Marketability (DLOM)
This discount answers a different question: even if the ownership of a company were attractive, how quickly could you convert it to cash? An owner of publicly traded stock can sell in seconds at a known price for a trivial commission. An owner of a 20% interest in a private family business faces months of searching for a buyer, extensive due diligence, legal fees, transfer restrictions in the operating agreement, and—bear yourself if I am describing you—a very short list of people on Earth who would want the position at all. Liquidity has value; illiquidity has a cost. The DLOM quantifies that cost.
Where does the evidence come from? Two classic bodies of research: restricted stock studies and pre-IPO studies. Restricted stock studies compare the price of a public company’s freely traded shares against identical shares that are contractually restricted from sale for a period (usually six months to a year). The restricted shares historically sold at meaningful discounts when compared to the publicly available stocks of the same company. Pre-IPO studies, on the other hand, compare private transaction prices in a company’s stock shortly before its public offering against the IPO price itself, again showing substantial discounts for the illiquid position (i.e., the price of the stock pre-IPO).
The observed discounts vary widely depending on where you look. Which is precisely why DLOM is among the most litigated numbers in tax court. The instructive framework here is the Mandelbaum line of analysis, in which the court articulated factors for calibrating a marketability discount to the specific interest (i.e., the company’s financial strength, dividend or distribution history, the pool of likely buyers, transfer restrictions, holding period expectations, and management quality, among others). The lesson generalizes beyond tax matters. As defensible DLOM is not “studies show 25% to 35%, so I picked 30%.” It is “here is the benchmark range from the studies, and here are the specific characteristics of this interest that place it where I placed it.”
Minority-Interest Traps
Discounts are where sophisticated reports quietly go wrong. So here is a field guide to the five most common traps; the ones I look for first when reviewing another expert’s work. These can be a tell on depth and thoroughness for the rest of the valuation.
Trap 1: Discounting from the wrong base—Discounts have an order of operations, just like arithmetic. First, get the value of the whole company right. Only then apply the interest-level discounts. One after the other, multiplied, never added. A 30% DLOC followed by a 25% DLOM leaves 52.5 cents on the dollar, not 45. A small mechanical error can have a six-figure consequence.
Trap 2: Counting the same risk twice—Ever added a 20% tip, then noticed the bill already included an 18% service charge? Same waiter paid twice. Valuators make this mistake all the time (and with more zeros). Customer concentration adds a point to the discount rate—fair—then reappears pages later justifying a bigger DLOM. One risk, two haircuts. The rule: every risk gets counted once, in one place, on purpose, and a defensible report can name that place.
Trap 3: Using the wrong definition of “value”—This trap catches attorneys as often as appraisers: the definition of “value” is not a valuation choice. It is a legal one and it changes at the state line. Fair market value generally allows minority discounts. Fair value, the standard many states impose, often forbids them. This means that location and jurisdiction matter.
Trap 4: Not reading the buy-sell agreement—Many disputes are governed by a document everyone signed and no one read. If the shareholders’ agreement fixes a price formula, defines “value” for internal transfers, or restricts the very transfer being valued, that document may control the outcome or at least heavily bend it. Valuing an interest without reading its governing documents is malpractice-adjacent.
Trap 5: Stacking discounts into absurdity—A 30% DLOC followed by a 35% DLOM leaves about 45 cents of every enterprise dollar. Sometimes that is genuinely right. But the total has to pass a sanity test: Would a real seller actually let their interest go at that price? Would a court in this jurisdiction find the combined haircut credible? Discounts that are individually defensible can be collectively preposterous.
The Interest is Now Defined
We now know what is being sold: the specific bundle of rights, powers, restrictions, and liquidity attached to this interest, in this entity, under this standard of value with every premium and discount traced to evidence and applied in the right order, exactly once. Whoa, a mouthful. But we are getting there.
Notice what all this risk profiling has taken as a given: the riskiness of the business itself. Two companies with identical revenue and identical earnings can deserve wildly different multiples, because one has contracts, diversification, and a management team; whereas the other has a heroic founder, one giant customer, and “hope as a strategy.”[2] What creates that gap, how buyers price it, and what owners can do about it before the sale is the subject of Part III.
[1] Think of a strategic buyer as someone who would pay a premium for a business because it has special or “strategic” value to them; a brand, a market share, a trade secret. If you are a die-hard fan of Elvis Presley, you might value Elvis’ guitar differently (you might be willing to pay a premium) than if you are simply not a fan (you might be only willing to pay market price for it).
[2] Hope is not a good business strategy.
David Lopez, CVA, is the Principal of M1 Valuations, a valuation and M&A advisory firm. He is a former Deloitte and PwC management consultant, and was CFO for an aerospace company holding contracts with the Air Force, NASA, and the Pentagon. He holds an MBA from INCAE Business School (awarded a full scholarship) and is a two-time TEDx speaker. Mr. Lopez has signed 200+ valuations totaling approximately $5B in enterprise value, has coached hundreds of CEOs through valuations, exits, and successions, and has presented at McCombs School of Business, Cox School of Business, Capital Factory, Tech Summit Silicon Valley, and on The Jeff Crilley Show.
Mr. Lopez can be contacted at (310) 490-5510 or by e-mail to David.Lopez@M1Valuations.com.
