What is Discount for Lack of Control: How is it determined?
What is Discount for Lack of Control
Discount for lack of control (DLOC) is a term used in the world of business valuation to refer to the reduction in the value of minority shares since the minority shareholder does not have controlling ownership interest in a company. This reduction in value is necessary because a minority shareholder does not have the same level of influence over the company’s operations and decision-making as a majority shareholder.
Several factors can affect the size of the DLOC. One of the most important is the level of control the minority shareholder has over the company. If the minority shareholder has a significant level of control, such as a seat on the board of directors or the ability to veto certain decisions, the DLOC may be smaller. On the other hand, if the minority shareholder has little control, the DLOC may be larger.
Another factor that can affect the DLOC is the size of the company. Smaller companies tend to have a larger DLOC than larger companies because smaller companies are more likely to be closely held and have fewer shareholders. As a result, the minority shareholders in a small company have less control over the company’s operations and decision-making.
Illustrative Examples
Here are a few examples of how discount for lack of control (DLOC) can be applied in business valuations:
- A minority shareholder in a privately held company owns 20% of the company’s shares but has no seat on the board of directors and no ability to veto major decisions. In this case, a DLOC of 30% to 40% may be applied to the value of the minority shareholder’s interest, as the minority shareholder has minimal control over the company’s operations and decision-making.
- A minority shareholder in a publicly traded company owns 10% of the company’s shares but has no seat on the board of directors. In this case, a DLOC of 15% to 25% may be applied to the value of the minority shareholder’s interest, as the minority shareholder has limited control over the company’s operations and decision-making. Still, the shares are publicly traded and, therefore, more liquid.
- A minority shareholder in a family-owned business owns 15% of the company’s shares and has a seat on the board of directors. In this case, a DLOC of 10% to 20% may be applied to the value of the minority shareholder’s interest, as the minority shareholder has more control over the company’s operations and decision-making than in the previous examples.
It is generally accepted that DLOC ranges from 5% to 40% depending on the level of control and risk associated with the company. In practice, it’s usually determined through a combination of comparable transaction analysis, precedent transaction analysis, guideline public company method, and discounted cash flow analysis. Valuation experts use their professional judgement and apply a DLOC that they believe is appropriate for the specific circumstances of the company being valued.
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The Court’s Perspective
There are several court cases where the concept of discount for lack of control (DLOC) has been used in valuation. Here are a few examples:
- In the case of In re Marriage of Fong, the California Court of Appeal used DLOC in valuing a minority interest in a closely held corporation. The court determined that a 35% DLOC was appropriate in this case, as the minority shareholders had limited control over the company.
- In the Estate of Andrews v. Commissioner case, the United States Tax Court used DLOC in valuing the interests of minority shareholders in a family-owned business. The court determined that a 20% DLOC was appropriate in this case, as the minority shareholders had limited control and the company was in a risky industry.
- In the case of In re Estate of Lillis, the New Jersey Superior Court used DLOC in valuing a minority interest in a closely held corporation. The court determined that a 30% DLOC was appropriate in this case, as the minority shareholders had limited control over the company and the business was in a risky industry.
- In the case of In re Estate of Martin, the New York Surrogate’s Court used DLOC in valuing a minority interest in a closely held corporation. The court determined that a 20% DLOC was appropriate in this case, as the minority shareholders had limited control over the company and the business was in a risky industry.
It is worth noting that DLOC, like any valuation concept, is a matter of judgement and the court determines it based on each case’s specific facts and circumstances. The court may also consider other factors such as market conditions, company performance and industry trends.
How to Determine Discount for Lack of Control
Determining the appropriate discount for lack of control (DLOC) in a valuation can be a complex process, and it is typically determined through a combination of different methods.
- Comparable transaction analysis: This method analyses similar transactions to determine the DLOC applied in similar situations. This method can help determine the DLOC for a minority interest in a closely held company.
- Precedent transaction analysis: This method involves analyzing transactions within the same industry or sector, to determine the DLOC applied in similar situations.
- Guideline public company method: This method involves analyzing publicly traded companies in the same industry or sector as the subject company and determining the DLOC that would be applied based on the trading prices of those companies. A variation of this approach also includes looking at the pre-IPO price vs IPO listing prices to arrive at DLOC.
- Discounted cash flow analysis: This method involves forecasting the company’s future cash flows and then discounting them back to present value. The DLOC can be applied as a percentage reduction to the value derived from this method.
- Market approach: This method uses market data to determine the DLOC by looking at similar transactions that have taken place in the market.
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Concluding Thoughts
Ultimately, the DLOC will vary depending on the value of the company and the level of control the minority shareholder has over the company. It is essential to use professional judgement and consider all available data to determine the appropriate DLOC. It is also important to note that DLOC is just one aspect that goes into determining the value of a business, and other factors such as market conditions, company performance and industry trends also play a crucial role.
In conclusion, DLOC is an essential concept in valuation that reflects the reduction in the value of a minority interest in a business since the minority shareholder does not have control over the company. The size of the DLOC can be affected by several factors, including the level of control that the minority shareholder has over the company, the level of risk associated with the company, the size of the company, and the level of liquidity of the minority interest.
