Marketability—the ability to convert an asset to cash quickly with minimal value loss—is a critical factor in business valuation. Privately held companies, lacking public market access, often require a Discount for Lack of Marketability (DLOM). While commonly associated with minority interests, DLOM is also relevant for controlling interests, though its application is more nuanced. This white paper explores the theoretical and empirical basis for DLOM in controlling interests, its application under the asset and income approaches, and its relevance to SBA 7(a) loan valuations, emphasizing the capitalization of earnings method.

Understanding Marketability and Control

A controlling interest grants significant rights, such as directing operations, controlling distributions, and making strategic decisions. Despite these powers, liquidity remains constrained by time, transaction costs, market conditions, and buyer availability. Even controlling interests in private companies lack the immediate liquidity of public counterparts, justifying a marketability discount.

Empirical Evidence Supporting DLOM for Controlling Interests

While most DLOM research focuses on minority interests, studies and authorities confirm its relevance for controlling interests:

• Private Equity Exits: Research indicates that controlling stakes held by private equity firms often require years to exit, incurring significant transaction costs and risk premiums, highlighting illiquidity (Silber, 1991).
• Mercer’s QMDM: The Quantitative Marketability Discount Model quantifies DLOM for controlling interests by modeling holding periods, cash flows, and risk-adjusted returns (Mercer, 1997).
• Long-Term Holding Studies: Studies document liquidity discounts for controlling interests when no ready market exists.
• Observed Practice: DLOMs for controlling interests typically range from 5% to 20%, depending on deal size, industry, and exit strategy.

Application Under the Asset Approach

The asset approach, often using the adjusted net asset method, values the enterprise by adjusting assets and liabilities to market value. For a controlling interest:

• The enterprise value assumes 100% control.
• Liquidity depends on the marketability of assets (e.g., real estate, machinery, intangibles) and the time/cost to convert them to cash.

Most assets are not immediately marketable, even with control. Achieving liquidity through sale requires time, transaction costs, and market effort. Thus, a DLOM may apply at the enterprise level when liquidation is not immediate, aligning the valuation with realizable value.

Application Under the Income Approach: Capitalization of Earnings Method

The capitalization of earnings method capitalizes future cash flows to derive enterprise or equity value. Key considerations:

• The weighted average cost of capital (WACC), built using public market data (e.g., Kroll’s equity risk premium, size premium), assumes high liquidity.
• Applying WACC to free cash flow to the firm (FCFF) may produce an enterprise value that overstates realizable value for a private company with limited exit options.

Example: A $10 million enterprise value, based on capitalized free cash flow, may face a 15% DLOM, reducing realizable value to $8.5 million due to a 2-year sale process and 5%-10% transaction costs (e.g., broker fees, legal expenses).

Conceptual Support for Enterprise-Level DLOM

Liquidity assumptions in enterprise value calculations—whether from fair market value-adjusted assets or public market-derived WACC—may misalign with private company realities. Supporting factors for enterprise-level DLOM include:

• Adjusted assets under the asset approach lack immediate cash realizability.
• Public market WACC inputs assume efficient capital access and exit options.
• A hypothetical seller may not achieve full enterprise value without a multi-year sale process, fees, or strategic preparation.

These factors justify a DLOM to reflect economic substance.

Factors Underlying DLOM for Controlling Interests

Applying DLOM to controlling interests is based of these factors:

1. Time Value of Money: Monetizing a private company, even with control, takes months or years, exposing owners to market risks and delaying capital use. Discounting expected proceeds to present value accounts for this.
2. Transaction Costs: Selling a business incurs broker fees, legal expenses, and operational disruptions, reducing net proceeds. DLOM adjusts for these costs.

Conclusion

Controlling interests in private companies, despite strategic flexibility, face marketability challenges. Under the asset or income approach, DLOM may be applied at the enterprise level to align valuations with private market realities. For SBA 7(a) loans, the capitalization of earnings method, adjusted for DLOM, ensures sound lending decisions.