Separating the Discounts

All valuation practitioners have been taught that there are essentially two discrete types of discounts – control and marketability.In practice, these are applied and quantified separately.This practice has become embedded in our analyses. With that said, there remains the question of whether this is entirely appropriate. Digging into the details, the two seem to be quite intertwined. While a thorough review of this topic is worthy of some aspiring finance doctoral student’s dissertation, a few haphazard attempts at highlighting perplexing overlaps is not. Personally, I see some issues with some of the conceptual overlaps. For example, in looking at marketability discounts, we have been taught to take into consideration historical dividends/distributions and the prospect for these going forward.This is considered “partial” liquidity I suppose. However, with most non‐controlling interests where the instrument in question is not contractually obligated to make distributions (most equity), this really also encompasses control aspects.Another example is the notion of management, controlling shareholders, or the like, who must “approve” the recipients of transferred interests in order for those interests to retain certain rights and privileges. These are often evaluated in estate/wealth transfer contexts. While I think these are often viewed in the context of restricting marketability of the interest, there certainly seem to be aspects of control (or lack thereof) here as well. When you really get down to it, most marketability issues are really control issues – timing and form of exit via IPO/sale, dividend policy, transfer restrictions, capitalization, company management, redemption policy, etc. That being said, how do we quantify one, “aggregate” discount?The market really isn’t helpful here either. Venture investors and co‐investors in private equity deals putting money to work in minority situations often invest at the same valuation and terms. Transactions in closely held businesses usually involve related parties and just as much politicking and negotiation as solid fundamental analysis. Restricted stock and pre‐IPO studies include public interests, which I have to rule out entirely (separate post on that topic).

For marketability discounts I do like some of the theoretical models – QMDM, protective put, etc, but those have their own challenges ‐ the ranges rendered are incredibly wide and the assumptions very hard to support. I have to say, a solid LBO analysis renders a very solid marketability discount. The price delta required to generate the same IRR when one layers on the transaction costs at exit (underwriting fee for an IPO, sell side fee for a sale) is exactly equal to the discount for translating the interest into cash. A marketability discount that is totally transparent and completely defensible. Now, it does stand to reason that someone might want an additional discount for lack of control. But what if the business is owned by a reputable PE fund (think Blackstone) – you’d be delighted to get a co‐invest parri passu at that valuation, right? A free ride off all their hard work for managing the investment! The control issue gets complicated. It would be nice if our attorney brethren maintained a database of price concessions for specific terms in capital raising and buyout deals. An impossible task of course, but one that we would deeply appreciate.

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By |2018-06-20T18:58:10+00:00June 1st, 2010|Valuation|Comments Off on Separating the Discounts