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One of the most common questions about minority interest appraisals is, “Why are there discounts (for lack of control and marketability) for entities owning fully liquid assets (like bank deposits and marketable securities)?” After all, these are easily convertible to cash!
The answer is that we are not only valuing the liquid assets, we are also valuing a minority interest in an entity that owns them: a corporation, partnership, or limited liability company. The operating agreement usually limits a minority owner’s ability to force asset liquidation / distribution and to transfer, sell, or liquidate their interest.
Imagine that there are two assets on a table before you: a crisp $100 bill (not counterfeit!) and a transparent locked safe with another $100 bill inside it. You do not know the safe’s combination.
A buyer would obviously pay $100 for the bill. She would pay $100 for the bill in the safe ONLY if she also got the combination. The combination is of value to her, meaning she would pay less than $100 for the bill in the safe without the combination. The value of the combination is the discount for lack of control and marketability!
The same logic applies to a seller. He cannot get or spend the bill in the safe without the combination.
In the case of a minority interest in an entity, the operating agreement’s restrictions on control and marketability play the role of the safe’s combination and create valuation discounts. In addition, liquid assets may be required to fund operating losses, pay liabilities, service debt, and pay taxes (whose distribution does not provide economic return for interest owners).
This applies to all entities (operating businesses or holding companies). To ignore valuation discounts is to ignore the operating agreement, which is not logical (exceptions occur if the operating agreement does not stipulate a legitimate business purpose and / or its restrictions on withdrawal, transfer, or liquidation are loose). Much market data validates the existence and magnitudes of discounts. What is controversial is whether allowing them is good public policy. Currently, the IRS is trying to eliminate or limit them.
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About Western Reserve Valuation Services LLC
Western Reserve Valuation Services LLC, based in Columbus, Ohio, is a leading provider of valuation services and financial opinions relating to corporate finance transactions, corporate tax planning and compliance, succession planning and wealth preservation, employee stock ownership plans (“ESOPs”), financial reporting and portfolio / fund valuations. For more information, visit www.wesresvaluation.com or call (614) 448-3700.
Western Reserve Valuation Services is an affiliate of Western Reserve Partners LLC, a FINRA-member investment banking firm offering financial advisory services relating to mergers and acquisitions, capital raising and financial restructuring. For more information on Western Reserve Partners, please www.wesrespartners.com or call (216) 589-0900.