Valuing a privately held company is never just about the numbers on a balance sheet. Unlike public companies, private businesses don’t have a ready market where shares can be sold at the click of a button. That lack of liquidity, combined with the question of who controls the company, means two valuation concepts are crucial: the minority ownership discount and the illiquidity (or marketability) discount.

These discounts have significant financial and legal consequences. They can affect estate tax liabilities, influence shareholder disputes, and alter negotiations when businesses change hands. Business owners and investors who overlook them risk being caught off guard when theory collides with reality.

Price vs Value: Why the Distinction Matters

One of the most important points in valuation is that price and value are not the same thing.

• Price is what changes hands in an actual transaction.
• Value is an estimate; a professional opinion based on assumptions, market data, and methodology.

Courts, regulators, and tax authorities often rely on valuation reports, but real-world buyers and sellers make decisions based on perceived risk, timing, and negotiating leverage.

Business owners planning for succession or estate transfers should be especially cautious. What looks like a $3 million stake in theory may only translate into $2 million of realizable value once discounts are applied.

Minority Discounts: Why Control Equals Value

Ownership without control is inherently less valuable. A shareholder who cannot dictate dividends, elect directors, or veto strategic decisions is at a disadvantage compared to one who can.

John Schumacher of True Financial POV explains that an investor will pay less for a stake that doesn’t come with control over the company. The minority ownership discount reflects the lower value of an interest that lacks decision-making authority, compared to a controlling position. The discount is applied against the value of the business as if it were owned on a control basis, adjusting it downward to reflect the reduced rights of a minority owner.

Imagine a family-owned company worth $10 million. A 10% shareholder might expect their stake to be worth $1 million. However, if they lack any control over dividends or operations, a willing buyer may only pay $700,000 or $800,000 for that stake.

In real-world disputes, courts often must decide whether minority shareholders should be subjected to such discounts. Illinois courts, for example, generally do not allow minority discounts in ‘fair value’ determinations because doing so would unfairly penalize minority shareholders.

Applying these discounts isn’t always straightforward. Valuation professionals must carefully avoid ‘double counting.’ For example, when using discounted cash flow models, appraisers may focus specifically on the cash flows attributable to a minority interest, rather than applying a blanket discount after valuing the company as a whole. By tailoring methodology to the rights and restrictions of the minority shareholder, experts can prevent excessive or unfair devaluation.

Illiquidity Discounts: When Shares Can’t Be Sold Easily

Liquidity is a central feature of value. Public stock can be sold instantly, but selling a stake in a private business is another story. It may take months or even years to find a buyer. That uncertainty is why appraisers apply a discount for lack of marketability (DLOM).

Ashok Abbott of West Virginia University explains that liquidity refers to how quickly and easily an asset can be sold without losing value. If selling takes time and prices might change before a buyer is found, the stake is worth less. That’s a discount for lack of liquidity.

Marketability also adds another layer: this refers to the regulatory rules that can limit how much or how quickly owners are allowed to sell, stretching the timeline for cashing out. For example, large owners of publicly traded companies may be restricted to selling only a small percentage every few months.

Together, both factors explain why minority stakes in private companies often carry steep, compounded discounts compared to their ‘on paper’ value.

John Levitske of HKA Global, LLC adds that courts will sometimes treat these concepts differently. Illiquidity may be seen as a company-wide issue, affecting all owners because the business itself cannot easily be converted into cash. Marketability, on the other hand, often applies at the individual shareholder level, reflecting the restrictions and limitations that prevent a particular owner from selling their stake quickly. In practice, this means a business could face an overall discount for being illiquid, while individual owners may face an additional discount depending on their rights and obligations.

Standards of Value: Fair Market vs Fair Value

Another key driver of whether discounts apply is the standard of value. Two of the most common are fair market value and fair value, and they lead to very different results.

• Fair market value reflects the amount that a hypothetical buyer and seller would agree to in an open market transaction. Both minority and illiquidity discounts are typically included because they mirror market realities.
• Fair value is usually a judicially defined standard used in shareholder disputes or appraisal proceedings. Many states exclude minority discounts when applying fair value, reasoning that doing so would unfairly harm minority shareholders.

Courts and statutes define these standards differently, making it crucial for agreements to spell out which one will apply in a given situation.

Michael Zdeb of Holland & Knight LLP warns that sloppy drafting of agreements can often magnify the problem. In cases where shareholder or LLC agreements fail to define valuation standards properly, heirs or spouses may find themselves shocked by steep discounts. For instance, a widow inheriting shares could expect full proportional value, only to discover that ambiguous drafting allows for discounts of 30% or more. This is why careful legal language is as important as the valuation methodology itself.

What matters most is clarity; without clear drafting in shareholder or LLC agreements, parties may end up fighting in court over which standard applies.

Levels of Value: Thinking in Tiers

Valuation experts often describe ownership interests in terms of levels of value, like rungs on a ladder.

• At the bottom is restricted minority, which is non-controlling and illiquid.
• Next is marketable minority, which assumes the interest could be sold in an open market.
• At the top is marketable control, where an owner both controls the company and enjoys liquidity.

Each step up the ladder increases value, and the gap between the steps is where discounts or premiums are applied. The difference between a restricted minority stake and a marketable control position can be enormous. For business owners, understanding these levels isn’t academic. It frames how potential buyers, courts, and even tax authorities will view their ownership interests.

Empirical data sources can often help quantify these discounts. IPO studies and restricted stock analyses provide benchmarks for how much of a haircut investors typically demand for illiquid or minority stakes. Option-based models are another tool, allowing analysts to simulate restrictions on selling and estimate the resulting value reduction. Together, these empirical approaches give courts and appraisers a framework to justify the discounts applied in practice.

Protecting Value Through Planning

Minority and illiquidity discounts are powerful forces in private company valuation. They reflect the economic reality that ownership without control, or ownership without liquidity, is worth less than its pro-rata share of the whole. Courts, regulators, and appraisers all recognize these adjustments, though they differ on when and how they should be applied.

For business owners and investors, it’s important to draft agreements carefully, specifying which standard of value will govern future buyouts. Be realistic about the limits of non-controlling or illiquid ownership. Above all, remember that the ‘headline number’ in a valuation report is not always what ends up in your pocket.

By understanding how minority and illiquidity discounts operate and planning around them, you can better protect yourself and your financial interests.

To learn more about this topic, view Minority and Illiquidity Discounts. The quoted remarks referenced in this article were made either during this webinar or shortly thereafter during post-webinar interviews with the panelists. Readers may also be interested to read other articles about valuation.

This article was originally published here.

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