Factors influencing discounts applied in private-company valuations
Valuation professionals find that business owners are frequently surprised to learn that their business may not be worth as much as they expected – or close to what they are counting on in order to have a comfortable retirement or the life they’ve dreamed of having after selling the business.
These owners may have estimated their business value by talking with peers who had sold a business or by looking at the sales multiples for publicly traded companies involved in mergers and then applying those multiples to their own business. This “value gap” becomes apparent when a valuation professional begins providing numbers to the owner of a privately held business and begins explaining all of the factors that influenced the final value, and it can sometimes result in an unhappy business-owner client.
Instead of waiting for the client (or his or her heirs) to be disappointed by their company’s valuation, valuation professionals can proactively educate business owners about the need to understand various factors influencing their company’s valuation — factors such as discounts, says Ashok Abbott, Ph.D, MBA, an associate professor of finance at West Virginia University who has published extensively in scholarly finance research journals and presented at national and international finance and valuation conferences..
“This is really the right time to be thinking about this, because that generation that started businesses in the 1960s is now transitioning to their golden sunset or beyond,” says Abbott, who recently led a Sageworks webinar on valuations. “A lot of business exits have been well planned, but many more occur in an unplanned manner due to the terrible D’s – death, divorce or dissolution, as when partners fight or when one partner divorces or dies.”
The benefit of proactively educating business owners about factors influencing valuations (and any incorporated discounts) is that valuation professionals generate more value for the clients, and of course, work for the practice. Discounts come in many hues. Selling clients may seek assistance to minimize any discounts, while clients in estate-planning mode might need help documenting any discounts that might benefit them in a transition.
A common discount affecting privately held firms that Abbott recommends valuation professionals help their business clients understand is a discount for lack of marketability. Marketability refers to the legal ability to sell in the marketplace without any impediments. The ability to sell can be influenced by two major factors – information and restrictions on resale – Abbott says, so valuation professionals should help owners understand how these influence the discount for lack of marketability that may be applied to a company’s value as derived from cash flow.
Publicly traded companies, of course, are required by the Securities and Exchange Commission to have and provide audited financial statements in regular intervals and in a timely manner, and they are required to disclose material financial information. This requirement is aimed at ensuring both the buyer and the seller of company shares have equal access to information about the financial performance.
Most privately held companies, on the other hand, have wide discretion over the release of financial information. Creditors may require a certain level of financial disclosure, but prospective buyers face “information asymmetry” and therefore, will require a discount from the cash-flow derived value to price in the related risk. Abbott noted that information asymmetry can vary, depending on the nature of a transaction, as can the related discount. For example, if a business has three owners who are all involved in running the business and one decides to sell to the other two, the level of information asymmetry would be low, so the discount would be small – perhaps up to 25 percent. A discount model called the “Asian Average” is often used in cases like this.
On the other hand, an outsider buying from an insider would want a more aggressive discount to be applied to protect against the risk that the insider has superior information and is selling when the business and cash flow are strongest. A discount model known as the “Lookback put” could be used in such a case. Finally, in the case of an owner holding a minority stake in a business selling to another outsider, both sides may equally lack any private information. The “Black-Scholes model” for pricing and determining the discount could be used.
Restrictions on resale
As is the case with discounts tied to information asymmetry, discounts related to resale restrictions will vary depending on the circumstances. For example, Abbott says, a seller placing no restrictions on the resale of the business stake would generate less of a discount than a seller limiting how the stake could be utilized in the future.
The classic example of restrictions being placed on a resale is a family trust. “There’s a substantial amount of stock held in a trust that will never be sold,” Abbott says. “So generation after generation, dividends have to be distributed to heirs, and that block is never going to be sold by any individual descendent of the founder.” Business owners will sometimes place restrictions on resale to avoid estate tax issues, and the larger the business, the more common these restrictions become, according to Abbott. But the restrictions affect the marketability of the company, so a discount is applied in any valuation.
Abbott recommends that valuation professionals work with business clients to understand some of the factors that can result in discounts in valuations and how they can prepare. Business owners looking to do a quick deal will need to have a lot of good clean financial information available. “Otherwise, it will take time,” Abbott says. “The best thing you can do as an owner is to keep as clean a set of books as you can, because the more good quality information available, the smaller the discount is going to be.” Likewise, accountants and valuation professionals can help clients think through possible restrictions on resale as they discuss estate tax issues and other succession-planning matters.
To learn more about discounts and valuing privately held companies, listen to a replay of Abbott’s webinar with Sageworks, “DLOM Myth Busters: Things You Wanted to Ask But Were Hesitating to Ask.”
Or download a practice aid to help you identify for clients and prospects ways that a valuation can help them: “How to Sell More Valuation & Advisory Services: 17 Questions to Ask Every Prospective Client.”