A valuation discount is a reduction in the value assigned to an interest in a company compared to its peers in the same industry. Valuation discounts typically apply to closely held companies. We will cover some examples below.
The two most significant factors for valuation discounts are the following:
- Minority Interest Discount
- Lack of Marketability Discount
Minority Interest Discount. This discount applies to owners who purchase equity in a company where they cannot exert control over the business.
For example, John Doe opened a limited liability company (LLC) and contributed $100,000 cash to the LLC. John owns 100% of the LLC units and wants to sell 2% of his interest. The LLC has no debt and has not started any business operations.
The LLC’s total book value is $100,000.1 Theoretically, a 2% interest in the LLC is worth $2,000 (2% times $100,000 net book value). However, the prospective buyer must consider the lack of control discount.
If John approaches a buyer and offers 2% of the company for $2,000, the buyer should ask for a discount because they have no control over the company given the minority ownership. The buyer may suggest a purchase price of $1,300 for a 2% interest to account for the minority interest discount.
Lack of Marketability Discount. Investors generally prefer to have highly liquid investments. The fair market value of an asset is the price that the property would sell for on the open market, which is an agreed-upon price between a willing buyer and seller.
Investors holding shares in a publicly traded company can quickly sell them in the public market. However, investors holding shares in a non-publicly traded company cannot quickly sell their shares. For this reason, the price of stock in a privately held corporation is generally lower than its publicly traded counterpart.
For example, assume we have two companies with the same revenues, expenses, and net equity. Public Company Alpha is a publicly traded company and Private Company Bravo is a closely held corporation.
The stock of Public Company Alpha is valued higher than that of Private Company Bravo simply because Company Alpha is publicly traded. Private Company Bravo must consider a lack of marketability discount when valuing its shares for sale to third-party investors.
- Book Value = Totals Assets – Total Liabilities ↩︎