How do you incorporate minority and marketability discounts into your buy-sell agreement valuation?

2 Why are they important for buy-sell agreements?

Minority and marketability discounts are important for buy-sell agreements because they affect the fairness and feasibility of the valuation and transfer of ownership interests. If the buy-sell agreement does not account for these discounts, it may result in overpaying or underpaying for an interest, creating conflicts and disputes among the owners or with third parties. Moreover, ignoring these discounts may expose the owners to tax and legal risks, as the IRS and the courts may challenge the valuation and impose penalties or adjustments.

3 How do you calculate them?

Calculating minority and marketability discounts can be challenging, as they depend on various factors, including the nature of the business, industry and market conditions, buy-sell agreement terms, and comparable transaction data. Common approaches to calculating discounts include applying a percentage discount based on empirical studies or industry averages, using a valuation method that incorporates discounts implicitly, and applying a specific discount based on the facts of the case. For example, some studies suggest that minority discounts range from 10% to 40%, while marketability discounts range from 20% to 50%. Additionally, the income approach discounts expected future cash flows by a required rate of return that reflects the risks and benefits of ownership interest. Alternatively, the market approach compares the value of the interest to similar transactions or public companies that have similar discounts. Lastly, calculating a specific discount may consider the size, profitability, growth, governance, liquidity, and diversification of the business as well as the rights and obligations of ownership interest.

4 How do you document them?

When valuing a buy-sell agreement, it is essential to document the rationale and methodology of applying minority and marketability discounts, as it adds transparency, credibility, and consistency to the process. To do this, you should use an experienced and qualified appraiser to provide a detailed report on the purpose, scope, assumptions, data sources, calculations, and conclusions of the valuation and discounts. The valuation and discounts should also be reviewed and updated periodically or when certain triggering events occur. Additionally, the valuation and discounts should be incorporated into the buy-sell agreement as part of the price determination clause with conditions and procedures for applying them.

5 What are some challenges and pitfalls to avoid?

Incorporating minority and marketability discounts into your buy-sell agreement valuation is not an easy task, and it may involve some challenges and pitfalls that you should be aware of. These can include using arbitrary or inconsistent discounts that do not reflect the reality of the business or the ownership interest, applying double discounts that overstate the value reduction of an interest, ignoring or violating the tax and legal rules and regulations governing valuation and transfer of ownership interests, or failing to communicate or negotiate with other owners or parties involved in the buy-sell agreement. Neglecting any of these could result in misunderstandings or conflicts that may jeopardize the relationship or the transaction.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?