Business valuers often use the terms liquidity discounts and marketability discounts interchangeably. Adopting Robert Reilly and Aaron Rutkowski’s (1) approach, liquidity here refers to an owner’s ability to sell a business enterprise or a controlling interest. A marketability discount relates to an investors ability to sell an individual share or block of shares.
The degree of liquidity relates to the ability of the owner to convert the investment to cash quickly. An investor can sell shares in a public company instantly; an investor in a private business must first find a buyer.
A controlling interest in a private company is not liquid. If the valuation of a controlling interest in a private business is being calculated using comparable listed companies as a basis, then liquidity discounts often apply.
Liquidity discounts factors for private businesses
There are typically many buyers, internationally, for shares in a listed company; there are usually few buyers for a controlling interest in a private business. Banks may accept traded listed shares as security for a loan, but are reluctant to allow a borrower to hypothecate a controlling interest in a private company. A willing but not anxious private business seller faces transactional factors that have a depressing effect on price expectations, these factors include (2):
- an uncertain time frame for completion of the sale
- the cost of preparing the business for sale and executing the transaction
- the risk as to eventual price achieved
- the prospect that some of the sale consideration may be only obtainable in a non-cash form
Delay in selling is not just a cost in itself, but it indicates price negotiation and uncertainty.
In Business Valuation Discounts and Premiums, Shannon Pratt (3) considers the following when calculating a discount for a controlling interest:
- assessing the costs of selling a private business, such as the business broker commission (often paid as a percentage of the sales price) and legal and accounting fees
- discounting back to today the expected proceeds from the time that it takes to sell the business; private businesses often take at least six months to sell (although the investor is still generating a return while waiting to sell)
- discounting back to today the expected proceeds from the deferred components
These factors affect both the net proceeds to the vendor and will also be a concern to a buyer (when they come to sell) and so will influence price.
How much for a private company control discount?
Shannon Pratt in his Cost of Capital (4) and states that private company control discounts (compared to liquid stock investments) are often in the range 10% to 25%. James Hitchner (5) talks of between 0 and 20%. Trugman (Understanding Business Valuation) says the US Tax Courts have allowed DLOM on controlling interests of between 3% and 33%.
Professor Aswath Damodaran (6) appears to like the Silber, liquidity model. According to the model, the higher a firm’s revenue, the lower the discount. Assuming income of $10 million, 100% control and a profitable business, the Silber formula (see formula below*) results in a control discount of 29.5%
Professor Damodaran in Investment Valuation uses 25% as a private control discount base for a profitable firm with $10m in revenue and then reduces the discount using the Silber equation.
Alternatively, Damodaran proposes a bid-ask spread approach. The gap between the bid and ask price, being indicative of the cost of immediate liquidity.
2. Dismin Investments Pty Ltd v Commissioner of Taxation , Federal Court of Australia 1703 3. Pratt, s, Business Valuation Discounts and Premiums, John Wiley & son, 2001 4. Pratt, S and Grabowski, R, The Cost of Capital: Applications and examples, Wiley Financial, 5th edition 5. Hitchner, J, Financial Valuation, Applications & Models, Wiley Financial, third edition 6. Damodaran, A, Investment valuation, tools and techniques for determining the value of any asset, Wiley Finance, second edition
** Silber formula: ln(1-liquidity discount) = 4.33+(.036* ln(revenue $m))-(0.142*ln(block size in %, control=100))+0.1749(if earnings positive)
Simon is a CA Business Valuation specialist, Chartered Accountant and a Certified Fraud Examiner. Simon specialises in providing valuation services. Prior to founding Lotus Amity, he was a Corporate Finance and Forensic Accounting partner with BDO Australia. Simon provides valuation services in disputes, for raising finance, for restructuring, transactions and for tax purposes.