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Key Factors That Determine the Valuation Discounts
February 19, 2017

© 2017, by Daniel T. Jordan, ASA, CBA, CPA, MBA

The two types of discounts we determine in a fractional interest discount study (such as for Family Limited Partnerships) are the discount for lack of control (DLOC) and the discount for lack of marketability (DLOM).

To determine the discounts, it is necessary to review carefully the legal documents of the entity such as the Partnership Agreement, Operating Agreement, or Bylaws.

In this blog, I discuss the main factors that have a material impact on the above discounts. I also bring a few examples and discuss briefly the magnitude of the discounts we regularly apply.

I have identified the following key factors:

  • Control vs. Minority
  • Size of interest
  • Underlying assets
  • Expected Holding Period
  • Cash Distributions

Control vs. Minority

This criteria matters the most. A minority interest or more accurately a non-controlling interest1 has higher discounts than the controlling interest2 in two ways:

First, when computing the non-controlling interest, we apply the discount for lack of control. There is obviously no discount for lack of control for the controlling interest.

Second, the non-controlling interest gets a higher discount for lack of marketability than the controlling interest, since it is less marketable.

Size of interest

Usually the larger the interest, the lower the discounts. A 90% LP interest has a lower discount for lack of control than the 1% LP Interest. Both are non-controlling interests but the 90% interest has more power. For instance, it could have swing vote potential. This means depending on the distribution of the stock, a block could have the potential to gain a premium price over a pure minority value because of its potential as a swing block.

Underlying assets

The more liquid the underlying assets of the entity, the lower the discount of lack of marketability and vice versa. Real estate is less liquid than marketable securities. It takes longer to sell real estate than marketable securities and the transaction costs are higher. Thus, the discount for lack of marketability is higher for real estate.

Expected Holding Period

The longer the expected holding period of the assets, the higher the discount for lack of marketability and vice versa.

Cash and marketable securities with a likely short holding period would have the lowest discount for lack of marketability.

Illiquid Assets with No Cash Distributions with a likely long holding period (such as holdings of vacant land) and interests in privately held companies with no cash distributions and poor future prospects, have the highest discount for lack of marketability.

The DLOM for income producing real estate with a likely medium holding period would be in between both levels.

Cash Distributions

If the Company is profitable and the profits are distributed to the owners then the discounts should be lower as this makes the investment more valuable.

Below I present several examples:

Example 1:

If we are dealing with a non-controlling interest in a family limited partnership whose underlying assets are real estate properties, the combined discount (i.e. the discounts for lack of control and marketability) is typically between 30% and 40%. If the entity has a distribution history the discount would be at the lower end. If the entity has no distribution history, the discount would be at the higher end.

If the underlying assets are marketable securities only, the combined discounts for the minority interest (i.e. non-controlling interest) are about 25% to 30%, depending on whether there are cash distributions or not.

Example 2:

If we value a 1% GP interest in a Limited Partnership, the discounts depend on how much power the Partnership Agreement gives to the GP. If the GP has absolute power then the discount for lack of control is zero. However, the GP still gets the discount for lack of marketability, which could be between 10%-20%.

The GP has absolute power when the GP has the exclusive right and authority to manage, conduct and operate the business of the Partnership, including buying and selling assets and retaining available cash for future Partnership use. Additionally, the GP is in control of Partnership distributions and is authorized to amend the Agreement.

If the GP has control but not absolute power then we would apply a discount for lack of control between 5% and 10%.

Example 3:

If we value a 51% controlling interest in a C corporation or LLC that is managed by the majority member, there is no discount for lack of control, since it is a controlling interest. However, there is a discount for lack of marketability, which could be around 15%.

 

Endnotes

  1. Such as the LP interest in a Limited Partnership, which could be a majority interest.
  2. Such as the GP interest in a Limited Partnership.