Issue: In recent conversations regarding valuation discounts applied to business interests that are not actively traded on a major exchange or over the counter, I have noticed a great deal of confusion regarding when and how these discounts should be applied. Should a minority interest discount be applied to all valuations representing a minority ownership position? Are discounts for lack of marketability always appropriate for privately-held securities? This three-part article explores the two major discounts often applied to the valuation of privately-held securities.
Discussion: ATI Capital Group of Colorado, LLC (ATICG) divides discounts into two major groups: primary and secondary. The primary group consists of discounts considered in virtually all valuation assignments for private businesses, such as discounts for minority interest and lack of marketability. The secondary group of discounts only consists of discounts appropriate in special situations, such as a key man discount, or a blockage discount. In this article, I will address only the primary discounts, the consideration of which is appropriate in all private company valuations.
Starting Point of Valuation: Before getting into the specific discounts, it is important to establish a starting point on the valuation – a point from which the discount will be applied.
Certain valuation methodologies produce a value considered to be a minority interest or a controlling interest from the beginning, without applying a discount or premium to the base number. For example, the use of the capitalization of net free cash flow method produces a minority interest value without the application of a discount for minority interest. This is because the capitalization rate used is produced from public market rates, and those rates are already considered on a minority basis. A clarification of this thinking can be found in purchase/sell transactions in public stocks, which are clearly executed on a minority value basis. Therefore, in most cases, any methodology that uses capitalization rates or discount rates, which were developed through the use of public market rates, will render a value that is already on a minority basis.
Other methodologies will render a value on a controlling interest basis from the beginning, without applying a control premium. An example would be the net asset value method, with which is assumed to be on a control basis to begin. The reason is that minority shareholders would have no way to get to, take possession of, or dispose of the company’s assets. Such power lies only with controlling shareholders.
Accordingly, when deciding the appropriateness of discounts (or premiums), one must be aware of the starting point. In some cases, discounts are appropriate, in some cases they are not. Unfortunately, it is difficult for the non-valuation professional to make that judgment.
Assuming that discounts are appropriate, our discussion can now turn to the two primary discounts.