Keeping Your Balance: A look at other valuation discounts

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Trust and estate attorneys are familiar with the discounts that are common to the valuation of closely held businesses and business interests: 1) the discount for lack of control and 2) the discount for lack of marketability. The application of these discounts is dictated primarily by the valuation assignment. There are, however, other valuation discounts to consider that are not a function of the valuation assignment but rather, they are a function of the valuation subject.

Pratt, Reilly and Schweihs, in Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 4th edition, group these other valuation discounts into two categories: 1) transferability restrictions category and 2) nonsystematic risk attributes category.

Here we will discuss the nonsystematic risk attributes category, which includes discounts that relate to the subject business only; the individual features or unique attributes that affect the expected risk of an investment in the subject business or business interest. These risks do not consider systematic risks such as inflation risk and interest rate risk that are normally incorporated into the application of general valuation methods.

More common nonsystematic risk discounts include:

1. Discount for key person dependence;

2. Discount for key customer dependence;

3. Discount for key product dependence; or

4. Discount for obsolescence of technology or facilities; and

Key person: The key person does not need to be the principal owner of the business. A key person may contribute value to a company in day-to-day management duties, from strategic judgment responsibilities based on long-standing contacts and reputation within the industry, or this person could be “key” in any business operation functions such as finance, new product development or sales and marketing.

Key customer: Key customer dependence creates risk due to an unusually concentrated dependence on one or a small group of customers. The Securities and Exchange Commission requires public companies to disclose to shareholders instances when a customer is responsible for over 10 percent of a company’s annual revenues. As such, many valuation professionals use this 10 percent disclosure requirement as an indication of key customer dependence.

Key product: Key product dependence occurs when a concentration of a company’s sales come from one particular product or product model, particularly when the company’s competitors offer a broad array of products.

Obsolescence: Risk arises when a company is dependent on either technologies or facilities (or both) that are outdated. To assess the need and size of this discount, it is necessary to identify benchmarks, such as the company’s industry and/or competitors.

Each of these discounts relates to the facts and circumstances of the company under consideration and typically relate to dependencies of the company that are not common throughout the company’s industry. These unique discounts are not as common as the discount for lack of control and discount for lack of marketability.

Sources:

1. McGraw-Hill, 2000; Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 4th edition, Chapter 18, 426-436, 601-603;

2. National Association of Certified Valuation Analysts 2009; Business Valuations: Fundamentals, Techniques and Theory, Chapter 7, 42-51; and

3. BVWire – #93-1 (Wednesday, June 9, 2010), NACVA/IBA attendees debate whether there’s such a thing as a “key person discount?”

Kristin Coffey is the manager of Business Valuation Services with Mengel, Metzger, Barr & Co. LLP. She may be reached at [email protected]