During divorce proceedings, one of the most complex financial issues may be “what is the value of a business interest?” When the business is the single largest asset on the marital balance sheet, the complexities for division and income may be even larger. This is where business valuation experts assist the process. For non-controlling business interests, two of the significant debated valuation adjustments are the discount for lack of marketability (“DLOM”) and the discount for lack of control (“DLOC”, or together, “valuation discounts”). Whether valuation discounts apply depends not only on the facts and circumstances but also on the state laws where the divorce is filed.
Simply put, a discount for lack of marketability reflects the concept that a business interest that cannot be readily sold is worth less than an investment that can be freely traded, like shares in a publicly traded stock.
By illustration: if you own 100 shares of Apple stock, you can sell them today with the click of a button. But if you own 25% of a family-owned construction company, finding a buyer for that 25% minority interest can be much more complicated. You may be subject to approvals or rights of first refusal by other owners, among other attributes or restrictions, that preclude swiftly selling your interests. The lack of a ready market reduces the attractiveness of the investment, and thus its value.
In business valuation, experts often apply a DLOM when valuing non-controlling interests in private companies. That is because majority stakes in private companies can often exercise some level of control to achieve liquidity. It is important for a business valuation expert to understand the company’s governance structure, among other considerations, and how that influences the marketability of the subject interest and therefore its valuation. As there is a range of possible discounts, the analyst reviews and analyzes various qualitative and quantitative attributes to support his/her concluded valuation discount(s).
Not all business valuation experts have experience valuing subject interests that are subject to minority and marketability discounts. These discounts are applicable in valuations scopes, like transactions, shareholder matters, and estate/tax valuations. Fifteen years ago, the IRS published the Discount for Lack of Marketability Job Aid for IRS Valuation Professionals, which defined the DLOM, discussed the benefits and drawbacks of available methodologies at the time, and generally provided a framework for professionals when valuing for gift and estate tax purposes.
Some practitioners may bifurcate the various negative valuation influences of a discount for lack of control (such as the ability to compel a sale or dividends) rather than marketability. While this can be reasonably defended, it is important that practitioners do not double-count the same negative consequence in both a DLOC and DLOM, and some practitioners prefer to capture all of this in a single DLOM that considers all the factors.
The standard of value applied in a divorce valuation has ramifications, as seemingly identical terms have different implications. The specific definition for each term can vary depending on the context and the standard-setter or regulatory authority. Below, we provide definitions and explain how each standard of value impacts the applicability of a DLOM.
Whether a state uses fair market value or fair value may determine whether valuation discounts are applicable in divorce. We note, however, that some states may have their own versions and/or definitions based on interpretation that do not directly correlate to the above definitions.
It is important to understand the relevant statutes in the local jurisdiction, as states differ in their approach.
These examples show the importance of state statutes (or judicial interpretation of those statues). Two otherwise identical divorces can have very different outcomes depending on where they are filed. Furthermore, many cases are settled outside of the courts, and outside of any appeals process, providing further nuances to current considerations.
Proponents of applying a DLOM in divorce assert that valuations should reflect economic reality. If a 25% stake in a private company couldn’t realistically be sold for “full” pro rata value in the open market, why should it be valued that way in a divorce?
From this perspective, not applying a DLOM creates an inflated conclusion of value that does not reflect the true financial worth of the marital interest. This could leave the owner-spouse saddled with an obligation (such as a buyout or cash settlement) based on an unrealistic valuation conclusion. A DLOM recognizes that private company stock isn’t as liquid as public stock.
On the other hand, some assert that applying a DLOM unfairly harms the non-owner spouse. In most divorce cases, the owner isn’t actually selling the business interest. Instead, they continue to run the company and benefit from its cash flow.
Applying a DLOM in this situation results in a lower valuation and less economic benefit for the non-owner spouse. This may be especially problematic in cases where the business is the family’s largest marital asset. The underlying point of contention is: Why should the non-owner spouse bear a discount for a problem (marketability) that doesn’t actually exist in the divorce context? In other words, why assume a hypothetical sale when no such sale is contemplated?
In part 2, we will provide examples that demonstrate the real-world considerations that practitioners face in valuing non-controlling business interests in divorce.
