Most business owners will incur a discount of some kind when selling and/or valuing their business. There are a lot of reasons why this happens, and it all starts with fair market value. The shortened definition of Fair Market Value is “the price at which an interest (i.e. the business) would change hands between a willing buyer and a willing seller.”
Here are the most common kinds:
This discount occurs because the seller needs to find a buyer that is willing, and the buyer must also be capable of making the purchase. There simply is not a lot of people with a few million dollars waiting to be invested in a business. Businesses often take a year, sometimes longer, to find a willing buyer. The transaction process may take up to another year to complete. This discount is also sometimes seen as a “liquidity” discount. Just because the business is worth X amount of dollars, it doesn’t mean you can generate that cash quickly.
A discount for lack of control happens when a business owner owns less than 50% of the company. If the Company requires a supermajority vote of shares, i.e. 66%, then an owner with more than 50% of the company may still incur a discount for lack of control. This discount exists because a minority shareholder can’t legally force a company to act or behave as they’d like. A minority shareholder can’t adjust a majority shareholder’s pay, decide where the company should reinvest its profits, or make the company pay dividends.
This is another extremely common discount seen in small businesses. This is because the company’s management team has to wear a lot of hats. The CEO is also the CFO and maybe the janitor too. When there is a lot of institutional knowledge held by a few people in the company, there could be a very difficult challenge to replace them, or sometimes even to grow. In very small companies there is often thin management because the owners can’t or don’t want to hire someone or want to control a certain part of the operations. While this can help a company maintain a reputation for excellence or make sure the owner’s standards are enforced, it can hinder a company’s long-term growth and value.
This discount is usually seen when a business receives 15% of its revenue from a single client. What if that client decides to bring the product or service they get from the business in-house? Or the sales may be based on a relationship with current management. What happens if the owner is no longer there? Because of the increased risk of these situations happening, there is usually a discount that is incurred when this is present. This is one of the hardest discounts to eliminate because it can take a long time to eliminate.