Valuation Discounts and Premiums

Control and/or marketability adjustments are often included in valuations of interests in private companies.

Discount For Lack of Control (DLOC)

The discount for lack of control is a reduction in a company’s share value as a result of a shareholder being unable to exercise his or her control over the company. This is necessary for valuing non-controlling equity interests in private companies if the value of total equity was developed on a controlling interest basis.

For a private company, the discount is higher when the company has not paid dividends and has no probability of going public. On the other hand, the discount is lower when a private company is seeking an IPO and when it is a strategic sale.

$$\text{DLOC}=1-\bigg[\frac{1}{1+\text{Control premium}}\bigg]$$

Example: DLOC

If the control premium is 15%, then:

$$\text{DLOC}=1-\bigg[\frac{1}{1.15}\bigg]=13\%$$

The application of DLOC varies:

• If the investor values the company from a non-controlling perspective, the DLOC should not be applied.
• If the investor values the company from a controlling perspective, then a DLOC should be applied.

Lack of Marketability Discounts (DLOM)

A discount for lack of marketability is the percentage deducted from the value of an ownership interest to reflect the relative absence of a ready market for a company’s shares compared with publicly traded companies. It is applied to the valuation of noncontrolling equity interests in private companies.

Factors that Increase DLOM

• Restriction on sale of shares.
• Restrictions on transferability.
• Higher risk.
• Greater uncertainty of value.
• Concentration of ownership.

Factors that Decrease DLOM

• High prospects for liquidity.
• Payments of dividends.
• Large pool of potential buyers.
• Duration of asset.

The value of equity interest is then calculated as:

$$\begin{align*}\text{Estimated value of equity interest}&=\text{Pro rata value of equity interest}\\& \times(1-\text{Control discount})\\&\times(1-\text{Marketability discount})\end{align*}$$

Example: Calculating the Estimated Value of Equity Interest

Given a DLOC of 15% and DLOM of 11%:

$$\begin{align*}\text{Total discount}&=1-[(1-\text{DLOC})(1-\text{DLOM})]\\&=1-[(1-0.15)(1-0.11)] \\&= 0.243 \\&= 24.3\%\end{align*}$$

Question

For a company with a discount for lack control is 8% and a discount for lack of marketability of 9%, the total discount is closest to:

1. 16.28%.
2. 17%.
3. 17.14%

Solution

The correct answer is A.

$$\begin{align*}\text{Total discount}&=1-(1-0.08)(1-0.09)\\&=0.1628\\&=16.28\%\end{align*}$$

Reading 27: Private Company Valuation

LOS 27 (j) Explain and evaluate the effects on private company valuations of discounts and premiums based on control and marketability.