Discounts for lack of marketability are well established when valuing minority interests in closely held businesses. But many valuation experts believe that controlling business interests also warrant a marketability discount to reflect the uncertainty and risk associated with the timing of the sale and the ultimate price. Here’s a closer look at this issue.
Minority (noncontrolling) interests
In a business valuation context, “marketability” refers to the ability to quickly convert property to cash at minimal cost. While publicly traded stocks are readily marketable, interests in private companies typically require substantial time, cost and effort to sell. To the extent that public stock data is used to value private businesses, a discount may be warranted to reflect the lack of marketability.
Marketability discounts are well established when valuing minority interests in closely held businesses. These interests lack elements of control. Several empirical studies support and quantify these discounts. Restricted stock and pre-IPO studies, for example, demonstrate the spread between prices paid for freely traded shares and identical shares that are less marketable because they’re restricted or not yet publicly traded. Discounts typically average between 30% and 45%.
Controlling interests
Applying marketability discounts to controlling interests is somewhat controversial, although courts have sometimes accepted them. Most experts agree that the size of marketability discounts should shrink as the level of control increases. But while many argue that some amount of discount should be available at all levels of control — even 100% — others say it’s inappropriate to apply a marketability discount to a controlling interest.
With a controlling interest, it takes time and expense to complete a sale. So marketability discounts applied to controlling interests are sometimes referred to as “illiquidity” discounts to help differentiate them from discounts taken on minority interests.
The rationale behind taking a marketability discount on a controlling interest is that fair market value is a cash equivalent concept. In contrast, a future sale of a controlling interest is speculative and expensive. The deal also may include noncash terms, such as employment contracts, restricted stock or installment payments.
For example, in a divorce case, it may seem inequitable for one spouse to receive a $1 million interest in an illiquid business while the other spouse receives $1 million in cash and real estate, which are considerably more liquid.
When quantifying illiquidity discounts, valuation experts consider the time, costs and risks of selling the business (or a controlling interest within it). Alternatively, they may estimate the costs of going public. No official empirical data exists to support marketability discounts on controlling interests. But all else being equal, most experts agree the discount for a controlling interest should generally be lower than for a minority interest in the same company.
Recent case
An August 2024 decision by the Court of Appeals of Iowa provides an interesting example of this issue. It affirmed a lower court ruling allowing a 10% marketability discount on the value of a garden center that was part of the marital estate. (In re the Marriage of Baedke, No. 23-0219, Iowa Ct. App., 2024.)
The couple in this divorce case had started a business that grew over the years to include a full retail garden center and landscaping, gardening and lawn care services. The husband ran the day-to-day business operations. The wife performed various administrative tasks for the business, such as customer service, marketing, bookkeeping, payroll and receivables processing, and office management.
The settlement agreement called for the husband to retain the business. Both sides hired experts to value it.
The district trial court accepted the value set forth by the husband’s expert, which included a 10% marketability discount. His expert explained that “you cannot turn the value of the company into cash in three business days like you can if you had a $700,000 investment on stocks and bonds.” His discount also covered the transaction costs of having to sell a private business but included no discount for lack of control or being a minority shareholder.
The wife’s expert argued for no marketability discount. But the expert conceded on cross-examination that a 10% discount was “conservative.”
The appellate court noted that the discount tracked with Iowa precedent that had affirmed discounting the valuation of a closely held business when there was no ready market. The husband also had no imminent plans to sell it. Therefore, the appellate court found that the district court’s “valuation of the business, including the marketability discount, was within the range of permissible evidence” and didn’t result in an inequitable division of the marital estate.
We can help
The application and magnitude of marketability discounts are matters of professional judgment and can vary significantly from one business valuation to the next. Contact us for help supporting or challenging the use of a marketability discount for a specific case.
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