If given the option to pay full price or receive a discount, it’s safe to say the majority of individuals would prefer a discount, regardless of what they’re purchasing. Why would this be any different when it comes to your business?
When valuing a minority interest in a business (an ownership interest of 50% or less), it’s typical of buyers in the marketplace or a valuation analyst to apply minority discounts, which are more technically known as a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM).
We know what you’re thinking: what are these discounts and why do they matter? Here’s a look at each type:
A DLOC is an amount or percentage deducted from the operating value of an entity to reflect the absence of some or all of the powers of control. When someone holds a minority interest in a business, they lack the ability to:
In other words, the person buying into the business is receiving a discount because they are not receiving the full benefits of control.
A DLOM is an amount or percentage deducted from the operating value of an entity to reflect illiquidity (inability to quickly convert to cash) in privately-held entities when compared to public companies. In the valuation world, we refer to liquidity as “cash in three days”, which is expected when selling publicly-traded stock. However, when it comes to selling private companies, it takes much longer than three days to receive cash, which is why a DLOM is appropriate.
Discounts are extremely important to understand when negotiating transactions with investors. Investors’ primary way to receive a return on their investment is through distributions, which are primarily dependent upon the company’s financial stability, and diversification among the services and/or products and geography of the business.
Going back to the concept of “cash in three days”, investors will also look at the obstacles they could encounter if they decide to sell their interest in the future, which could potentially be affected by the company’s transfer restrictions and redemption policy. Therefore, appropriately discounting a minority interest is important as it could potentially make or break a deal.
Of course there are some risks that should be considered on the sell-side of a transaction. The amount of time it takes to complete a transaction, accounting and administrative fees incurred and the probability that the actual sales price could be much less than the asking price are some sneaky issues worth keeping an eye on.
Not only are discounts important to consider when searching for outside investors, but they are also a strategic tool that can be helpful when exiting a business. In fact, if you’re planning to sell your business, there’s a good chance you might encounter these discounts. It’s important to understand them so you know what price you can realistically expect from the sale of your business.
It goes without saying that buyers appreciate discounts to the share price, but sellers may not. After all, everyone wants to get top dollar for their business. Buy-sell agreements are commonly used to allow a company or its shareholders to purchase the interest of a shareholder who decides to withdraw from the company for a specific price or by using a set formula to determine a price. However, instead of preparing for a smooth exit, many buy-sell agreements tend to cause more issues as the use of a set price or a formula may not consider the current economic and financial condition of the company, which could lead to legal (and expensive) issues.
An effective buy-sell agreement should include an explanation of relevant discounts and the requirement for an appraisal from a certified appraiser to determine the current fair market value of the company. A well written buy-sell agreement will help minimize misunderstandings and disagreements, ensure proper discounts are appropriately applied to the company value and make for a smoother transaction among all parties involved.
Buy-sell agreements and all pieces of the puzzle can be difficult to put together. Luckily, our business valuation team is trained and ready to help you conduct a successful business transaction. If you need help, just ask!