What are the common valuation adjustments for minority and majority interests?

Many practitioners have moved away from the application of a DLOC and accepted the premise that control, or lack thereof, is captured in the cash flows. If the cash flows are not adjusted for the prerogatives of control, they are on a non-controlling basis. If control adjustments are made, the cash flows are on a control basis. Control is also exerted on the balance sheet. The control decision to, for example, use no debt when the overall cost of capital could be lowered by the introduction of debt, also affects the ultimate return to the non-controlling (and controlling) owners. So is the application of an inferior capital structure really a hidden DLOC?

In the realm of business valuation, one often encounters adjustments tailored to reflect the nuances of minority and majority interests. For instance, minority interest discounts are applied to account for the lack of control or influence wielded by minority stakeholders, acknowledging their limited say in strategic decisions. Conversely, in scenarios where one holds a majority stake, adjustments might revolve around control premiums, acknowledging the added value attributed to having significant influence over company direction. These adjustments are pivotal in ensuring fair and accurate valuations, aligning with the intricacies of ownership dynamics within organizations.

Part of the reason DLOC calculations based on MergerStat data were criticized is that they were based on industry averages, when perhaps an industry median could be considered as well. MergerStat has other data that can be considered as part of the process of developing a DLOC. One of the more interesting is Table I-19 on page 46 of the 2022 review where the premiums offered for a controlling interest versus a significant minority interest are compared. This could be considered when attempting to distinguish between pure control and synergies.

Evaluate decision-making impact: Assess how the inability to influence corporate decisions affects value. Compare with controlling shares: Look at differences in value between controlling and non-controlling interests. Adjust based on industry standards: Use industry benchmarks for discounts due to lack of control. Consider voting rights: Factor in the lack of voting power in the valuation.

Dismissing a DLOC as simply a lack of influence overlooks the power dynamics within a business. Acknowledging the lack of control does highlight limited decision-making power. As Peter Drucker noted, "Management is doing things right; leadership is doing the right things." Control is about leadership, and its absence can create significant barriers. Understanding this discount requires deeper analysis of how control impacts strategic direction and value creation.

Quantify decision-making benefits: Calculate the value of having strategic control over business decisions. Benchmark against market transactions: Use premiums paid in similar transactions for guidance. Adjust for synergies: Include value from potential operational synergies control may bring. Evaluate future growth control: Consider how control could influence future growth and profitability.

Disputes with the IRS over the values of privately held business interests are not uncommon. A frequent trigger for such disputes is the discount for lack of liquidity and marketability (“DLOM”) applied by the appraiser to a non-controlling minority interest in the subject business. Both qualitative and quantitative tools can be used to identify a reasonable DLOM. After applying due weight to qualitative measures such as restricted stock studies, pre-IPO studies and court cases, the appraiser can narrow in on the DLOM by considering the risk related to the hold-to-sale period for a particular investment using quantitative models like Mercer’s Quantitative Marketability Discount Method (“QMDM”) and protective put option pricing models.

Assess sale timelines: Estimate how quickly interests can be sold compared to readily marketable securities. Compare liquidity levels: Look at differences in liquidity between the subject interest and a fully marketable position. Use recent sales data: Apply data from recent sales of similar illiquid interests. Adjust for transfer restrictions: Consider how legal or contractual restrictions affect the ability to sell.

Highlight liquidity advantage: Emphasize the ease and speed of selling the interest. Benchmark liquidity benefits: Compare liquidity premiums of similar investments. Consider broader market conditions: Adjust for current market liquidity conditions. Evaluate access to markets: Factor in the interest’s access to liquid markets or platforms.

This is the least used, least understood and hardest to apply discount in this category. Here is the reason: This discount may be more dependent on the buyer than the seller. For example, if you are dealing with a Strategic Buyer, one that has knowledge, systems, and processes that the purchased operations are plugged into, that buyer may discount less or even pay a premium. A knowledgeable Financial Buyer, those dependent on the current operations, will pay less. Just one more reason that Stategic Buyers often pay more than Financial Buyers. This leads into the huge issue of allocating goodwill between the owner and the business, which is not the current subject.

Especially when valuing for estate or divorce (or other non-M&A reason), the importance of a key person to the value of the company should be considered. However instead of a harder to quantify discount or premium, and adjustment to the level of risk of a company may be more appropriate.

Identify dependency: Assess how much the business depends on one or a few individuals. Estimate impact of loss: Calculate the potential value impact if the key person were to leave. Consider succession plans: Adjust based on the presence and effectiveness of succession planning. Use insurance policies as benchmarks: Look at key person insurance amounts as a basis for discount levels.

The discount for a key person might be less about the individual and more about the organization's dependency. Recognizing the importance of a key individual does highlight potential vulnerabilities. As Jim Collins mentions in "Good to Great," building a company around great processes, not just great people, ensures longevity. Focusing on reducing this dependency can mitigate the discount and enhance overall stability.

Highlight unique contributions: Emphasize the key person's unique skills or relationships that add value. Quantify leadership impact: Estimate the value added by the key person's leadership and decision-making. Benchmark against industry leaders: Compare the premium for key individuals in similar roles/industries. Adjust for potential growth: Consider the key person's role in future growth opportunities.

The concept of a Premium for Key Person (PKP) underscores the critical role that individual talent plays in business valuation. The PKP will likely gain prominence in valuation methodologies, particularly in sectors reliant on specialized skills or strong client relationships. As the workforce evolves with remote and hybrid models, the dynamics of PKP may shift, necessitating a reevaluation of how key personnel contribute to business value. Investors should remain vigilant in assessing not only the current contributions of key individuals but also the potential risks associated with their departure, which could significantly impact valuations.

Tax affecting is a key issue when valuing an interest in a pass-through entity ("PTE"). PTEs do not pay federal income tax at the entity level. Instead, the PTE's owners typically report their share of PTE income on and pay the tax thereon with their personal income tax returns. Tax affecting reduces the earnings of the PTE used in deriving value, recognizing that even though income taxes are not paid at the entity level, a reasonable hypothetical buyer of the subject interest would estimate value based on the earnings he/she could keep after payment of income taxes.

Valuation is as much about storytelling as it is about numbers. Financial metrics are crucial, but understanding the business's narrative, market positioning, and strategic vision is indispensable. As Simon Sinek puts it, "People don’t buy what you do; they buy why you do it." The 'why' behind the data can reveal hidden value and growth potential. Balancing quantitative analysis with qualitative insights provides a fuller picture of a business's true worth.

Understanding the nuances of control premiums and discounts is crucial for accurate assessments. The significance of these adjustments will likely increase, particularly with the rise of private equity and venture capital, which often emphasize control in their investment strategies. The growing importance of intangible assets and the digital economy may lead to new valuation adjustments, particularly regarding marketability and the perceived value of key personnel.