By Christopher Sargent, CPA/ABV, AM
Senior Analyst, Valuation & Litigation Services
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Jason S. Thompson, CPA/ABV, ASA, CFE, CFF
Partner, Director of Valuation & Litigation Services
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The Indiana Court of Appeals (the “Appeals Court”) recently issued a memorandum decision denying the application of a five percent Discount for Lack of Control (“DLOC”) that was applied in determining the fair market value of a business for purposes of a marital dissolution. The subject business was owned 50/50 by a husband and wife, and both hired their own experts to determine the business’s value. Both experts in this case applied a DLOC in arriving at their respective values.
So, what is a DLOC? According to the International Glossary of Business Valuation Terms (the “Glossary”), a DLOC is a percentage or amount deducted from the pro rata share of a business’s equity interest to reflect the absence of some or all control powers. This discount is typically applied when determining the fair market value of a partial interest (usually less than 50 percent) of a business. The discount is meant to reflect the impact on the value of being an owner but not having the necessary rights or ability to control how the business is run or the benefits available to you as an owner.
The DLOC is a concept that is inherent in determining fair market value. Fair market value is a specific standard of value that is often utilized when determining the value of a business or partial interest in a business. Fair market value is defined by the Glossary as:
The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
The DLOC applies under fair market value because fair market value doesn’t identify a specific buyer or seller, instead the buyer and seller are hypothetical. This is generally interpreted to mean that when determining fair market value, the value is independent of the parties involved and resulting positions post transaction. This is an important concept in this particular case because the Appeals Court’s decision mentions the trial court’s awarding of the entire business to the husband, thus “negating the need for a lack-of-control discount” as support for their position.
Taking into account who received the asset (the husband) and what his position was after receipt (the 100 percent owner) the Appeals Court viewed the value of this business from a different standard of value than fair market value. The Appeals Court applied what we in the valuation field refer to as investment value as the standard of value. Investment value is defined by the Glossary as:
The value to a particular investor based on individual investment requirements and expectations.
While neither the parties, their counsel or the experts in this matter knew the Appeals Court would take this position, the uncertainty of which standard of value will be applied by the courts emphasizes the importance of working with knowledgeable and experienced professionals. When valuing a business, the right professional can anticipate the required standard of value to apply and explain to the court the reason for its application and the necessary discounts.
If we can be of assistance in determining the value of a business, partial ownership interest in a business or the application of valuation discounts for you or one of your clients, please call us (317) 608-6699 or email Chris or Jason.