WFU Law School
Law & Valuation
5.4 Business Valuation - Discounts and Premia

5.4.1 Ownership Interests - Bundle of Rights

Business ownership interests carry certain essential rights:
  • financial rights to a portion of the firm's income stream
  • governance rights to participate in choosing managers and making business decisions
  • liquidity rights to sell or dispose of these rights to others

Financial and governance rights, though they typically inhere in business ownership, are often not equally divided. Although financial and governance rights are usually allocated according to the proportion of ownership interests held by each participant, these rights have varying value depending on the participant's actual governance power. In a firm in which governance matters are decided by majority vote, a 51% shareholder has significantly more power than a 49% shareholder. Although the 51% shareholder may be entitled only to 51% of any declared dividends, the shareholder's power over governance matters makes the majority shares significantly more valuable than the minority shares.

This additional value for majority shares (or other controlling positions) is known as a "control premium." The corresponding diminishment in value of minority shares (or other non-controlling positions) is known as a "minority discount." How are these premia and discounts valued? When does the law recognize their existence?

In addition, business interests have varying liquidity rights. By definition, closely-held firms do not have developed trading markets on which ownership interests can be bought and sold. Many firms also place contractual restrictions on the ability of members of closely-held firms to sell to their interests. This "lack of marketability" affects the value of ownership interests. How does the lack of marketability affect value? When does the law recognize this?

For an illustration of how control shares create a minority discount, consider how Alfred Taubman's real estate company shortchanged its shareholders, even while Taubman served a one-year jail sentence for fixing commission's at Sotheby's.

 

Illustration

A real estate holding company, based on a DCF valuation, is worth $100,000. The company operated as a corporation is owned by A-60% B-20% C-20%. What is the market value of their shares?

At first glance, you might think this is a simple question of computing proportions. But consider the value of control, namely A's ability to elect the board and decide such fundamental matters as selling all the corporate assets, merging with another company, or dissolving and liquidating. A purchaser of A's shares might be willing to pay a premium for A's shares - perhaps $15,000! A's shares (financial rights and governance power) could well fetch $75,000 in an arms-length transaction - a 25% premium ($15,000/$60,000). (More>>)

Example - Marketability Discounts and Control Premium

Estate of William J. Desmond, v. IRS
[full text] [excerpted]
T.C. Memo 1999-76 (U.S. Tax Court 1999).

William Desmond died holding 136,000 shares (81.93%) of Deft Corporation, a small closely held company that manufactures industrial paint for military and commercial uses. The IRS claimed that Desmond's estate tax return underreported the value of Desmond's interest in Deft and accordingly determined a deficiency and assessed a large penalty. The key issue before the court, therefore, was to determine the fair market value of Desmond's interest in Deft.

Both Desmond's estate and the IRS submitted expert valuation reports to the court. The estate valued Deft using three methods: Asset method, income method, and market method. It averaged the results obtained under the three methods and then applied a 25% lack of marketability discount. THe IRS's expert did not address the fundamental ("unadjusted") value of the company, focusing solely on the appropriate lack of marketability discount instead. (More>>)

5.4 Business Valuation - Discounts and Premia

©2003 Professor Alan R. Palmiter

This page was last updated on: April 7, 2004