Discounts for Lack of Control and Lack of Marketability
Two adjustments that routinely move a conclusion by more than the underlying earnings analysis does — and that draw more challenge than anything else in a valuation report.
Two different discounts, routinely confused
They are frequently spoken of together and they are not the same thing. One is about power; the other is about exit.
| Lack of control (DLOC) | Lack of marketability (DLOM) | |
|---|---|---|
| What is missing | The ability to direct the business — set compensation, declare distributions, sell the company, change strategy | The ability to convert the interest to cash quickly and at low cost |
| Applies to | Minority interests, and interests without control despite size | Interests in closely held entities generally, including some controlling ones |
| Empirical anchor | Difference between control and minority pricing in observable transactions | Restricted stock studies and pre-IPO studies |
| Common error | Assuming any interest under 50% lacks control, or that 51% has it | Applying a benchmark median without adjusting to the specific company |
Size is a starting point for control, not the answer. A 49% holder with supermajority veto rights may hold meaningful control; a 51% holder bound by an operating agreement requiring unanimity on every decision that matters may hold very little. The governing documents decide it, and reading them is part of the work.
The empirical basis for DLOM
DLOM is supported by two families of empirical study. Restricted stock studies compare the price of shares carrying transfer restrictions against the freely traded price of the same company's stock. Pre-IPO studies compare private transaction prices before a public offering against the offering price. Both attempt to isolate what the market charges for illiquidity.
The leading case on how to use them is Mandelbaum v. Commissioner, T.C. Memo 1995-255, decided 12 June 1995 and affirmed by the Third Circuit the following year. The taxpayer's expert proposed a discount of 70–75%; the Commissioner's expert proposed 30%. Judge David Laro rejected both, and set out a list of company-specific factors by which an appraiser should adjust the benchmark averages — now universally called the Mandelbaum factors.
| The Mandelbaum approach | What it requires |
|---|---|
| Start from the empirical range | Restricted stock and pre-IPO study results are the anchor, not the answer |
| Adjust to the specific company | Financial statement analysis, dividend policy, the nature of the company, management, transfer restrictions, holding period, redemption policy, and the costs of a public offering |
| Show the work | The adjustment from benchmark to conclusion is the analysis. A number asserted without it is the thing the court rejected in Mandelbaum |
Thirty years on, courts still follow that shape: begin with the empirical evidence, then demonstrate the adjustment. The IRS publishes its own DLOM Job Aid for valuation professionals, which is worth reading precisely because it shows how the other side approaches the same question.
How these discounts get attacked
Discounts attract more challenge than any other part of a valuation report, because they are large, judgemental, and easy to characterise as arbitrary. The attacks are predictable, which means they are answerable in advance.
| The attack | What defeats it |
|---|---|
| “The discount is a number you picked.” | A documented path from the empirical studies to the conclusion, factor by factor, in the report rather than in the appraiser's head. |
| “You used a median from studies of companies nothing like this one.” | Explicit treatment of how the subject differs from the study population and which direction each difference pushes. |
| “You applied a minority discount to a controlling interest.” | Analysis of the governing documents, not the percentage. Control is a bundle of rights, and the bundle is what gets examined. |
| “You double-counted — the income approach already reflected it.” | A clear statement of the level of value the approach produced before any discount, so it is visible that the adjustment is not applied twice. |
| “The holding period assumption is unsupported.” | Transfer restrictions, redemption provisions and any realistic exit path, read from the documents and stated. |
The level-of-value question in the fourth row is the one that most often goes wrong in otherwise competent reports. An approach can produce a controlling, marketable indication or a minority, non-marketable one depending on the inputs used, and applying a full discount stack to a result that already sits at a minority level understates the interest twice.
When these discounts do not apply
Discounts are not automatic, and applying them reflexively is as much an error as omitting them. Several common situations reduce or eliminate them.
| Situation | Effect |
|---|---|
| The standard of value excludes them | Some statutes and many agreements specify fair value, which in a number of contexts is applied without a minority discount. The instruction governs — see buy-sell agreements. |
| The interest actually carries control | A DLOC applied to an interest that can direct the business is not supportable, whatever its percentage. |
| The approach already produced a minority, non-marketable indication | Applying the stack again double-counts. The level of value the approach produced has to be stated before any adjustment. |
| A realistic near-term exit exists | A pending sale, a redemption obligation, or a mandatory buy-out on a known date shortens the holding period and compresses DLOM. |
| Aggregation of interests | Where interests are considered together and together they control, the control analysis changes. |
There are also discounts beyond these two. A key person discount may apply where the business depends heavily on one individual — closely related to the personal goodwill question in professional practice valuation. A blockage discount can apply where an interest is large enough that selling it would itself move the price. Each has its own evidentiary basis and neither is a substitute for the other.
A worked example
Illustrative arithmetic, not a benchmark. Percentages invented to show the sequence and the double-count risk. Real discounts are derived from study evidence adjusted to the specific company.
| Step | Illustrative figure | Level of value |
|---|---|---|
| Income approach indication | $5,000,000 | Controlling, marketable |
| Less DLOC at 15% | $4,250,000 | Minority, marketable |
| Less DLOM at 25% | $3,187,500 | Minority, non-marketable |
| Pro rata share of a 20% interest | $637,500 | — |
Order matters, and so does the starting level. Had the income approach already produced a minority indication, applying DLOC again would have understated the interest by roughly 15% for no reason other than sequencing.
What the report has to show
USPAP Standard 9 requires correct employment of recognised methods; Standard 10 requires that the result not be communicated in a misleading way. For discounts specifically that produces four requirements a reviewer will look for immediately:
- The level of value before adjustment, stated explicitly, so it is visible whether the discount is being applied to the right starting point.
- The empirical evidence relied on, identified — which studies, over what period, covering what population.
- The adjustment from benchmark to conclusion, factor by factor. This is the Mandelbaum requirement and it is the part most often missing.
- The governing documents, read and summarised, because control and transferability are determined by them rather than by percentage.
One dismissal belongs on the record in most of these reports. A blockage discount is considered and, in a typical closely held company, not applied — blockage addresses the price impact of selling a large block into a market that has to absorb it, which presupposes a trading market for the shares. Where there is no such market the concept has nothing to bite on, and saying that is better than leaving a reader to wonder whether it was overlooked.
A discount conclusion that cannot be traced back through those four steps is not necessarily wrong. It is simply undefended, and in a contested matter undefended and wrong tend to arrive at the same destination.
Where this sits
Discounts are an adjustment applied after the three approaches have produced an indication of value. They arise most often in estate and gift reporting, marital dissolution, and partner and shareholder disputes. Where a buy-sell agreement governs, its own terms may restrict or exclude them — see buy-sell agreements and the standard of value. Counsel may prefer what we do for attorneys.
Jeremy C. Johnson, Arizona Certified Residential Real Estate Appraiser #21358 · AQB Certified USPAP Instructor.
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