|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
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?
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).
Example - Marketability Discounts and
Estate of William J. Desmond,
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
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>>)