By: Joshua R. Johnson, ASA
Our clients oftentimes ask us if there have been any changes to discounts in the past few years, given the monumental changes that have taken place in the economy and financial markets. After researching our various sources of data, we can say with complete confidence that it, well, depends.
There are two primary discounts used in business valuation, the discount for lack of control (DLOC) and the discount for lack of marketability (DLOM). From here, the discounts are further subdivided amongst discounts applicable to operating companies, that is companies making products or serving customers, and discounts applicable to holding companies, or companies that merely hold an interest in an operating company or hold a piece of real estate. Given the risk profile attributable to each class of business, it is readily apparent that there would likely be different discounts applicable to each. In most cases, the operating company receives a higher discount than the holding company. As such, we will break down our analysis into those two categories.
We will start with operating companies. The primary source for lack of control discount information relating to operating companies that Shenehon Company uses is culled from the Mergerstat Review, an annual and quarterly publication that has been tracking control premiums paid for corporate acquisitions. By inverting the control premium, one can obtain the implied lack of control discount. Since 1988, the median control discount ranged from 18.8% to 30.4% with an average and median of 24.2%. It is important to note that prior to the 2008-2009 recession, the lack of control discount trended lower, while during the recession the discount trended higher. Since the recession subsided, the lack of control discount has begun reverting back to the historical average and median.
In regard to the marketability discounts applicable to operating companies, these do not vary as much as the control discounts, at least using the resource Shenehon utilizes called Management Planning Studies, as this is not a market-driven metric so much as a company-driven one. The subject company’s actual revenue, earnings and earnings growth (or lack thereof) are the key factors influencing the marketability discount. Management Planning Studies separates companies into quartiles based on revenue size, earnings size, and earnings growth. Based upon the data derived from Management Planning, marketability discounts range from a low of 17.9% for a company with revenues in excess of $53 million to a high of 32.7% from companies with revenues below $9.1 million. For earnings the lack of marketability discount ranges from 16.7% for companies with earnings in excess of $2.9 million to 40.2% for companies with earnings of less than $400,000. Finally for earnings growth, the discounts range from 16.0% for companies growing earnings at between 50% and 150% annually to a discount of 36.6% for companies experiencing earnings growth of between 1% and 50% annually. Interestingly, these are the second and third quartiles, whereas the first and fourth quartiles have higher and lower discounts, respectively. We then weight and arrive at a reconciled marketability discount applicable to the subject company.
The last two items to consider when applying discounts to an operating company, is the existence of a shareholder/member/partner control agreement, and the level of distributions that the company has been making to the owners. Depending on the covenants outlined in the agreement, this will hold significantly more influence on potential discounts for marketability than the metrics applied above in the Management Planning Studies.
The control and marketability discounts discussed thus far assume no agreement to a neutral agreement, with no provisions that would be considered out of the ordinary for a company of the type being analyzed. Overly restrictive agreements will cause potential discounts to increase, and is much more qualitative as a result. Distributions, whether there are any at all or a significant amount as a percent of earnings, can also have significant influence on potential marketability discounts. Distributions in turn are impacted by the strength of earnings and any debt covenants. The Management Planning Studies do not consider distributions or distribution potential in its metrics.
The second type of company discounts we will look at involve those applied to holding companies. With holding companies, since there is usually significantly less operational risk, we turn directly to the stock market for our data. There is a class of investment called closed-end funds, which are publicly traded mutual funds. Where these differ from the mutual funds prevalent in many retirement plans, is that there are a finite number of shares issued, as opposed to the more prominent mutual funds in retirement accounts that constantly issue new shares as new money is deposited and invested. Another well-known feature of closed-end funds is that on average, the closed-end funds typically trade at a discount from the funds net asset value (NAV). That is, the 100% market value of the fund is something less than the 100% book value of the assets owned. Given that closed-end funds are empirically purer than many other investments from a dilution standpoint, and trade at a discount to NAV, this implies that the primary cause for the fund trading below NAV is due to a lack of control on the part of the shareholders. As these are market-based prices, subject to influences from broad economic and financial changes, these discounts change daily. Over the last several years, these discounts ranged from a low of 5% to a high of 19%, but have varied within a tight range of 10% to 14% since the end of the recession for a lack of control discount.
The marketability discount applicable to holding companies is unique from everything we discussed thus far, as it is largely driven by the agreements placed upon the shareholders/members/partners of the company, primarily as it relates to distributions of earnings or cash flow. There are three central tenants influencing the marketability discount as Shenehon applies it. First, what is the extent of the lack of control? This is a fine line, as we must ensure that we do not double count with respect to the DLOC already applied. What this attempts to convey is, are there any other factors present in the corporate structure that cause a deviation from neutral (with the assumption that the closed-end fund derived DLOC is neutral)? This could include a majority shareholder, for example. The second factor revolves around the quality of the underlying asset. If the asset is a high-quality real estate property that is cash flowing, the corresponding discount would be lower than an investment in the equity of a tech start-up. Finally, the third factor revolves around the agreement itself. Are the provisions overly restrictive, are distributions frequently made, can an interest be freely transferred? Based on these three factors, the applicable lack of marketability discount can generally range from a low of 10% to a high of 25%.
As stated at the start of our discussion, the discounts applicable to both operating and holding companies vary widely and are dependent on underlying factors unique to the company itself. While the economy and financial markets have some influence on discounts applied, the agreements in place and underlying assets owned will primarily drive the discounts in both the case of the holding company and the operating company (where the underlying asset for the operating company is the intangible value inherent in its product/service).
The application of discounts for lack of control and lack of marketability is a slowly evolving field, whereby practitioners and academics alike test and theorize about new methods of accounting for control (or lack thereof) and marketability (or lack thereof) within a company. However, few of these new methods of discounting have stood up to rigorous testing and been widely accepted in the valuation community.
If you have any further questions regarding discounts or trends in discounts, please contact Shenehon Company at 612-333-6533.