What Are the Key Business Valuation Discounts?
A private ownership interest is rarely worth its pro-rata share. Understand the specific rights and limitations that reduce its value and how this is measured.
A business valuation discount is a reduction from an ownership interest’s proportional value, reflecting that some stakes are not worth their exact fraction of the total company value. These adjustments are common in gift and estate tax planning, shareholder disagreements, and business sales. The core idea is that not all ownership shares are equal, as factors inherent to the interest can diminish its value, requiring an analysis beyond simple arithmetic.
Discount for Lack of Control
A primary valuation adjustment is the Discount for Lack of Control (DLOC), sometimes called a minority interest discount. This discount addresses the difference in value between a controlling interest and a non-controlling, or minority, interest in a business. The value disparity arises because a controlling owner possesses powers that a minority shareholder does not.
A controlling shareholder can make decisions that shape the company’s financial and operational future. These powers include appointing management, setting executive compensation, declaring dividends, and deciding whether to sell or liquidate the company. Because a minority owner cannot direct these actions, their shares are considered less valuable on a per-share basis.
Consider a private company where one shareholder holds 51% of the stock and another holds 49%. The 51% owner has control over the business’s strategic direction, while the 49% owner can be outvoted on every issue. This inability to influence corporate policy directly impacts the value of the minority shares, and the DLOC quantifies this reduction.
Discount for Lack of Marketability
The Discount for Lack of Marketability (DLOM) is a separate concept that addresses an asset’s liquidity. Marketability is the ability to convert an ownership interest into cash quickly at a price reflecting its underlying value. This discount compensates an investor for the risk associated with selling an interest in a privately held company.
Shares of a publicly traded company, for instance, are highly marketable and can be sold on an exchange within seconds. In contrast, shares in a private family business are not marketable, as there is no established marketplace. Finding a willing buyer can be a lengthy and expensive process with uncertainty about the final sale price.
The DLOM is different from the DLOC, though both discounts can be applied to the same interest. Even a 100% controlling interest in a private company will have a marketability discount applied to its value. While the owner has full control, they still face the challenge of finding a buyer and executing a sale, which is less certain than selling public stock.
Other Key Valuation Discounts
Beyond control and marketability, other discounts may apply depending on a company’s specific circumstances. These adjustments account for unique risks that can affect a company’s value. They are applied to address specific, identifiable issues that would cause a potential buyer to lower their offer for the business or an interest in it.
Built-In Gains Discount
The Built-In Gains (BIG) discount is relevant for C-corporations holding assets, like real estate, that have appreciated in value. This discount accounts for the corporate-level income tax triggered if the corporation sells these assets. Since the Tax Reform Act of 1986, C-corporations face double taxation on asset sales—once at the corporate level and again at the shareholder level upon distribution. A buyer of the corporation’s stock inherits this potential tax liability and will discount the price to account for this future tax burden.
Key Person Discount
A Key Person Discount is applied when a company’s success is dependent on a single individual. This discount reflects the risk that the business’s value would diminish if this person were to die, become disabled, or leave the company. The individual’s unique skills or relationships may be so important to operations that their absence would jeopardize future earnings. The discount quantifies this potential drop in value, with ranges falling between 5% and 25%.
Quantifying and Substantiating Discounts
Determining the percentage for a valuation discount requires a defensible analysis by a qualified appraiser. For tax-related valuations, such as those on Form 706 for estates or Form 709 for gifts, the Internal Revenue Service (IRS) requires that any applied discount be substantiated with empirical evidence and a reasoned methodology.
To quantify a DLOM, appraisers often rely on empirical studies that compare public securities with restricted, non-marketable shares. For example, restricted stock studies analyze transactions of public company shares that are legally restricted from trading for a period. Pre-IPO studies compare the price of a company’s stock in private transactions before it goes public to the price at the Initial Public Offering (IPO).
For the DLOC, appraisers may analyze control premium studies. These studies examine the price difference when a controlling block of a public company’s stock is acquired, with the amount paid above the market price representing the “control premium.” This premium helps quantify the discount for a minority interest, often using the formula DLOC = 1 – [1 / (1 + Control Premium)].
The appraiser must connect data from these studies to the specific facts of the company being valued. A valuation report details the rationale for the selected discounts, referencing the company’s financial health, dividend policy, industry risks, and shareholder agreements. A generic, unsupported discount is likely to be challenged by the IRS or in court.