When we are assessing a company in a business valuation, we look at a number of future risks, some of which I’ve discussed in previous blog posts. Discounts and premiums are adjustments we make to the estimate of value in business valuation based on risk and depending on modeling and comparisons to known sample sets. Today I want to talk about the marketability discount, which is based on both the time value of money and the risk that the value will decrease–or even disappear.
What is the marketability discount?
The Business Valuation Glossary defines marketability as “the ability to quickly convert property to cash at minimal cost.” Basically, can an owner in the business sell their interest quickly and with certainty about the final sales price? The marketability discount in business valuation is a discount calculated based on risk during the time involved to find a buyer and get to closing.
How does the discount for lack of marketability (DLOM) apply to valuations?
In many ways, this discount is magnified with small and very small businesses because they tend to have limited product offerings in limited geographic markets. This limitation means situations beyond their control can very quickly cause a large loss of value. These situations might include the loss of a major client, the illness of an owner, calling of a line of credit, a loss or disruption in supplies, or the loss of a franchise or license agreement, to name a few. You might know that these are a possibility, but they are not usually foreseeable during day-to-day operations, and usually don’t apply for a valuation that takes place at a specific time (before that risk becomes reality). If larger businesses are being valued for estate or gift tax more detailed analysis and review should be applied.
How does risk relate to marketability?
Many risks increase over time and are very tied to marketability. One of the harder issues is that sometimes risks are all-or-nothing risks. For example, a company that has essentially one contract (and few easy replacements) which can be terminated at will has a business concentration risk. This situation would justify a large discount for marketability, even if it may have a high cash flow that continues for a long time.
An example of this is a valuation of a business during a divorce where the business owner has a contract with a local school system that brings in $2,000,000 of revenues and the SDE cash flow is $500,000. But, the contract is at-will of the school administration, which tends to change every two or three years. While the revenue is good and may continue for a number of years, it could also disappear if the school administration chooses another vendor. This company has a risk that will make selling more difficult than most competitors, making a marketability discount appropriate even for a control owner. Fact patterns such as this require additional background, experience, and professional judgment.
What are the methods used to estimate the discount for lack of marketability?
Currently, the primary methods used to estimate the discount for lack of marketability (DLOM) in business valuation are the quantitative approach, the qualitative approach, and the option pricing models. Quantitative approaches use databases and data to attempt to quantify the DLOM. They are used for larger businesses that have clear financials and meaningful business ratios, and data can be compared carefully to database data and converted into a discount rate. Qualitative approaches provide a more general framework to compare the subject company to the databases, since detailed financial analysis is often impossible. Option pricing models such as Longstaff, Finnerty, and Chaffe each attempt to “model” the discount based on statistics and available option pricing formulas.
As I always say, business valuation is not a strict science, but an art and a science. This is especially true with the marketability discount, where there are many factors and risks that have to be taken into account. Contact me today to learn more about my professional business valuation services.
This month’s Business Valuation Update published by Business Valuation Resources (BVR) featured my article about implementing a “COVID-19 Marketability Discount”. This is a Discount for Lack of Marketability (DLOM) that arises due to an unusual amount of risk because of COVID-19 and the related economic fallout affecting small and micro businesses.
The methodology used to determine a COVID-19 Marketability Discount can be applied as a separate discount or it can be used as a basis to adjust the historic information based market method multiplier or income method company specific risk premium (SCRP). In many current situations, due to the risk presented by COVID-19, our historic data sources (market method data bases and income method build-up data (BUM method)) do not adequately address the short term risk that is currently being placed on small businesses and their valuations
Micro and very small businesses generally cannot provide forecasts. Therefore the valuation analyst has to use a single period valuation method. As is always the case, the cash flow should be adjusted to reflect the most likely future. But, if the analyst believes an economic recession or 2nd waive of the virus could further impact cash flows there is likely to be more risk to these future cash flows than that reflected in the historic data. Assessing that risk and making an appropriate adjustment is the purpose of this COVID-19 Marketability Discount.
Alternative method: In a new article, an analyst reports that he has been using a “COVID-19 marketability discount” on control interests to make the extra risk adjustment.
“In many situations, I favor the methodology of showing a separate COVID-19 marketability discount,” says Greg Caruso (Harvest Business Advisors), “because it clearly shows the valuator’s thought process and the actual discount being applied for the current high level of uncertainty.”
His methodology is based on the weighing of factors such as those used in Mandelbaum and the IRS DLOM Job Aid but with categories modified to fit the current situation.
Caruso first developed this technique to use in a valuation for an SBA loan. The company was temporarily shut down and appeared to be fully recovered on a monthly cash-flow basis for the two months after reopening. Yet, there was still risk of another shutdown and customers would have economic issues if a recession hit, so Caruso’s basic capitalization rate was a buildup for “normal times,” which included a normal company-specific risk that he further discounted by the COVID-19 marketability discount.
Caruso explains his methodology and presents a case study in more detail with a sample analysis in the November 2020 issue of Business Valuation Update.”
I am grateful to BVR for their support through the years. They are truly a valuable resource.
In the upcoming weeks, I will be conducting several webinars on this topic. Please visit the Events Page for more details.
The book, “The Art of Business Valuation, Accurately Valuing a Small Business” has over 400 pages covering many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller or directly from Wiley.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
Coronavirus, caused by Covid – 19 has raised new issues to consider when preparing business valuations. Many businesses are going to struggle to stay in business to hopefully rebuild business value on the other side of this contagion. A few considerations for business valuations in a world with Coronavirus are below.
Known or Knowable – It may be unclear when the effects of the coronavirus become known or knowable as it affects business valuation. In addition we clearly do not really know what is going to happen next (perhaps better or worse) at this point from Covid – 19. But, we need to address it based on what was known or knowable as of our valuation date. Here is a timeline from the New York Times giving some key dates and history of official actions on the coronavirus that could be useful for business valuation. Was this known or knowable on January 31, 2020, February 28, 2020? I’m not sure. It certainly was known by March 15, 2020 when the CDC recommended restricting gatherings to 50 people or less. Is this actually a regional issue? In New York area it was clearly a problem in early March. In Colorado things seemed normal in many places until mid-March.
Handling subsequent events – Until the effects of the virus on the economy were known or knowable as of the valuation date the Covid – 19 issue is a Subsequent Event. Subsequent events are events that probably would change the business value found if they were considered but they are not considered because they are after the valuation date, but obviously, before the report issue date. Another question is just how serious a warning do you need to give about the affects of coronavirus in the business valuation. For many industries and businesses this is a huge adjustment not just a little more or less risk. I recommend giving a clear analysis that the effects on the economy as a whole are going to be very large and work down to the business at hand while making it clear this has not been factored into the final business value found.
Business valuation methods depend on modeling. When business valuation models become unreliable due to the effects of coronavirus the results of business valuations become unreliable. Here are some charts and commentary on the current state of the economy the impact business valuation. Note that these results are beyond what economists or business valuation experts know how to model as they are outside anything ever seen.
Business Valuation is about predicting future cash flows. Issues in predicting future cash flows include:
How quickly can closed businesses bounce back? Initial thoughts were that business will bounce back very quickly but that is seeming much more unlikely as the economy falters and the likely time periods for stay-at-home orders and the like looks longer.
When will this lock-down end and recovery begin? One month, two months, three months?
How much of a hit are operating businesses going to take to cash flows? Is this cash flow hit going to be merely timing as collections get deferred but paid, reduced revenues do to lower sales, or will work be delivered but then clients then are unable to pay?
A liquidity crisis is brewing as the inability to pay debts and rents due to layoffs etc. increase. This will reduce payments throughout the economy even in industries not directly affected. It is unclear how this will impact other industries not directly affected and eventually the economy as a whole. A prime example of what is to come is the tremendous and quick reductions in tax revenues to state and local governments. These entities as a rule need to balance their budgets and budgets are collapsing. This will lead to deep cuts and payment issues. You can Google coming tax issues for your state and here is a link to a Pew Charitable Trust Article.
Discount rates and related capitalization rates and multipliers will need to be adjusted for the increased risk business investors face. The VIX index which measures implied volatility was in the 12 to 18 range in January 2020. It measured 66 on March 20, 2020. Click here to see the VIX chart. This indicates extreme uncertainty. Risk in business valuation and finance is the perceived likelihood that a financial return will not be received. The higher the risk the lower the value. Right now it is very difficult to estimate an appropriate discount rate or other risk rate.
Marketability discounts – Should additional marketability discounts be taken. Public stocks as a group are off by at least 30% from their highs. They can be liquidated quickly. Right now there are unlikely to be market buyers for private companies unless the buyer can “steal” something. The buyer’s rational is that is the only way to avoid insurmountable risk. The buyer may still get hurt if the company requires more cash infusions than planned to remain in business. This implies a marketability discount possibly in addition to an increased discount rate.
Business resiliency – most businesses in America are service businesses. How will reductions in force, layoffs, downsizing, and the like affect the ability of companies to restart and grow when this ends. How long will it take to retrain and get systems operating again. For most businesses their intellectual property (systems, specialized knowledge, customer quirks etc.) goes home every night and if it does not come back what will happen?
How will death affect the living – One thing that economists have not started looking at is how will the effect of 100,000, 200,000 or possibly a million deaths from coronavirus affect the living. Common sense says it will change habits and patterns but how? I live in central New Jersey. Death is getting very real here.
The net effect is uncertainty is off the chart and it is almost impossible to value a business with a valuation date of March 15, 2020 or later in most industries. Of course, in some cases business valuation professionals will have to do the impossible.
