It is commonly recognized and well documented that a non-controlling interest in the equity of a company generally sells at a price less than a similar interest that has control. Also, an interest that is not readily marketable generally trades at a price lower than a similar interest that is readily marketable.
When valuing a business interest for gift and estate tax purposes that lacks certain elements of control and marketability, two discounts are generally appropriate. They are commonly referred to as the discount for lack of control (DLOC) and the discount for lack of marketability (DLOM). These discounts can significantly impact the value of business interests and, consequently, gift and estate tax liabilities for individuals. Understanding these discounts is essential for defensible valuations and effective planning.
Adjustments for Lack of Control
Control is the “power or authority to guide or manage.” A shareholder having control over a business generally has the authority, within legal limitations and subject to fiduciary responsibilities, to change the nature of the business, sell or buy the business assets, hire personnel, and generally conduct the affairs of the business in a manner that the shareholder believes is appropriate.
Purchasers of controlling interests in companies will often pay a premium for the right or ability to elect board members, determine company strategies, set compensation levels for key employees, and otherwise control the business enterprise. The observed premiums suggest that a discount would be applicable when valuing non-controlling equity interests using valuation methods that result in a control indication of value.
There are many reasons why a control position in a company is typically worth more on a pro-rata basis than a minority position. Some of these reasons are embodied in the rights of controlling shareholders that can:
| ● Elect directors;
● Select and/or remove management; ● Set dividend policies; ● Establish compensation and benefits; ● Set corporate strategies and goals; ● Acquire and liquidate assets; |
● Self-dissolve, or recapitalize the company;
● Revise articles of incorporation and bylaws; ● Establish or change buy-sell agreements or clauses; ● Go public; and ● Acquire or merge with another company. |
The existence or absence of control can be measured by assessing the amount of influence that can be exerted over business decisions. When assessing control, it is important to consider the following factors:
- Relative Ownership Distribution – The size of the block of stock being valued in relation to other blocks is important in establishing the degree of control. In a corporation that has hundreds of shareholders, a 20% interest can have a tremendous amount of control, while in a corporation with only two shareholders, the owner of a 20% interest can have no control. If there are two shareholders, each owning 50%, neither has absolute control, but both have the ability to block any decision requiring a majority vote.
- Swing Vote Characteristics – The existence of “swing vote” characteristics can significantly impact the value of a particular ownership interest. For instance, in a situation where a corporation has only three shareholders, two of them owning 49% each and the third owning 2%, the 2% owner can effectively exert significant control by casting the “swing vote.”
- Supermajority Statutes – Many states require a supermajority vote, usually 66 2/3%, before certain actions, such as a merger, can take place. In situations requiring a supermajority, a single owner with only a 34% interest is able to “block” the actions of the majority owner(s).
- Minority Dissolution Statutes – Some states permit minority interests to sue for dissolution. The specific applicable circumstances and size of the interest varies by state.
- Articles of Incorporation, Bylaws, and Organizational Agreements – The rights and restrictions of shareholders contained in the articles of incorporation, bylaws, and organizational agreements can vary greatly from company to company. Such rights and restrictions can affect the ability to control or influence an entity in innumerable ways. The rights and restrictions that are most commonly addressed in organizational documents involve voting rights such as:
- Nonvoting Stock – A holder of nonvoting stock has little influence over the affairs of a corporation. If the holder cannot vote for board members or any other matter that requires a vote of the shareholders, such a holder has no control and little or no influence over the company, even if a shareholder has 99% of the outstanding shares.
- Cumulative Voting – Cumulative voting is a system whereby shareholders are allowed votes in proportion to their ownership percentage. The effect of cumulative voting can be illustrated by considering a vote of shareholders to elect directors. Under cumulative voting, a 20% owner can elect 20% of the board members. In situations where cumulative voting is not present, a 51% owner can elect all of the board members and deny board representation to all others. In some states, cumulative voting is mandated by statute.
- Contractual Agreements – Certain contractual arrangements may also restrict control. A shareholders’ agreement may preclude shareholders from exerting certain rights. Additionally, shareholders may forfeit the right to do certain things, such as obtaining additional debt.
In order to quantify the appropriate adjustment for lack of control, appraisers typically analyze general minority interest discounts that have been derived based on public company acquisitions. These acquisitions are of control positions in publicly traded companies whose stocks trade on a minority basis. In most cases, an acquiring company will pay a “control” or “merger” premium over and above the market price per share of stock of the company to be acquired. By quantifying this control premium, it is possible to then determine the implied DLOC.
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Adjustment for Lack of Marketability
Market-based valuation methods are often computed using data from studies of securities traded on national exchanges. There are, however, certain marketability differences between an investment in private and publicly traded securities. An owner of publicly traded securities can know at all times the market value of his/her holding. The investor can sell that holding on virtually a moment’s notice and receive cash, net of brokerage fees, within several working days. Such is not the case with private companies. Consequently, liquidating a position in a private company would be a more costly and time-consuming process than liquidating an investment in a publicly traded firm. The value of holding any investment is what could be generated from that investment net of the costs of liquidating the investment.
Numerous studies have been conducted on the DLOM and have followed two broad approaches to do so:
- Restricted Stock Approach – “Restricted shares” (also called “letter stocks” or “restricted stock”) generally possess the same attributes as freely traded shares, except that they are restricted from sale on the open market for a specified time period (usually one or two years).
It is generally accepted that the primary difference between freely traded shares and their restricted counterparts is the relative DLOM for the restricted shares. Consequently, the price differences between the two types of shares are cited as measures of the lack of marketability.
From the mid-1960’s through the late-1990’s, various studies were performed that quantified the value differences between freely traded common shares of certain public companies and their restricted shares. Studies in this category include the SEC Institutional Investor Study and the Moroney Study, among others.
Restricted stock studies can provide compelling evidence about the lack of marketability of an ownership interest. When relying upon restricted stock studies to determine a DLOM, it is important to compare the characteristics of the companies that make up the studies to those of the subject company. Revenue Ruling 77-287 amplified Revenue Ruling 59-60 and presents guidelines for valuing restricted securities. This is a good source of information concerning the characteristics of restricted stocks and the companies that issue those types of securities.
Revenue Ruling 77-287 defines a restricted security as follows:
“… these particular securities cannot lawfully be distributed to the general public until a registration statement relating to the corporation underlying the securities has been filed, and has also become effective under the rules promulgated and enforced by the United States Securities and Exchange Commission (SEC) pursuant to the Federal securities laws.”
Revenue Ruling 77-287 states that “certain provisions are often found in agreements between buyers and sellers that affect the size of discounts at which restricted stocks are sold.” If the factors of restricted stocks listed in Revenue Ruling 77-287, which are fairly common in restricted securities, would reduce the discount, then the absence of these attributes would surely support a discount.
- Initial Public Offering Approach – There are several “Pre-IPO” lack of marketability discount studies, including those studies conducted by Mr. John Emory, ASA, of Robert W. Baird & Co. As opposed to examining restricted stock, Mr. Emory examined the transaction values of privately held company stock (not freely traded) prior to its initial public offering (“IPO”) and compared them with prices paid for the shares when the company’s stock was taken public.
Prospectuses of IPO’s are required to disclose the terms of recent past insider transactions in respective company’s shares, enabling a comparison of prices before and after “marketability” being achieved via the IPO. For example, if a shareholder disposes of company stock at $6.00 per share and the stock is subsequently brought public at $10.00 per share, Mr. Emory calculates a marketability discount of 40%.
Option Pricing Models
Several theoretical quantitative models exist to support the restricted stock and IPO studies described above. One of these models is the Black-Scholes-Merton model, which is widely accepted by academics, valuation professionals and option traders as a means to value derivative investments.
A put option represents the right to sell a given underlying security at a specific price at a specific date in the future. When provided with an option to sell, otherwise non-marketable shares are given marketability. Following this logic, a put option’s price represents the value of the right to sell stock for a guaranteed price. In other words, the price of a put option provides market evidence of what investors are willing to pay to guarantee marketability. Appraisers often consider the implied DLOMs resulting from the put option models developed by Chaffe, Finnerty and Longstaff in their valuation analyses.
- The Chaffe model serves as the foundation for other option-based methods. In this method, the DLOM is estimated as the value of an at-the-money put with a life equal to the period of the restriction, divided by the marketable stock value. By purchasing an at-the-money put option, the buyer guarantees a price at least equal to today’s stock price, thus creating liquidity. As the Chaffe model assumes the strike price is fixed, this method tends to be more representative of restricted stock studies at lower volatilities than other comparable methods.
- The Finnerty model assumes that the strike price is equal to the arithmetic average of market prices over the holding period, rather than the optimal price. The Finnerty model often more closely reflects the discounts observed from fair market value study data at low volatilities than other comparable methods. It is important to note that the Finnerty model produces no discount in excess of 32.3% regardless of the magnitude of volatilities and holding periods. This limitation may significantly understate the implied DLOM for volatilities exceeding 125% and a six-month holding period. As a result, this method tends to produce a minimum DLOM.
- The Longstaff model is based on the price of a hypothetical “lookback” option, which is a type of American option that permits the option to be exercised prior to the expiration date. A “lookback” put option differs from most other put options in that the holder can look back at the end of the put option’s life and retroactively exercise the option at the highest stock price during the holding period, yielding the maximum return. As a result, this method tends to produce an estimate of an “upper boundary” DLOM.
Other Factors
Along with the aforementioned studies and put option analyses, appraisers often consider the following factors as outlined in the Estate of Mandelbaum (T.C. Memo 1995-255, June 12, 1995) in determining an appropriate DLOM:
- Financial statement analysis – This factor analyzes the results of operations and other factors. If past operating results and financial position have indicated that the subject company has performed unfavorably when compared to industry peers, this could warrant an above average adjustment for lack of marketability.
- Company’s dividend or distribution policy – If the subject company has a favorable dividend/distribution policy, a history of paying dividends/distributions and is projected to continue paying dividends/distributions going forward, this factor could warrant a below average adjustment for lack of marketability.
- Ability to transfer ownership – If certain restrictions (e.g., right of first refusal, etc.) exist on the transferability of the subject company’s shares, this could warrant an above average adjustment for lack of marketability.
- Amount of control in transferred interests – Control reflects a shareholder’s ability to direct a corporation in its daily operations. Control of a closely held corporation represents an element of value that justifies a higher value for a controlling block of stock. A non-controlling shareholder’s interest has less marketability given its inability to control.
- Nature of the company, its history, position in the industry and their economic outlook – If the subject company has a long history of successful operations, is one of the largest of its type in the area and the long-term industry and economic outlooks are positive, this factor could warrant a below average adjustment for the lack of marketability.
- Company management – If the subject company has a management team that is not well educated or experienced, this factor could warrant an above average adjustment for the lack of marketability.
- Holding period for owner interests – An investment is less marketable if an investor must hold it for an extended period of time in order to reap a sufficient profit. Market risk increases and marketability decreases as the holding period gets longer.
- Company redemption policy – Whether a company has the right to purchase its stock before it is sold to an outsider is another factor to consider when determining the value of a company. This may be particularly critical if the redemption agreement sets a price on the stock.
- Costs associated with making a public offering – An above average discount may be warranted if the buyer completely bears the cost of registering a private stock. The discount is lessened if the buyer can minimize his or her registration cost.
Conclusion
DLOCs and DLOMs are pivotal in business valuations for gift and estate tax purposes. They ensure that the valuation of business interests accurately reflects the practical limitations of control and marketability. Proper application of these discounts is crucial for achieving fair and supportable valuations, which are essential for effective planning and tax compliance.
Bennett Thrasher can assist in considering the specific circumstances of your business and the interests involved in determining the appropriate discounts. If you need a valuation for estate, gift and trust tax purposes, we can help. Contact Gina Miller or Brett Dixon to schedule a consultation.
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