Of all the factors considered by business divorce lawyers and appraisers when valuing an owner’s interest in a closely-held company, the calculation and applicability of a discount for lack of marketability (“DLOM”) is among the most fertile grounds for sharp disagreement.
It’s easy to imagine why. For one, in cases where parties offer competing appraisals of an interest in a closely-held company (such as fair value proceedings under New York Business Corporation Law Sections 623 or 1118), the DLOM often is the largest driver of the differences between the two appraisals, and the parties naturally focus their efforts on the issues producing the largest swings in value. Second, application and calculation of the DLOM involves—perhaps more than anywhere else in the business appraisal process—a considerable amount of judgment. The appraiser’s judgment calls in applying a DLOM are frequent targets for attorneys seeking to undercut or enhance the final number.
One need not look far to find disputes over DLOMs playing out in courts across the country. Consider for example, Peter Mahler’s encapsulation of the DLOM debate in New York here, the apparent divergence between the First and Second Departments regarding the DLOM in real estate holding companies under the statutory fair value standard (explained here), or the Indiana Court of Appeals’ refusal just weeks ago to apply any DLOM whatsoever under the fair market value (FMV) standard to a wife’s share of a dental practice because, as that court observed, “dental practices are easily tradeable as they have a ready market of purchasers (new dentists) graduating each year.” (Kakollu v Vadlamudi, 21A-DC-96 [Ind Ct App July 26, 2021]).
Putting hard numbers to the extent of professionals’ disagreement concerning the DLOM, Business Valuation Resources recently released its annual survey regarding calculation and application of the DLOM. Gathering responses from more than 200 valuation professionals, the BVR Survey on Methods Used for Estimating a Discount for Lack of Marketability demonstrates that, with respect to almost all matters DLOM, a general consensus is rare. For example, to the question, “Would you apply a DLOM to a 100% interest in a private company?,” 33% of those surveyed indicated that they would, 27% indicated that they would not, and 40% indicated “maybe.”
In the wild west of DLOM calculation and application, I recently came across a novel issue that, in my view, merits serious consideration from business owners, litigators, and appraisers: how should contractual restrictions on a controlling owner’s ability to transfer his or her control factor into the calculation of the DLOM?
Restrictions on Transfer of Control in Closely-Held Businesses
Consider the case of an LLC equally owned and managed by two 50% managing members, both of whom have significant and independent control rights. They can both bind the company, make distributions, add or remove product lines, and hire employees. Under the operating agreement, either member may freely transfer his or her interest, subject to a caveat: “Upon either managing member’s sale, transfer, assignment, conveyance, or disposal of its interest, such interest shall become a non-managing interest, which shall not participate in the control, management and direction of the business of the Company, and the remaining managing member shall become the sole managing member.”
These types of provisions are common, and they often are advisable. They protect the non-selling managing members from a situation where they are forced into co-management with an unknown purchaser. Unless the non-selling managing members consent, an outside purchaser of a managing member’s interest will lose the seller’s management rights. While these restrictions ensure that the managing members dance only with the date they chose, they may or may not also have the unintended consequence of inviting a potentially significant DLOM when valuing any member’s interest in a contested appraisal proceeding.
Do Control Transfer Restrictions Invite a DLOM? The Competing Views
I recently encountered this question in a dispute concerning the FMV of a successful consulting company. The company (the party incentivized to lower the value of the member’s interest) argued that the control transfer restrictions in the operating agreement militated strongly in favor of applying a significant DLOM. Because “control” is a factor to be considered in the calculation and application of a DLOM under the FMV standard, (see Mandelbaum et al. v. Commissioner of the Internal Revenue, 69 TCM 2852 ), the company argued, the reality that such control would vanish in a hypothetical sale must also be considered.
After all, the company argued, FMV seeks to calculate the price at which the subject interest would exchange hands in a hypothetical sale: what would a hypothetical arm’s-length buyer be willing to pay for the subject interest? Any hypothetical buyer considering an arm’s-length price would account for the fact that upon her purchase of the subject interest, she would lose control.
The member (seeking a higher value) argued that these restrictions on the transfer of control cannot be considered at all when determining the value of his interest. The purpose of these restrictions, he argued, was to ensure that the existing managing members continue to work together until they both agree otherwise. They are protective provisions that should not be interpreted to impair value. Consequently, one must assume that these provisions temporarily lapse in the constructed, hypothetical sale. A fair market valuation must assume a willing hypothetical buyer and a willing hypothetical seller who is able to convey what the member has. If the control transfer restrictions applied, the hypothetical buyer would not buy and the hypothetical seller would not sell.
Put another way, the valuation exercise calculates a value for the member’s interest as if he were to maintain the same interest, not after penalizing him for hypothetically selling that interest to a hypothetical buyer.
An Unsatisfying Conclusion
Both sides’ experts gave plausible testimony on the debate, and neither side in post-hearing briefing could find any cases or persuasive authority directly on point. The case settled before the parties could see a ruling on the issue.
While I’m not prepared to say who had the better view, from the standpoint of a New York business divorce lawyer mostly handling appraisal cases under the statutory fair value standard, I wonder how this question interacts with New York jurisprudence on the DLOM and the discount for lack of control, or minority discount. While courts in New York fair value proceedings permit consideration of a DLOM because it applies at an enterprise level, they reject application of a minority discount on the theory that it unfairly penalizes the minority shareholder and results in a windfall to the controlling owner. (See Matter of Blake, 107 AD2d 139 [2d Dept 1985]).
Courts in Delaware statutory appraisal proceedings, in which both DLOM and minority discounts are verboten, reason similarly. (See Cavalier Oil Corp. v Harnett, 564 A2d 1137, 1145 [Del 1989] [“[T]o fail to accord to a minority shareholder the full proportionate value of his shares imposes a penalty for lack of control, and unfairly enriches the majority shareholders who may reap a windfall from the appraisal process.”]).
In the context of DLOMs based on the presence of control transfer restrictions, a court might find a risk of windfall similar to that created by the impermissible minority discount. If the remaining members were to repurchase the interest—subject to the same control transfer restrictions—it would give them complete control of the company. A clever attorney might argue that acquiring complete control based on a value that includes a DLOM for “vanishing” control rights results in a windfall analogous to the one the courts reject in the context of the minority discount.
On the other hand, because control transfer restrictions generally apply equally to all owners, the potential for any windfall is mutual. So unlike a minority discount, a DLOM based on control transfer restrictions would not penalize minority owners; it would apply to everyone, even majority owners.
To better understand the inputs to the DLOM analysis and the effect or non-effect of control transfer restrictions, I spoke with Atticus Frank, a Senior Financial Analyst at Mercer Capital and expert in the DLOM. He added:
“Our firm has consistently answered the question on the marketability of subject interests in private companies: it depends. You have to analyze the shareholder’s expected cash flows, risk profile, and growth expectations to determine what, if any, DLOM is appropriate.”
Until a court gives a more definitive answer, owners of closely held-corporations with interests subject to control transfer restrictions should expect those control transfer restrictions to feature prominently in any dispute concerning the fair value (or FMV) of their interest.