One of the factors to be considered in a valuation is marketability discount. As valuation analysts, we often have to value a controlling interest both in private and publicly-traded companies. In working through a valuation project, the following question will eventually come up during the concluding step: Should we apply a discount for lack of marketability (DLOM) for a controlling interest?
Before this step, valuations undertaken through commonly-used methodologies (e.g. cost approach, market approach, and income approach) with the same sets of comparable companies or forecasts will likely yield similar results. Why? Because most of the calculating steps in these methodologies have already been defined as a valuation base, or in other words, standardized. Yet, a DLOM applied to a controlling interest appears to be the only area that has never received standard guidance.
Without guidance, the application of a DLOM is up to the analyst, or the practice of the company. Typically, analysts will only apply five to 20 percent of DLOM for controlling interest. Many analysts do not apply a DLOM, especially when valuing a 100 percent controlling interest. Instead, they question the economic rationale, in terms of the expected cash flow of a business, its risk, and its expected growth, that would lower the controlling interest value. Even though they do not apply a DLOM, most analysts do agree that different levels of marketability and liquidity for controlling interests exist. According to Shannon Pratt, a well-known figure in the field of business valuation, the United States Tax Court cases have a range from 3 to 35 percent in DLOM application.
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The major issues debated by valuation professionals are:
- The size of cash flow and the cost of capital may illustrate some level of marketability and illiquidity.
- The application of public company valuation multiples may transfer some level of liquidity.
- The length of time to sell a controlling ownership interest may illustrate some level of marketability and illiquidity.
- Selling a private business may be more difficult and involve higher costs (i.e. broker fees, flotation costs, legal costs, monitoring costs, etc.) when compared to selling a publicly-traded stock.
- Whether empirical research, such as data on restricted stocks, can be utilized to gauge the price impairment for the illiquidity of a controlling interest. Although restricted stocks deal with minority sales, the underlying degree of illiquidity is comparable to a controlling interest in a private company.
Furthermore, some valuation professionals believe that the marketability and illiquidity can be reflected in the flotation cost (e.g. the expenses, such as advisory and legal fees, in taking a private company public). The U.S. Internal Revenue Service, however, argues that the flotation cost itself cannot reflect the market and time risk.
However, it is still rare to see valuations prepared by investment bankers that would apply a DLOM when attempting to sell 100 percent of a private company. Also, the sale of a controlling interest and the sale of a minority share of a public company or of a private company, respectively reflect different levels of liquidity and marketability. In short, if there is no recognized authority coordinating the effort to resolve this issue, debate will go on.
The e-series
With the continuing debate, it is important for valuation practitioners to understand the rationale behind the arguments. To assist, I have conducted several valuation related e-series for the Institute including “Valuation for Mergers and Acquisitions” and “Understanding Business Valuation for Transactions of Hong Kong Listed Companies,” which focus on valuation issues and requirements for the transactions while the latter one stresses more on listed companies’ specific aspects. Two other e-series, “Mastering Intangible Assets Valuation” and “Common Impairment Issues on Listed Companies and Their Mitigations,” address valuation issues in the context of post-transactions, – situations which are commonly encountered in accounting professionals’ daily tasks.
All these e-series aim to help accounting professionals and senior executives to understand more about the requirements and challenges of valuation under different contexts.
Valuation is becoming more common nowadays and is closely related to financial reporting for any company. By knowing more about relevant valuation rules and requirements, members will be prepared to handle any commercial negotiations.
Ferry Choy is the Managing Director of Flagship Appraisals and Consulting Limited. He has worked in the accounting and the valuation professions for over 12 years, 10 years of which were spent in valuation profession with the first two years with Sallmanns and five years with Greater China Appraisals. He is also a CFA Charterholder and an International Certified Valuation Specialist.
