This discount is often applicable a appraising a business interest, such as when valuing shares for gift and estate tax planning. Or perhaps when seeking an investor’s value assessment in a merger or purchase scenario.

A Case in Point

Assume Economou Porta Potty Corp. is a publicly listed corporation with exactly the same product line, sales, earnings, assets and management as Michel Down & Dirty Inc., a privately held corporation. Economou sells for $12 per share. Is the value of 50 shares of Michel the same as the value of 50 shares of Economou? The IRS, courts and valuators say no, in most circumstances.

Why? Selling a small closely held business usually takes several months and the seller must spend considerable time, effort and money in the process. The seller may have to pay a brokerage fee or incur other direct costs that it wouldn’t incur in the sale of publicly traded shares. The seller may also have to make price concessions to facilitate the sale.

When Are They Appropriate?

Using this discount inappropriately can result in misstated market value. Some cost and income valuation methods don’t lend themselves to the use of marketability discounts. I’ve seen these include:

• The liquidation value premise. This valuation premise may not require a marketability discount because some degree of illiquidity is already assumed in the asset valuations.
  

• The excess earnings method. This method – often used to determine a 100% controlling interest value – more than likely already has some degree of illiquidity built into the multiples.

But marketability discounts are generally appropriate when a valuator uses a market multiple or capital market valuation approach. Because each method estimates a company’s equity value by comparing its stock value to the stock prices of publicly traded (and therefore liquid) companies, a discount representing closely held stock’s non-marketability (or illiquid nature) is, again, generally appropriate.

Seek Advice

If we’re playing in the tax arena, we can pretty much assume the IRS won’t automatically allow a lack of marketability discount. Sometimes, the taxpayer must present expert testimony that the stock or other business interest lacks marketability. A valuator needs to consider the specific facts and circumstances when determining the discount’s size.  Remember, indiscriminate use of a marketability discount might raise a red flag and cause the IRS or other triers of fact to scrutinize the entire valuation.

Determining the Discount’s Size

When a marketability discount is appropriate, what percentage should a valuator apply? The discount’s application and size depend heavily on the specific situation. Historically, observed discounts have been across the board -- ranging from 6% up to 94% from the prices of publicly traded companies. The average discount is about 35%.

And how about a discount for the risk of depending on a key person?

Does a business depend on a key person? Whether this person is the company’s founder or a leading salesperson, one important risk to consider in a business valuation is the impact losing him or her will have on cash flow -- both revenues and expenses.

Analyzing the Risk

The purpose of a valuation also affects the risk analysis. If you are the key person and you are selling the business, you will try to maximize the sale price by working to increase the likelihood that strategic relationships will transfer to the buyer.

A succession plan may have transferred these strategic relationships before an owner or manager’s death, thus making the estate valuation easier. But an orderly transition period is less likely for an estate with no plan in place. Or a valuation for marital dissolution purposes can create wide variations. Some states require fair market value under the definition of Revenue Ruling 59-60. But other family law courts suggest that consideration of the key person issue is unnecessary. These courts assume that the parties involved aren’t really contemplating a sale, or the spouse who actively manages the business is, in fact, the buyer and that these risks should have little effect.

How Losing a Key Person Affects a Business

In addition to cash flow, here are some other aspects of a business that may suffer if a key person leaves:

• Sales. If one person has the sole working relationship with most major customers, maintaining the sales level after his or her departure may not be possible. Assessing this risk is part of the valuation process. The valuator may reviews sales and evaluate whether each relationship could be transferred to someone else, whether the competition can take these sales away and what sales level the company can expect in the future.
• Operations. Reviewing vendor relationships can help determine the stability of the company’s gross profits. If only one person knows where to buy raw materials at the best prices or has a unique relationship with the vendor, the gross profit margins may not be sustainable if he or she departs.
•  Work force. Employees whose loyalty stems from a relationship with the owner may leave if the business is sold.
  

Assess the Impact

Evaluating the risk of reliance on a key person is an important consideration in many business valuations. Owners should address this when preparing to sell their businesses. Proper analysis of its impact on value is essential.

Abo and Company, LLC and its affiliate, Abo Cipolla Financial Forensics, LLC, Certified Public Accountants – Litigation and Forensic Accountants are members of XPX-Philadelphia. The above article was retrieved from the “E-mail alerts” disseminated to clients and friends of the firm. With offices in Mount Laurel, Morrisville, PA and Franklin Lakes, NJ, tips like the above can also be accessed by going to the firm's website at www.aboandcompany.com  or by calling 856-222-4723.