In Part 1 of this post, we defined valuation discounts such as the discount for lack of control and discount for lack of marketability. We discussed the difference between fair value and fair market value, illustrated the importance of the prevailing state statute, and gave arguments for and against employing valuation discounts in a divorce context. Now we will discuss common drivers of marketability discounts and contextualize them with common provisions in partnership agreements and go through a case study.
Valuation discounts are not arbitrary devices to reduce value in litigation. They exist because of real-world features that make certain ownership interests more difficult to sell or less attractive to outside investors. In fact, many of these features are intentionally built into partnership agreements or shareholder arrangements to protect the business and its stakeholders. A few include:
While there are many potential provisions in governance documents that would influence valuation discounts, the above are some of the most common. The degree to which these provisions impair the ability to achieve liquidity influences the magnitude of the discount. In most cases, experts agree that a DLOM applies, but they may disagree as to the magnitude.
If a spouse invests liquid marital funds into a less liquid minority interest in a private company, that spouse could later argue that the subject interest lacks marketability. Thus, the value of this asset for division would be lower.
Suppose a divorcing party invested $1,000,000 from the marital estate for a 25% stake in a limited partnership which invests in real estate. Next, let’s assume the underling real estate was acquired for $10,000,000, financed by $6,000,000 in debt and $4,000,000 in equity, from four investment partners who each contributed $1,000,000.
On the date of contribution, it would be hard to argue that each individual’s investment is worth anything other than $1,000,000. But what if this investment had occurred many years prior to the divorce proceedings? What is the property worth now? What is the remaining debt balance? Has the partnership been making regular distributions?
For this fact pattern, let’s assume the parties have hired real estate appraisers to value the property for the divorce and it is worth $12,500,000, and the debt balance has been paid down to $4,500,000 for an equity value of $8,000,000, or $2,000,000 pro rata for each partner.
If the divorce is filed in a state fair market value state, discounts for lack of control and/or marketability would likely apply, reducing the value. If the 25% subject interest is determined to support a combined valuation discount of 30%, that would be applied to the $2,000,000, resulting in a nonmarketable minority value of $1,400,000. While there are legitimate reasons (and support) for this discount, the non-owner spouse would likely be considered disadvantaged if the investment occurred after divorce proceedings commenced. This is a clear example of why temporary restraining orders (TROs) are common divorce. These types of orders seek to protect the other spouse from a DLOM that one could argue was intentionally manufactured.
The debate over DLOMs in divorce comes down to economic equality versus market reality. Should the valuation(s) and resulting divisions aim to replicate what the open market would pay? Or should there be more consideration such that the non-owner spouse isn’t disadvantaged by a “hypothetical” discount? For divorcing couples with a privately held minority business interest, the answer depends on the standard of value in the relevant jurisdiction. Furthermore, the facts and circumstances of the subject interest may support a discount on the lower or higher end of a reasonable range.
This is precisely why we typically caveat responses to such questions with “facts and circumstances matter.” The jurisdiction matters. The intent and timing of the investment matter. The relationship between the other investing parties matters. What if the other 3 partners in the hypothetical venture were all related to one of the divorcing spouses… and the partnership agreement states that owners may only be blood-line relatives (limiting a potential pool of buyers for hypothetical resale)? A trier of fact is likely to consider all these factors, even in a jurisdiction that does and doesn’t allow for discounts.
This makes it even more important that the retained business valuation expert is experienced with engagements requiring the determination of discounts for lack of marketability and control, what quantitative and qualitative methodologies to consider, documents, data & information to consider, among other factors. Contact a member of Mercer Capital’s litigation support services team today.
