Evaluating Value

Anne Meltzer, CPA/ABV
Mark W. Norris, CPA/ABV, CVA, CFFA, ASA

Tucker & Meltzer Valuation Advisors

In order to transfer an interest in a privately held business for estate and gift tax planning, a business valuation is required. The first step in this process is to determine the value of the business. The second step is to determine the value of the minority interest in the business by applying discounts for minority interest and lack of marketability.

Determining the Value of the Business

When using a valuation for estate and gift planning purposes, the standard is fair market value.  This is defined as the price at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

There are three approaches that can be used to determine the fair market value of a business. They are the asset-based approach, the income approach and the market approach. The asset-based approach is not used often for operating companies as this approach focuses on the balance sheet of the business and does not reflect the earnings potential of the business. The income approach is the most common approach used for valuing small businesses. In this approach, the company’s future potential income stream is discounted back to present value using a market rate of return. There are two variations of the market approach. In the first variation, the subject company is compared to similar publicly traded companies. The second method involves seeking transactions of companies in similar lines of business and comparing the subject company to the transactions.  A good valuation will utilize as many of these approaches as possible to arrive at a value of the subject company as a whole.

Determining the Value of the Minority Interest

In order to determine the value of the interest in the business, the business valuation analyst will often apply discounts to the overall value.  The two most common discounts are the discount for lack of control (also referred to as the discount for minority interest) and the discount for lack for marketability.

The discount for lack of control is applied because a minority interest has a lower value than a controlling interest because an outsider acquiring a minority interest in a closely held company would have no authority or control over the regular day-to-day operations of the business. To arrive at a discount for lack of control, most business valuation analysts utilize data from control premium studies that are published by Houlihan, Lokey Howard & Zukin’s Mergerstat Review.  Each year a number of publicly traded companies are sold for more than their pre-acquisition market capitalizations. These are control premiums, from which the inverse or minority interest discount may be implied.  In general, these discounts range from 10 to 18 percent.

Determining the Discount for Lack of Marketability

Most often the interest being valued is privately held and, therefore, there is not a ready market for the interest. This is the reason for the application of a discount for lack of marketability. The most common method for estimating the discount for lack of marketability is the analysis of restricted stock transaction and pre-IPO transaction data. This method considers earnings, restrictions on the sale of the security, alternative investments and the time horizon in which an investor might achieve liquidity. Generally, the pre-IPO transaction studies result in a median discount of 30.0 percent and the restricted stock studies have a median discount of 33.0 percent.

Another method, which is commonly used in valuation practice is the Quantitative Marketability Discount Model (QMDM).  The QMDM is a discounted cash flow (present value) model that values illiquid interests of privately held businesses based on their expected shareholder-level cash flows and the risks associated with those cash flows. The QMDM is particularly sensitive to current market rates of return, dividends or distributions during the duration of the investment and the required holding period for the investment.

In general, the discount for lack of marketability is much more subjective than the discount for lack of control and can range from a low of 10 percent to a high of 40 percent depending on the specific issues surrounding the interest being valued.

Combined Discounted Value

Since the results of these discounts can be quite substantial, transferring ownership interests in a company rather than transferring the entire company can save a business owner a great deal in taxes. As can be seen from the example below, a gift of a 10 percent interest in a company worth $1,000,000 would be valued at $63,750 instead of $100,000, or a $36,250 reduction in value.

Value of Company        $1,000,000
Interest Being Valued        10%
Control, Marketable Value        $100,000
Minority Discount    15%    (15,000)
Minority, Marketable Value        $85,000
Discount for Lack of Marketability    25%    (21,250)
Minority, Non-Marketable Value        $63,750

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