Denice R. Preston
In the past, when a business was evaluated, it was assessed primarily based on its capability to generate cash flow in the future and the subsequent value of these flows, determining its deal with investors. But, when taken on their own, the results of such assessments don’t completely depict the business’ worth. There are detailed and contextual aspects of transactions that are not included in the accounting statements. They must be taken into account.
Its marketability (liquidity) along with the amount of control the buyer will enjoy through ownership of equity are the two factors that determine the level of value that a transaction can have. Their resulting calculations will create a premium, also known as a discount, to the financial value of an asset. This will yield a fair market value.
Levels of Value: The Hierarchy
The value levels define what type of claim is made on the asset an equity investor owns. They are outlined in the structure in the following table. The strategic investor represents the most valuable level and is frequently used in the media to refer to significant investors whose presence within the most prominent company can transform the game regarding their reputational, financial, or operational power. The other end of the spectrum is illiquid, restricted equity with no control stake. The ascending order (or upwards) of the scale is determined by discounts (premiums) that are appropriate for security-level or enterprise-level limitations (autonomy).
Applying Through the Valuation Process
An average valuation procedure begins by utilizing the inputs (observable information points) from the market, resulting in a value comparable to the value of an equity share of the public stock. In this stage, the values can bring the matter by the marketability and the control scenario.
In terms of how to apply discounts and premiums, below are my top suggestions:
Applying discounts or premiums at the same level as the one you’re looking at is recommended. For example, if you arrive at the level of public stock, apply to control (DLOC), then use the liquidity (DLOL) discounted prices, and vice versa.
Discounts must be applied only to the actual value and not mixed into time-value-based discount rates. For instance, consider a 30% discount on DLOC at the public stock level instead of increasing the discount rate by 3 percent.
Any discount is converted into a premium by using the following equation.
Connect the inputs to the value levels that are being considered. For example, if the inputs involve cash flows for minority shareholders in DCF and DCF, then no DLOC will be needed since control is unnecessary.
The discussion will now shift to each of the premiums or discounts that are applied to the various levels of value. Starting at the lowest value (restricted inventory). Each section will explain the reason for the adjustment, how it is needed, and provide examples of benchmarks typically used by those working in live settings.
Discount for Transferability Restrictions
Equity shares are less valuable to the holder if there are limitations on their transferability. These restrictions ultimately reduce the potential for liquidity by decreasing the number of buyers and making the timing for selling more challenging. In contrast to a publicly-held company with a tightly held shareholder, Private limited companies are more restricted in transfers of shares owing to legal restrictions that shareholders are bound by under their shareholder agreement. Anyone valuing a private company should study the company’s bylaws and the articles of association or partnership understanding to know the limitations better.
In many private company documents, transferability limitations are outlined in clauses about the right of first refusal (ROFR) or right of first offering (ROFO) that each has precedent before shares are transferred to outside entities. You might already be familiar with these terms. I have given brief explanations below:
Rights of First Refusal (ROFR) If the third party offers to purchase a shareholding, the holders of ROFR can match the offer before any external sale is conducted.
Rights of First Offer (ROFO) is when a selling shareholder is required first to make an offer to the owner of an ROFO. If a bid is accepted, the owner can only sell the asset to a third party if its proposal is more than the offer of the right holder.
Furthermore, transferability may be hindered by procedures related to the valuation of an asset. It could be because of the requirement of a valuation agent appointed by the board or an established basis-based value method. Each of these options can create a further restriction on sharing transfer and, therefore, will require the purchaser to obtain an additional discount to meet regulations on transferability.
Discount for Lack of Marketability (DLOM)
A Discount for Insufficient Marketability (DLOM) is “an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.”
Marketability refers to the asset’s selling ability (not necessarily that of the liquidity). The NAVCA defines this attribute as “the ability to convert property to cash at a minimal cost quickly.” It must be noted that this should also consider the possibility of expected profits not being realized.
When it comes to calculating DLOM, most valuers point to a set of prescriptions called The Mandelbaum Factors. They were derived from a famous tax ruling 1995 in which Judge David Laro of the US Tax Court set out several factors to consider when calculating the marketability discount.
Discount for Lack of Liquidity or Liquidity Discount
Liquidity refers to the ability to convert a financial asset into cash with no substantial reduction in principal. NYU faculty member Aswath Damodaran explains it as the price of buyer’s remorse – the impact of reversing a trade quickly after making it. Even the assets that are most liquid are illiquid in the sense that they incur an execution cost. The liquidity discount can be divided into both tangible assets and non-tangible:
Costs of transaction or brokerage (visible but with only a slight impact).
Spread of the bid-ask prices in the market, e.g., the amount of the spread between selling and buying prices (visible and more significant impact).
Impact of the market, commonly referred to by the term ” blockage discounts.” This is the effect of trading open and what effects third parties can have on the advancement (invisible and more significant impact).
Delayed and missed trades (internal/opportunity cost and most significant impact).
Benchmarks for liquidity discounts may vary considerably based on the asset’s market conditions and the amount of shares that must be traded. As a guideline for liquid assets, Damodaran recommends 20-30%.
A summary of the various research findings into DLOL limits is provided in the following table, with each offering a broad range of lower and upper boundaries. A method of particular interest is the calculation of NBER, which employs the Black Scholes option pricing model to assess the most significant effect of several liquidity limitations. This includes the standard beta volatility, volatility, timing factors, and the “fraction of wealth” variable that represents the percentage of an asset’s value to the investor’s total wealth.
