Factoring Governing Documents Into the Valuation Equation

When valuing a business interest — as opposed to valuing the entire entity — it’s critical for your expert to examine organizational documents. This examination helps determine the interest’s relative levels of control and marketability, as well as the cash flows the interest is entitled to receive.

A discount for lack of control may be appropriate when an interest holder doesn’t control management, operations, distribution of earnings, and major business decisions. Conversely, a discount for lack of marketability may be appropriate to reflect the time and cost required to convert the interest to cash.

Issues to Examine

When assessing these issues, relevant governing documents may include:

• Articles of incorporation and corporate bylaws,
• Partnership agreements,
• Limited liability company (LLC) operating agreements, and
• Buy-sell, voting trust, and other shareholder agreements.

Other areas to examine are:

Type of interest. Companies may issue different types of ownership interests with different rights. For example, a company may have voting and nonvoting interests, preferred shares, profits interests, and promote or carried interests. Governing documents explain how these interests measure up.

To illustrate, compared to common shareholders, preferred shareholders typically enjoy advantages, such as higher and more regular dividends and a preference on liquidation. But the impact of these advantages on value depends on the precise terms of governing documents. For example, because preferred shares have limited upside potential, those that are convertible into common shares are generally more valuable.

Sometimes, a discount for lack of control may be appropriate for certain majority interests. For example, if governing documents require a two-thirds “super majority” to liquidate the business, then a 60% voting interest would likely receive a discount to reflect its inability to control those decisions.

Transfer restrictions. Discounts for lack of marketability often apply to interests in closely held businesses. These discounts may be attributable to the lack of a public market, as well as to transfer restrictions imposed by the company’s governing documents.

Examples include prohibitions against transfers outside the family or to another ownership group, rights of first refusal, and restrictions on transfer without approval from other owners. A buy-sell agreement may affect an interest’s value by restricting certain transfers and setting the price for transactions, preventing an owner from realizing the interest’s fair market value.

Watch the Wording

When valuing a business interest, the wording of its organizational documents is critical. The only way to determine the appropriate discounts for lack of control and marketability — or premiums for certain advantages — is to understand the interest’s relative rights, restrictions, and preferences.