The impact of COVID-19 on Valuation Discounts

Everybody loves a good valuation discount in a more understated fashion than a discount on your favorite Target items, but the impact can be significant. Valuation discounts can be a business owner’s best friend when it comes to wealth transfer, but they can be a bit difficult to understand or measure.

Everybody loves a good discount.  It almost feels like you are making money when you see your favorite store put up the Labor Day blowout sale signs in the windows (do physical stores still exist?).  I meant to say, when your favorite online retailer sends you an e-mail about a 20% discount on all items, you act quick to pull out the credit card and start making it rain.

In many estate & gift-tax related valuations, with the fair market value standard, the valuator is able to incorporate Discounts for Lack of Control and Discounts for Lack of Marketability when concluding on the fair market value of a business interest.  I will take a look at the Discount for Lack of Marketability (DLOM) in this post.

To understand why and where a DLOM may be appropriate, we must first get into a bit of technical valuation mechanics.

Oftentimes, when figuring out the value of a business, the valuator uses techniques that are used to value publicly traded stock.  The primary methods are the discounted cash flow (DCF) or capitalization of earnings methods, or the guideline public company method.  The DCF and capitalization of earnings method use rates of return as observed in the public stock markets as a means to determine value.  The guideline public company method uses multiples (of Revenue or EBITDA) that are observed in public companies to apply to the private company metric to determine value.  For example, a publicly traded company may trade a 2x revenue.  So, we take our private company’s revenue and multiply by 2 to determine value.

The issue that arises here is that there are many differences between the public companies and rates of return and our private company that we are valuing.  One of them is the marketability of the equity interest.  Marketability deals with the ability to turn the investment into cash in a timely fashion (i.e. liquidity).  For a public stock, the investor can sell his/her shares on an exchange for cash usually within a few days, if not sooner.  Private company owners do not share this luxury.  Selling private company shares often involves a long and costly process, which may not yield an adequate buyer.

Ultimately, we apply a discount to the value that is calculated based on public company multiples to determine the value of our non-marketable private company shares.  There are many methodologies for determining the magnitude of the DLOM, including Restricted Stock Studies, Pre-IPO Studies, and Put-Option based models.  Another commonly used method is referred to as the “Mandelbaum Factors” and is a more qualitative approach to compliment the quantitative approaches employed in the studies and models mentioned previously. The Mandelbaum factors come from a famous (in the business valuation world) court case, Bernard Mandelbaum, et. Al v. Commissioner.”  The court ruled that certain qualitative factors can impact the DLOM in a positive or negative fashion.

Namely, these factors should be considered:

  • Financial Statement Analysis
  • Dividend Policy
  • Nature of Company (Company and Industry Outlook)
  • Company’s Management
  • Amount of Control in the Transferred Shares
  • Restrictions on Transferability of Stock
  • Holding Period for Stock
  • Company’s Redemption Policy
  • Costs Associated with a Public Offering

It is not a surprise, that COVID has likely increased DLOMs for companies across the board, but even more so in specific industries.  As revenue and earnings have decline, companies have reduced dividends, and the industry outlook has changed dramatically in 2020, a higher DLOM can be supported.

A higher DLOM is often reflective of a temporary decrease in equity value, whereas a change in the multiple or discount rate often reflects a more long-term change in the company’s value.  Given that many view COVID as a temporary disruption, it would make sense that multiplies may not change significantly, but DLOM’s have gone up.

The increase in DLOM makes transferring wealth more efficient for many business owners as a larger discount can be justified.  Estate planning opportunities are abound with the depressed valuations from increased discounts including DLOM, low interest rates, and relatively high estate tax exemption.

Contact DKB’s Valuation group to learn more about how we can help!