In addition to factors present in large firms, there are additional factors which must be considered when valuing small firms. These factors require special adjustments to be made to the final valuation, whatever method is used to calculate it. These adjustments include liquidity discounts, the importance of the entrepreneur, size and age discounts, the reason for the valuation, the valuer’s background, impacts from reconstruction and minority discounts or control premiums.
Liquidity or marketability discounts are reductions of a firm’s price to compensate for the difficulty associated with selling ownership shares. The average liquidity discount applied is 20 to 25 percent; it varies greatly depending on the method used for calculation and due to the difficulty of calculation (Feldman, 2003). In 2007 Stanley Block surveyed the effects of using two different calculation methods for liquidity discount, restricted stock comparison, and pre-initial public offering comparisons (Block, 2007). In examining restricted stock and its price discount below publicly traded stock, Block identified several problems that would make the results difficult to apply. These included the nature of the investors themselves, the effect of SEC regulations and the significant size difference between public and private firms. Through the comparison of pre-IPO and post-IPO prices Block found an average difference of a 47 percent. However, Block cited problems with this method, including a sample selection bias, uncertainty of whether the transactions were “arms-length,” and the fact that many calculations neglected to calculate the time value of money. In calculating the appropriate liquidity discount, factors that need to be considered include: the proximity of a liquidity event such as an exit or IPO; length of time to the new ventures stability; and the impact of market forces on the firm’s liquidity (IPEV Board, 2008).
If a entrepreneur is an important part of the business or has functions that are integral to the firm, a risk allotment may need to be made for the effect of the entrepreneur’s leaving (Lewis, 1988). In many small firms the entrepreneur and the firm are nearly indistinguishable, with the entrepreneur responsible for many different roles. This increases the risk for a transfer of ownership or sale, because the firm may not be able to operate without a knowledgeable person filling those roles.
Finally there is a minority discount or control premium that must be added if the valuation is for the transfer of only partial ownership (Feldman, 2003). A control premium may be assigned to the final valuation, to appropriately account for relinquishment of control to a new investor. A minority discount may be assigned if the ownership transfer is for less than half of the firm, compensating for the inability of the new investor to effect change within the firm. Possessing the controlling share in a venture gives the holder the option to use the firm’s assets and cash flows in a completely different manner. That ability has value.