Business Valuation: Discounts for Lack of Liquidity and Marketability are Often Confused Concepts
Business appraisals of privately held businesses often include hefty discounts under fair market value, which can go as high as 70% or more of the 100% equity value due to the lack of marketability and/or liquidity relative to other marketable and liquid assets such as stocks trading in the NYSE.
Liquidity and marketability are often used interchangeably by many business valuation appraisers; however, there is a significant difference often missed, leading to improper determination of the discount applicable to a business value. This can lead to higher risk of improper taxation, over payment for equity interest purchases, or higher risk of audit and investigation if under an employee stock option plan (ESOP).
Though both terms have a close relation they are not the same. Liquidity is defined as the capacity of an asset to be converted into ready cash without affecting its market price, while marketability is a term used for assets which have a readily available market. Generally, a non-marketable asset is also illiquid, but an illiquid asset is not necessarily non-marketable.
Tricky right? They both sound very similar. In the case of private businesses, a 100% controlling interest in a closely held business is in fact marketable as there are different avenues through which they can be sold, such as investment banks, business brokers or internet-based markets. This means there is a readily available market where sellers and buyers can meet and trade such assets.
Are Discounts Applicable to a 100% Controlling Equity Value of a Company?
A privately held business, although marketable it’s still not liquid. According to some brokers, a small business can take on average between 6 and 9 months to sell. This illiquidity vs the 3 days liquidity in the stock market, conveys a loss in perceive value of the private business.
For this reason, although a 100% controlling interest is marketable and requires no discount for lack of marketability, investors will punish it or apply a discount for lack of liquidity.
Not making the accurate distinction between marketability and liquidity, and their appropriate application in the valuation process, can lead to an improper taxation for a business owner. If 100% of a business is being transferred/sold/gifted a discount might not be applied as its already determined as marketable, leading to an overvaluation of the business. Hence a business appraiser should in fact consider the illiquidity of the company and apply an appropriate discount. There are quality, well known, and accepted empirical studies to demonstrate this discount for lack of liquidity on 100% controlling stakes in privately held businesses such as the Koeplin, Sarin, Shapiro study, the follow up study by Block, and the De Franco et al study.
What assets are non-marketable and illiquid?
An example of a non-marketable and illiquid asset will be a 10% non-controlling interest in a privately held business. The reason being is that there are very limited markets where a non-controlling interest in a privately held business can be sold. Additionally, since there is no readily available market, this asset will take longer to be sold, hence being an illiquid asset as well. Consequently, the discount applicable to a non-marketable asset is usually higher than the discount applicable to an illiquid asset.
Discounts play a significant part in the valuation of closely held businesses as the discounts can be as high as 70% of the total equity value. Imagine a $10 million business, of which a 20% equity interest you see as $2 million, in an actual fact, with correct application of discounts of 50%, the value is actually $1 million. There is a close relationship between marketability and liquidity, but both should not be used interchangeably because the lack of one does not necessarily mean that lack of the other. Furthermore, the discount applicable to a non-marketable asset is different than the discount applicable to an illiquid asset; therefore, using both terms interchangeably can lead to the non-application of a discount or a wrongful determination of it.
Its important to consult an expert accredited business appraiser to determine the appropriate discounts applicable to a privately-held business based on the unique case facts presented in the business. An inappropriate determination of discounts can increase the likelihood of an IRS audit, hefty penalties, improper taxation (including overpayment of taxes), overpayment of equity interests, or DOL investigations for improper sale of stock to the ESOP trust.