Is a private company really worth 20 to 40% less than a similar listed company?

Unsubstantiated rule of thumb

An unlisted – i.e. private – company is valued 20–40% lower than the same company would be if it were listed. That discrepancy is traditionally called the discount for lack of marketability. In Europe, a discount of about 25% is usually applied. “I’ve always been surprised by it”, Johan begins. “You start by determining the value of one of these companies very accurately, or at least you assume that’s what you’re doing, for example with discounted cash flows where you project cash flows over ten years and then try to calculate the discount rate to a figure after the decimal point. And then you just subtract 25% with no particular justification.”

You do find various models for determining that discount in the literature. There are both theoretical and empirical models, and the averages resulting from the empirical studies are particularly frequently used in practice, but the precise factors that influence or determine the discount for lack of marketability are indeed not very clear.

Wealth of information

To gain insight into those underlying factors, Johan decided to consult alternative sources of information: substantiated rulings by courts in cases involving a dispute over the valuation of private companies, triggered for example by a legacy or by a transfer or donation of shares. The most usable source turned out to be American court cases concerning inheritance and gift tax. “The advantage of these sources of information is that they contain a wealth of detailed quantitative and qualitative information about the company in question, its activities and the rights connected to the shares”, Johan explains. “Information from comparable European cases is unfortunately very sparse.”

With the help of law students from the University of Georgia School of Law, Johan conducted a meticulous analysis of 137 examples from more than 270 court cases, in which a ruling was made between January 1990 and July 2021 on valuation and the discount for lack of marketability to be applied on the basis of expert reports, testimonials and thorough analyses.

No standard discount

What did he find? The discount for lack of marketability applied varied from 0 to 50%. “So systematically applying a 25% discount means that you overvalue certain companies and undervalue others”, Johan clarifies. What is more, he found various extra explanatory factors that had previously been overlooked, but which do indeed influence the valuation of a private company.

• Shareholder structure: Private companies that are open to external shareholders are valued an average of 6.5% higher than similar companies that are not.
• Business activities: The discount applied to private holdings is about 7% lower than the one for private companies with their own business activities.
• Transfer and exit: Scrapping a strict limitation on transfers for the shares in a private business increases the value of these shares by about 5%, and if an exit option is built in, the value rises by another 10%. So shareholders aren’t looking for a stock market listing per se, but options for transfer and exit.
• Control: The discount for a controlling interest in a private company, i.e. half of the voting rights or more, is approximately 8% lower than for a non-controlling interest. So a controlling interest is worth significantly more.  

“Each of these factors must be considered and analysed separately when valuing a company”, Johan continues. “That makes it possible to determine the ultimate discount far more precisely, and your valuation will be better substantiated.”

The term doesn’t cover the meaning

Incidentally, Johan’s research revealed that the term discount for lack of marketability was poorly chosen, as the discount has to do with far more than a lack of marketability. For this reason, he would prefer to use the term private company discount from now on.

It won’t do any harm...

The most surprising finding is probably that companies themselves control a good many of the factors that determine the private company discount. Business leaders sometimes wonder whether they would do better to open up their company’s capital to staff or other interested parties. The debate is usually nipped in the bud with: “What good is it to them? We’re not listed, so the shares can’t easily be converted into cash anyway.” But now it has been shown to be indeed worthwhile. Opening up capital has a positive impact on valuation in itself, and a company can provide exit options other than a stock market listing, for example by setting up a purchasing arrangement or internal market.

The limitations on transfer that are often too readily included in the articles of association and frequently slip unnecessarily into shareholder agreements in M&A transactions, on the basis that ‘if it doesn’t help, at least it won’t do any harm’, do unfortunately cause harm: they reduce value by approximately 5%.

Control: not all discounts are the same

There is an important proviso to note when it comes to the impact of the level of control on the private company discount: it can change the valuation by 8%. In other words, as well as the discount for lack of marketability (i.e. the private company discount), there is also a discount for lack of control. But you need to account for this separately. It is not included in the private company discount.

If the level of control plays a role in the private company discount, what exactly does the discount for lack of control entail? The literature offers little enlightenment. “You might say that the discount is compensation for the value that the controlling shareholder creams off”, Johan says. “What we call the ‘private benefits of control’ are a generally accepted phenomenon, but they are difficult to quantify.” Johan was the first to be able to calculate that the majority shareholder in private companies attracts approximately 20% of the value to itself by means of various mechanisms. He has also demonstrated that the discount for lack of control is actually equal to the level at which the minority shareholders estimate these private benefits.

Doctoral thesis with business impact

This research does something that should have happened a long time ago: put generally accepted but poorly substantiated rules of thumb up for discussion and make it possible to apply a far higher degree of precision.

Thus the insights offered by Johan's work are relevant to anyone who deals with the valuation of companies and shareholdings in their professional life, including the government, which can use the research as a basis for determining the tax base more accurately.

“Shareholders in private companies will now know what they need to do if they want to maximise the value of their interest: open up the capital to external shareholders, scrap unnecessary limitations on the transfer of shares and provide an exit option. The combination of all these things can neutralise more than half of the typical private company discount. Notaries, accountants and legal advisers would also do well to keep these tips in mind”, Johan concludes.

Source: ‘Value and Marketability - Determinants of the Discount for Lack of Marketability’ by Johan Van den Cruijce. Doctorate in Business Administration at the KU Leuven and Ghent University in 2022. Promotors: Professor Cynthia Van Hulle (KU Leuven) and Professor Wouter De Maeseneire (Ghent University and Vlerick Business School).