Valuation Discounts: Applying DLOC and DLOM for Multi-Tiered Entities

Key Takeaways

• Multi-tiered entities require the appraiser to assess control and marketability separately at each entity level.
• Selecting defensible discounts depends on considering the appropriate empirical support for each entity’s specific assets.

Multi-tiered entities, which are structures where an entity holds an ownership interest in one or more other entities, are commonly used for favorable tax and legal attributes. When valuing an ownership interest in such a structure, the appraiser generally applies two widely recognized valuation discounts: a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM). Applying these discounts in a multi-tiered entity structure requires close attention to how each layer of ownership shapes the size and support for the discounts at that level.

Discount for Lack of Control

An appraiser applies a DLOC to reflect that a holder of a non-controlling interest in an entity lacks the ability to influence the entity's key operational and financial decisions. An entity's governing document, such as an operating agreement or partnership agreement, defines an interest's specific rights, including whether the holder can direct distributions, remove management, approve significant transactions, admit new owners, amend governing documents or dissolve the entity. An interest lacking these rights is non-controlling, regardless of its size.

To develop and support a selected DLOC, appraisers rely on market evidence specific to the entity's asset type. For holding companies that own real estate, this is often secondary-market data on non-traded real estate limited partnerships (RELPs), which present discounts from net asset value at which non-controlling interests have traded. It is important to note that these discounts also reflect elements of marketability along with control. For holding companies invested in securities, closed end funds are a similar type of market-based benchmark, as their shares trade publicly at a discount or premium to net asset value. Because closed end funds share a private holding company's fixed, limited-share structure, their trading discounts offer a benchmark, provided the selected funds hold a similar mix of investments to the entity being valued. For operating companies, appraisers commonly look to control premium studies, which analyze the premiums paid in acquisitions of publicly traded companies to derive the discount implicit in a non-controlling, freely traded share price.

Discount for Lack of Marketability

An appraiser applies a DLOM to reflect that an ownership interest in a private entity cannot be converted to cash as readily as a share of stock in a public, liquid market. The magnitude of a DLOM is grounded in the rights and restrictions the entity's governing document affords a holder, as well as attributes of the company and the interest being valued. These include the holder's ability to transfer the interest, an entity’s redemption policy, an entity’s distribution history, the depth of its management, the number of potential buyers, and the holder's anticipated holding period. These elements have significant impact on the determination of the DLOM.

Appraisers commonly reference restricted stock studies to support a DLOM, which measure the discount investors have historically accepted for holding stock that could not be immediately resold. Because SEC rule changes have shortened the required holding period for restricted stock, discounts in more recent studies tend to be lower than in older studies, underscoring why an appraiser should consider the entity's own attributes rather than rely solely on averages from the studies. The U.S. Tax Court's Mandelbaum v. Commissioner decision established a widely referenced framework for considering certain factors impacting marketability that directs the appraiser to consider elements such as distribution history, the cost of preparing for a sale and transfer restrictions specific to the entity.

Considerations for Multi-Tiered Entities

Understanding the ownership interest at each level of a multi-tiered structure is central to applying discounts, since discounts are generally applied at each entity level rather than simply at the top level. Since a limitation, such as a restriction on transferring an interest, may already be reflected in the discount applied at one tier, applying the same limitation again in full at the next tier can overstate the aggregate reduction in value and understate the ownership interest’s value. For this reason, discounts typically decrease at higher tiers, with each additional level contributing a smaller incremental limitation on control or marketability than the tier below, rather than applying the same magnitude of discount at every level.

Whether it is appropriate to apply discounts at more than one tier depends largely on how the lower-tier interest fits within the structure. Tiered discounts are more readily supported when the lower-tier interest represents one of several diversified holdings within the parent entity. Tiered discounts are harder to support when the lower-tier interest makes up most of the parent's value, or functions as its primary operating asset, since the parent's own value is then largely determined by that holding, such that a second layer of discounts may not reflect a genuinely separate limitation.

The discounts applied at each tier also need their own independent support. When valuing a holding company itself, the appraiser should draw on discount benchmarks specific to holding companies, such as closed end funds or RELP secondary-market data, rather than benchmarks developed for operating businesses, since the two carry different risk and control characteristics. This distinction matters most when a holding company owns a mix of asset types, for example, both an operating business and a securities portfolio, since each asset type impacts the determination of the selected discounts.

Concluding Thoughts

Valuing an interest in a multi-tiered entity requires an understanding of how control and marketability shift from one tier to the next. Evaluating these attributes level by level and supporting each discount with data suited to that tier's assets results in a value that withstands scrutiny.