In this fourth part of our series on buy-sell agreements, we discuss another key question that will allow for the clear and efficient execution of the agreement (see the third post in the series by clicking here):
Does the whole company need to be valued, or just a partial ownership interest?
Simple Math or a Complex Question?
Isn’t this just a question of simple math? Common sense would say that in a situation where a partial ownership interest (say, a 30% interest) in business is in question, the value of the interest would simply be the proportionate share of the value of the company as a whole. For example, if the Company’s total equity was estimated to be worth $1,000,000, the logical conclusion for the value of the 30% interest would be $300,000 [$1,000,000 multiplied by 30%].
As with many things in the world of valuation, the answer is “it depends”. In our last blog post, we discussed the need for the parties to decide on the “spirit” of the agreement. If the parties agree that what is fair is to value a partial ownership interest as a pro rata portion of the whole company’s value, then this likely is a simple math exercise. If the parties believe that the value of a partial interest should be based on what that interest could be sold for in the marketplace, the answer may be much different.
Partial ownership interests in businesses typically have limitations or restrictions in terms of the holder’s ability to participate in/influence the operations of the business. In valuation-speak, this is referred to as a “lack of control”. Privately-held businesses are also subject to some degree of illiquidity (or the ability to convert the asset into cash). This “lack of marketability/liquidity” can originate from either or both of the following sources: 1) the lack of a ready market into which the asset can be sold, and 2) restrictions on the ability to sell an interest set forth in an agreement between the owners. Both of these are considered unfavorable and lead to an increase in the perceived risk of holding such an asset.
Discounts and Premiums
There is a positive relationship between risk and return, such that when the risk of an investment increases, the required return to hold that asset also increases. The expected rate of return on an asset can be increased by lowering the purchase price or decreased by increasing the purchase price. Two of the most common types of discounts that exist in the valuation world to adjust the initial value of an asset for the risks described in the previous section:
- Discount for Lack of Control (or a Minority Interest Discount)
- Discount for Lack of Marketability (or Illiquidity)
When applicable, these discounts reduce the value of a non-controlling and/or non-marketable asset or ownership interest below the basic pro rata value implied by the simple math exercise we described previously. Each of these discounts can range from 15% to 30% in certain cases, thereby reducing the value by a substantial amount.
To apply or not to apply – this is the question when it comes to valuation discounts or premiums. We recommend parties discuss the pros and cons in advance, then make sure their agreement clearly states their intentions with regard to this important topic. If the issue is left to be decided at the time of a transaction, the buyer and seller may well disagree based on their respective positions and the inherent biases that can exist when negotiating a transaction.
In our next post, we will address the issue of funding a buy-sell transaction, and how the inclusion or exclusion of such funding can affect the concluded value.
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