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How A Volatile Market Affects Your Business Valuation

Recent market volatility may  translate into higher discounts for lack of marketability (DLOM). In business valuations, investors generally will pay less for illiquid or risky investments. However, there’s a benefit in these uncertain times of what comes next for the market. This uncertainty can provide an opportunity for wealthy individuals looking to gift private business interests at significant discounts, which could translate into a substantial amount saved in taxes.

DLOM Basics
According to the International Valuation Glossary — Business Valuation, marketability is the ability to quickly or readily convert property to cash at minimal cost.. Also, implied is a high degree of certainty that an expected selling price will be realized.

The two most popular sources of empirical data valuators use to support DLOMs are restricted stock and pre-initial public offering studies. These studies suggest that discounts for minority interests in private companies range from 30% to 50%. However, the DLOM can vary significantly depending on the specific characteristics of the subject business interest.

Evaluating Volatility
High volatility typically lowers marketability by making investments less attractive. But estimating private stock price volatility can be difficult. The reason being is there aren’t published stock prices for privately held shares — and private transactions are few and far between. Recently, valuators have turned to public volatility metrics to capture the specific effect volatility has on private marketability discounts.

One popular gauge of market volatility is the Chicago Board Options Exchange Volatility Index® (VIX®). VIX measures the expected volatility of Standard & Poor’s (S&P) 500 index options over the next 30 days. Also known as the “fear index,” VIX tells whether investors expect sharp changes in market prices — either upward or downward.

Beyond Volatility

Volatility is just one factor that affects marketability. Other considerations when estimating a DLOM include:

Put rights. These create a market for transferring ownership and, therefore, support a lower discount

Pool of potential buyers. Business interests that have more potential investors generally warrant lower discounts

Size and financial performance. Small companies, startups, and underperforming companies may be perceived as high-risk ventures that warrant higher discounts

Size of block. Large blocks of stock typically take longer to sell and have fewer potential buyers, justifying higher discounts

Imminent sale or public offering. These situations effectively create a market for the company’s stock, which can lower the discount

Availability of financial data. Companies without timely, accurate financial reports may warrant a higher discount

Restrictions on ownership rights. Contractual provisions — for example, those contained in buy-sell agreements and shareholder agreements — that restrict stock transfers or set a fixed price for buyouts may increase the discount

Dividends. Empirical studies show that dividend payments increase the desirability of a given investment and, therefore, reduce marketability discounts

Valuators consider these same factors in other parts of their analyses. For example, these considerations may come into play when quantifying the discount for lack of control, blockage discounts, or the cost of equity (under the income approach). To avoid undervaluing a business interest, it’s important not to double-count risk factors.

Get It Right
When quantifying a DLOM, it’s important to look beyond medians or averages from empirical studies. Experienced valuation professionals will make specific connections between the transaction data from the studies and the business interest in question. Contact us to discuss what’s appropriate for your situation.

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