Business Brokers: Discount for Lack of Marketability
Business brokers – and business owners: Would a discount for lack of marketability by appropriate for a business you’re considering bringing to market?
If you’re a business broker – or intend to become one – you’re going to encounter businesses that will require you to consider applying a discount for lack of marketability.
I hear some of you asking, “A discount to what?”
A discount to the value you arrived at when you did your valuation.
What is Marketability?
The “marketability” of a business relates to how appealing it is to the buying public. But marketability goes beyond the simple calculation of how much money it generates for the owners.
Marketability includes geographic location, product or service offered by the business, political and environmental considerations, and dozens of other issues that might negatively impact how the buying market will look at the business – and possibly reducing the size of that buying market for that business.
An analogy that might be a good example is a 20-acre piece of commercial real estate that, years ago, was the site of a chemical plant. The site is now cleared, has highway frontage, great visibility and 80,000 vehicles pass by every day.
Diagonally across the highway, a 15-acre site just sold for $200,000 per acre and the developers plan a luxury apartment project.
There is no decent shopping within 10 miles of the apartment site and the firm representing the nearby former chemical parcel thinks that the site would be ideal for an outlet mall or upscale shopping center and believes that, under normal circumstances, it would be worth about $250,000 per acre.
But the fact that the site was originally a chemical manufacturing plant will impact its marketability and the real estate firm has to account for that. It does so by applying a discount to the “normal circumstances” value of $250,000 per acre.
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Discount for Lack of Marketability for a Business
The same concept is applicable to a business.
If there are factors – existing or anticipated – that might limit a business’ marketability, those factors will likely impact that business’ value. Therefore, if your analysis of the business’ performance over the past five years suggests a Most Probable Selling Price (“MPSP”) of $4.7 million in a normal market, you have to consider the factors that might impact that value and apply some discount to your MPSP to reflect those factors.
Using the real estate example from above, if you are valuing an auto parts business that sits on a site that was once used to store junk cars, trucks and other equipment, the site might be contaminated and any remedial work that MIGHT be required must be considered in the valuation.
Likewise, if you are valuing a business that is based in a rural area where there is little population growth and few amenities, the fact is that most people will not want to more there. If the business needs hands-on management, a discount for lack of marketability will have to be applied.
Let’s look at a couple of examples.
One of our offices serves a rural area. One of the brokers there was contacted by the owners of a specialty wholesaler about selling.
The wholesaler was a husband and wife business that started supplying local retailers with products that local residents and visitors used for recreation.
Some visitors and tourists liked the products enough so that, when they went home, they suggested to the retailers in their area that the carry these products.
Soon enough, the rural business began to expand, was shipping its products throughout several states and had to hire additional help. Sales reached $3.5 million and the owners were pocketing more than $550,000 annually.
Our broker determined that the business, were it located in a more populous are, worth worth in the neighborhood of $1.4 million. But not long after bringing the business to market, it became apparent the business’ location – in a rural area – was deterring buyers and that, in order to get a buyer to bite, they would have to apply a discount for lack of marketability.
In a similar vein, political conditions that impact the business might change abruptly impacting the business and its value.
Over the past few decades, there has been an ebb and flow of political pressure on firearms manufacturers, most of which are publicly traded. If the party that advocates the elimination of firearms is ascendant, the stock price of the manufacturers – a company’s value – decreases.
Conversely, there is usually a run on firearms when there is a concern that they might be restricted and the revenue of retailers increases. If you’re valuing a retailer that offers firearms, you must consider two related issues:
First, how likely is the revenue increase to continue?
Second, if the political pressure is bad enough, is there a chance that the business you are valuing will be able to weather the storm? This is a classic example of the need to consider a discount for lack of marketability.
Product or Service
This example may be a little distasteful for some but it illustrates several factors from changing conditions to pride of ownership.
Twenty-five years ago, most cities had “adult entertainment” areas where adult clubs and bookstores were located and thrived. Some of these businesses were “mom and pop” one-store operators but others where part of large chains.
If you were brokering businesses in the mid-’90s and were contacted by the owners of a chain of 24 adult bookstores in six cities, you might know that this has been a lucrative business but you, being a schmatt cookie who is current on all the news, have heard of this newfangled thing called the internet and have concluded that the ability to download whatever you want for free is likely to have a negative impact on the adult bookstore trade and, though you believe there is some life still left in the business, you apply a discount for lack of marketability.
In a further examination of that them, though the internet is unlikely to replace adult clubs, there is, in many places, a stigma attached to them significantly reduces the breadth of the buyer market for such businesses. Recognizing this, you apply a discount for lack of marketability.
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When you value a business, one of the considerations is risk – and, if you want to sell that business, valuing for risk is is part of determining the need to discount for lack of marketability. These are just a few examples of instances where a discount for lack of marketability would apply.
Remember, your job is to get the client’s business sold. Discussing the buying market with the owners of the business – for any business – is what has to be done early on. This means not only the condition of the overall market and the availability of financing, but also any aspects specific to the business – or industry – that can reasonably impact its marketability.
If you have any questions, comments or feedback on this topic – or any topic related to business – I want to hear from you. Put them in the Comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!