By Judy Mason, CPA, CVA, CEPA – Partner
Business valuations are performed for a variety of reasons, including estate planning, shareholder buyouts, shareholder agreements, corporate strategic planning, and entity restructuring.
Often discounts for lack of control and marketability need to be considered to determine the value of a business. One of the most important sources of information for determining these discounts lies in a business’s legal documents. These documents can provide information regarding the rights, powers, and cash flows available to all the interests in that business.
The terms of a business’s governing documents are particularly relevant to the valuation of an interest in that business. The terms will be considered by the valuation professional when determining discounts for lack of control and marketability, as well as other rights that adjust the value.
Examples of relevant documents include shareholder agreements, by-laws for corporations, corporate minutes, operating agreements for limited liability companies (LLCs), and partnership agreements for partnerships. Separate buy-sell agreements are also taken into consideration.
Lack of Control and Marketability Discounts
The premise for the discount for lack of marketability is that private company stock is not as liquid as publicly traded stock. For that reason, an investor will pay less for a private company than a publicly traded company of otherwise equal value. Factors impacting this discount can be dividend-paying capacity, history of dividends, and the company’s redemption policy, all of which may be outlined in company documents.
Discounts for lack of control are taken on business interests that cannot control day-to-day operations, ownership transfer restrictions, cash flow, or distribution of cash. This can include both minority and majority interests if these restrictions are present. A business’s legal documents may explain the structure of control and will often detail the percentage of votes needed to pass certain resolutions.
Restrictions on Transfer
Restrictions on transfer are frequently included in LLCs, shareholder, and partnership agreements to prevent owners from selling their interest to an outside third party or competitor. These documents may contain certain restrictions on transfers, such as the prohibition of transfers, the requirement for approval from other owners, or the existence of a right of first refusal for other owners before transferring to another party. Exceptions that allow transfers to family members will sometimes be included in the agreements.
Governing documents may also limit the term of a business’s existence. It is common for the term to continue in perpetuity, but in certain instances, a business’s term may be limited by an agreed-upon time to exit.
Buy-Sell Agreements
A buy-sell agreement is a contract that stipulates how an owner’s share of a business will be reassigned if that owner dies or otherwise leaves the company. Most often, the agreement stipulates that the departing owner must sell their interest to the remaining owners. Some of these agreements include formulas to calculate a value or even have predetermined values that will be used to determine the value of the departing owner’s interest. These buy-sell agreements can become dated and may not reflect the fair market value of the interest at the time of a transaction. Alternatively, agreements will state that the value of an interest should be determined by an independent valuation professional. Agreements may also refer to the application of discounts for lack of control and marketability and whether they should be considered. However, a buy-sell agreement and its terms will be considered in a valuation under the fair market value standard even though the resulting value under the buy-sell agreement might not be the value a third party would pay.
Terminology in the documents can be crucial. The words “fair market value of the subject interest” imply that a valuation analysis would include discounts for lack of control and marketability, if appropriate. However, the words “pro rata value of the fair market value of 100 percent of the equity” indicate that the fair market value of 100 percent of the equity must be calculated first and then multiplied by the percent to be valued with no discounts applied. Given that combined discounts for lack of control and marketability can be upwards of 20 to 40 percent, wording can significantly impact the value of, and price paid for, the interest.
Ask the business valuation team at MichaelSilver to evaluate your operating and governance documents to determine how they might impact the value of your business when a transaction occurs. We can be reached at 847.982.0333.