By Gregory R. Caruso, JD, CPA, CVA
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.