Economics, oil, consumer spending, workforce, and supply chain issues are creating and escalating uncertainty about profitability and forecasts, which are impacting business valuations. This post highlights significant shifts in and how to take advantage of marketability discounts.
For a private company, a marketability discount is the difference in price for not being public and having access to the value of the private business within days. The marketability discount just got larger, and that larger discount can create tax savings for high net worth individuals and multigenerational wealth transfers. Let’s look at why marketability and other business valuation discounts are increasing in this COVID-19 environment, and how individuals might be able to benefit from these changes.
An Overview of Marketability Discounts and Market Absorption
Premiums and discounts are often applied by appraisers to ensure an accurate assessment of the value of an asset or a business. For example, appraisers apply a minority interest discount for a minority ownership stake in a company because that stakeholder has less control over the business. Privileges of a controlling interest include the ability to declare and pay dividends, appoint company management, sell or recapitalize the company, or make acquisitions among many others. A 1% controlling interest has greater value than a 1% non-controlling interest in the same company, and control premiums or lack of control discounts are constantly seen in the marketplace.
A marketability discount reflects the difficulty of selling an asset, like a piece of real estate or the share of a business. Fundamentally, a marketability discount is related to greater lengths of time and higher costs required to sell a particular asset. The traditional definition of marketability is that an asset can be sold and the seller receives cash within three business days. If a longer amount of time or additional costs are required to sell an asset, it is considered non-marketable.
One of the components driving a marketability discount is the relative number of potential qualified buyers. Typically, we can assume that there are plenty of buyers and that the assets being sold have a marketplace. When the number of buyers decreases (or sellers increase), the value of the asset decreases because the business has become harder to sell. The marketability discount increases to account for the decrease in value due to the inability of the market to absorb the relatively larger number of assets for sale. (To learn more about discounts, read our article on business valuation for litigation.)
In April 2020, we saw the price of oil go negative. The issue was related to storage, but fundamentally, the issue was that there were significantly more sellers than buyers. If you could store oil, you would get paid just for taking the asset instead of having to purchase it. The negative oil price scenario represented a market absorption issue because there weren’t enough buyers compared to the number of sellers.
Marketability Discounts Correct for Imbalances
Market absorption is about supply and demand. When supply and demand are equal, there should be no incremental marketability discount for market absorption. But when there is excess supply, for example when you have 1,000 fairly priced businesses but only 100 people who want to purchase a business, then only 100 of those original 1,000 businesses will sell. The imbalance of supply and demand puts buyers at an advantage. Buyers are more likely to move slowly and pursue the best possible deal, asking for lower prices, longer terms, and larger earnouts. For a motivated seller in this scenario, the only reliable sales strategy is to lower the business sales price and concede to the buyer’s requests, which results in lower values.
Why the Seller Pool is Increasing
Demographics suggest that more businesses than ever will transact in the next 10 years. Will there be enough buyers? Yes, if the price is low enough. We frequently see sellers that misunderstand the lack of buyer interest is really seller competition. Selling in today’s competitive environment can be significantly enhanced with professional assistance from accountants, lawyers, and investment bankers. Do you really want to compete with a low business price?
Why the Buyer Pool is Shrinking
There are many factors that can reduce the number of potential buyers in a market and drive up marketability discounts. Economic downturns, future uncertainty, and market volatility all contribute to a situation where there are fewer buyers — which we are seeing now with COVID-19. Widespread uncertainty about the duration or depth of the impact leads buyers to either wait and see what the long-term impacts might be or to choose the assets that appear to be safe.
Lower values and higher discounts can cause compounding problems for sellers. Sale price is down and marketability discounts are up. As the crisis continues, these discounts are likely to go up even more. This environment of turbulence and uncertainty is having a negative impact for businesses, owners, and investors.
A Deeper Dive into the Shrinking Buyer Pool
Professional buyers, including larger businesses and private equity funds, are now internally focused. They are spending 100% of their time on the existing investments. They are also reluctant to expand their social networking to include shopping and due diligence required to make acquisitions. It is very hard to get a bank to focus on a new loan because the bankers are internally focused on workouts with existing customers. So business shopping is at a standstill unless you are in an industry that has benefited from COVID-19, like healthcare, technology, and some entertainment companies.
Many sellers have or will soon be forced to sell or close. Buyers are interested in the good businesses that now realize they have too much debt (a bad balance sheet). These bad balance sheet businesses will be some of the first to sell, crowding the normal demographically driven sellers out of the current market. There was a window to sell a closely held business for an optimum price, and that window just closed. It may be years before it reopens. That fact drives marketability discounts higher as the length of time required to sell the business is longer.
Example: Marketability Discounts and Litigation
Higher marketability discounts also bring added challenges for those who are engaged in litigation and dispute resolution proceedings, because they may see buyouts and payments reduced dramatically.
For example, let’s say that someone holds 100 acres of land in an area where each acre is worth $1 million dollars. The math says that 100 acres would be worth $100 million dollars. If a partner had a 50% share of this land and wanted to be bought out, they might think it is reasonable to ask for $50 million dollars.
In this economic climate, however, there are fewer buyers. The data might show that only about ten acres are likely to be sold every year, and we can expect competition from other sellers. It might be decades before an investor could extract the full $50 million property value. In this case, application of a discount for market absorption is appropriate, and the partner would likely receive far, far less than the $50 million they were asking. In business valuation, this is reflected as an increased marketability discount considering the longer time required for market absorption.
The Impact of Market Absorption on Estate Planning
There is a silver lining for individuals with taxable estates. High marketability discounts due to market absorption issues provide a valuable opportunity to reduce the tax burden for high net worth individuals considering transferring assets — like an ownership share of a family business or a real estate holding — as part of their estate planning process.
Here’s how marketability discounts work in these situations. When assets are gifted or bequeathed as part of a multigenerational wealth transfer, they must be assigned a value for federal transfer tax purposes. Keep in mind that the IRS scrutinizes these valuations, and undervalued assets may result in tax penalties. The higher the value of the asset, the higher the taxes on that transfer.
Market absorption issues resulting from a limited number of buyers coupled with an increased number of sellers mean lower valuations for all assets. Individuals who use an independent valuation firm to appraise their assets today will most likely see reduced valuations compared to the last few years. And a lower valuation means a lower tax burden.*
In a related strategy, high marketability discounts offer high net worth individuals the opportunity to transfer more of their assets without increasing their taxes. After the crisis has passed, valuations will likely go up. If individuals wait until the economy completely rebounds, they will have to pay additional taxes. With all that considered, an economic downturn can be a boon for individuals looking to transfer assets as part of their generation-to-generation wealth management.
In 2008 and 2009, we assisted several wealthy clients as they shifted wealth to younger generations while minimizing overall tax obligations. These clients had taxable estates, were able to support their standard of living with assets they retained, and most importantly they acted to shift value to younger generations. These gifts and sales significantly expanded family wealth by lowering or eliminating estate taxes and successfully shifted wealth to the next generation.
There are many methods to accomplish minimizing wealth tax and shifting wealth to younger generations. Particular choices involve detailed knowledge of all assets, liabilities, and tax situation. Typically, the initial planning is done with your attorney and CPA. Our appraisal work product will likely be required to execute the plan. We are pleased to be a valuation resource at the appropriate time.
Act Decisively
Even though COVID-19 is presenting significant challenges for individuals, governments, and businesses, there is a silver lining for some. Individuals with a taxable estate can take advantage of increased marketability discounts, market absorption issues, and resulting lower valuations when transferring closely held assets. We have already seen some positive market recovery. The time to act is while market values are depressed and the outlook is at its worst and most bleak.
Adams Capital offers a no-cost initial telephone consultation to provide a sounding board to business owners and individuals as they consider estate planning, mergers, acquisitions, and litigation scenarios.
Please email us at tara@adamscapital.com or call us directly at 770-432-0308 to schedule a consultation or to learn more.
* US individual taxpayers have a lifetime exemption gift tax exemption currently that amount is $11.58 million but could change in an election year.