Financial valuation Applications and Models phần 4 ppt

Empirical Evidence of Marketability Discounts 289had to be able to withstand Securities and Exchange Commission [SEC], IRS orjudicial review, particularly in light of the subsequent publ

Empirical Evidence of Marketability Discounts 289

had to be able to withstand Securities and Exchange Commission [SEC], IRS orjudicial review, particularly in light of the subsequent public offering.”

The mean and median discounts for lack of marketability indicated by theaggregate of Emory’s eight studies of transactions that occurred five months prior to

an IPO were 44 and 43 percent, respectively For the most recent period studied,November 1995 to April 1997, the mean discount was 43 percent and the mediandiscount was 42 percent (see Exhibit 8.9)

Exhibit 8.9 Summary of the Emory Studies

Period of Study Number of Transactions Mean Discount Median Discount

(a) The Expanded Study

(b) The Limited Study

(c) The Dot.Com Study

(d) To avoid double counting, transactions from the Dot.Com and Limited Study are included only as a part of the Expanded Study

The following is a brief explanation of each study:

• January 1, 1980–June 20, 1981 Emory reviewed private placements of securities

taking place prior to initial public offerings The difference between the price of

a security sold prior to the IPO and the offering price is the discount for lack ofmarketability Emory examined 97 prospectuses of securities offered in theperiod from January 1, 1980, through June 30, 1981 Of the 97 IPOs, he chose

13 that involved “financially sound” companies and transactions that took place

no more than five months prior to the IPO Emory found that the private ments sold at a mean discount of 60 percent and a median of 66 percent

place-• January 1985–June 1986 Emory analyzed 21 IPOs and the transactions taking

place immediately before the offerings His analysis showed that the mean count of the securities before the offerings is 43 percent with a median of 43 per-cent Emory attributed the difference between the mean of this study (43 percent)and the mean of a similar study he performed in 1980 (60 percent) to the factthat the market for initial public offerings in 1986 was more active

dis-• August 1987–January 1989 Emory reviewed the prospectuses of 98 IPOs, of

which 27 met the study criteria of financial soundness, an IPO price greater than

$5, and transactions taking place five months before the offering He found that

the mean discount of the securities sold before the initial public offering is 45percent with a median of 45 percent.

• February 1989–July 1990 Emory’s analysis of transactions of 23 companies

showed that the mean discount for lack of marketability is 45 percent with amedian of 40 percent

• August 1990–January 1992 Out of 35 transactions, Emory found that the mean

discount on the price of the securities was 42 percent with a median of 40 percent

• February 1992 – July 1993 Emory reviewed the transaction data of 54

compa-nies selling securities in IPOs He found that the average discount on the price ofthe securities was 45 percent with a median of 44 percent Consolidating theresults of the six studies that he has performed, he found that the mean discount

of the total 173 transactions to be 47 percent

• January 1994–June 1995 Emory evaluated 46 IPO transactions Both the mean

and median discounts on the purchase price of the securities before the IPO were

45 percent The discounts ranged from 79 to 6 percent Emory combined theresults of all seven studies and found that the mean discount for the 219 trans-actions to date in all the studies was 45 percent and the median was 43 percent

• November 1995–April 1997 Emory evaluated 91 transactions The mean and

median discounts on these transactions were 43 and 42 percent, respectively Therange of discount was 5 to 85 percent The combined results of the 310 transac-tions to date in all the Emory studies indicated a mean discount of 44 percentand a median discount of 43 percent

• May 1997–March 2000 (Dot.Com Companies) For the first time, Emory

included Dot.Com companies in his study, and evaluated 53 transactions Themean and median discounts on these transactions were 54 percent

• May 1997–December 2000 Emory prepared two studies based on his review of

1,847 IPO prospectuses over this period In his “limited” study, he analyzed 36transactions and found a mean discount of 48 percent and a median discount of

44 percent In his “expanded” study, he broadened his search and did not nate companies on the basis of financial strength The “expanded” study analyzed

elimi-283 transactions and found a mean discount of 50 percent and a median discount

of 52 percent Over the entire 11 studies from 1980 to 2000, the 593 transactionsanalyzed had a mean discount of 47 percent and a median discount of 48 percent

Willamette Management Associates Studies11

Willamette Management Associates has published the results of 18 studies (timeperiods) that analyze IPO transactions that took place from 1975 to 1997 Thepremise of the studies was similar to that of the Emory studies; Willamette com-pared the sale price of stock placed privately before an IPO to the price at IPO todetermine the discount for lack of marketability

The Willamette studies, however, reviewed transactions that took place from 1

to 36 months before the initial public offering, whereas Emory analyzed transactions

up to five months prior to IPO Emory used information provided in the companyprospectuses while Willamette used S-1 and S-18 registration statements which dis-closed more information Willamette also compared the price-earnings (P/E) multiple

of the security at the time of the private transaction to the P/E multiple at the IPO

11Pratt, Shannon P., Business Valuation Discounts and Premiums (New York: John Wiley &

Sons, Inc., 2001), p 84.

Willamette also made adjustments to reflect differences in market conditionsbetween the dates To do this, Willamette used an Industry P/E multiple at the time

of offering and compared it to the Industry P/E multiple at the time of the privatetransaction

Exhibit 8.10 presents the results of the Willamette studies

Exhibit 8.10 Lack of Marketability Discount

Willamette Management Associates Summary of Discounts for Private Transaction

P/E Multiples Compared to Public Offering P/E Multiples Adjusted for Changes in Industry P/E Multiplesa

Period of Study Median Discount

a Pratt, Shannon P., Business Valuation Discounts and Premiums (New York: John Wiley & Sons, Inc., 2001), p 84.

Summary of the Emory and Willamette Initial Public Offering Studies

The range of discounts associated with both the Emory and Willamette IPO studies

is from a low of 32 percent to a high of 73 percent The majority of the discountsare in the range of 40 to 60 percent As discussed later, critics of these studies areconcerned with the reliability of both the pre-IPO prices and the IPO prices

Hitchner Study No 1

James R Hitchner, CPA/ABV, ASA, in Atlanta, performed an additional analysis onthe Emory study data Emory reported average discounts for companies that hadtransactions in their stock within five months prior to IPO Hitchner analyzed and cal-culated the discounts on transactions taking place in the fifth, fourth, and thirdmonths, respectively, prior to the date of the IPO to see if the discounts were higherfor those companies that had transactions farthest from the IPO date Hitchner alsoanalyzed the discounts on transactions taking place up to five, four, and three months,respectively, prior to the date of the IPO He also separately analyzed data on stockoptions only

Discounts on transactions occurring between January 1980 and June 1995 werebroken into fifth-, fourth-, and third-month analyses up to and including each period.

• Fifth Month The mean and median discounts on the 47 transactions taking

place in the fifth month prior to the IPOs were 54 and 50 percent, respectively.For the 219 transactions that took place within five months prior to the IPOs,the mean and median discounts were 45 and 43 percent, respectively

• Fourth Month The mean and median discounts on the 43 transactions that took

place in the fourth month prior to the IPOs were both 51 percent For the 172transactions that took place within four months prior to the IPOs, the mean andmedian discounts were 43 and 42 percent, respectively

• Third Month The mean and median discounts on the 56 transactions taking

place in the third month prior to the initial public offerings were 43 and 42 cent, respectively For the 129 transactions that took place within three months

per-of the initial public per-offerings (i.e transactions at one, two, and three monthsprior to the initial public offerings), the mean and median discounts were 40 and

39 percent, respectively

Discounts on transactions occurring between January 1994 and June 1995 alsowere broken into fifth-, fourth-, and third-month analyses, at only that monthly period

• Fifth Month For the most recent Emory study period, January 1994 to June

1995, the mean and median discounts on the 10 transactions that took place inthe fifth month prior to the IPOs were 50 and 46 percent, respectively The meanand median discounts on the 46 transactions that took place within five monthsprior to the IPOs were both 45 percent

• Fourth Month For the January 1994 to June 1995 study period, the mean and

median discounts on the 17 transactions that took place in the fourth monthprior to the IPOs were 48 and 50 percent, respectively The mean and mediandiscounts on the 36 transactions that took place within four months prior to theIPOs were 43 and 45 percent, respectively

• Third Month For the January 1994 to June 1995 study period, the mean and

median discounts on the 11 transactions that took place in the third month prior

to the IPOs were 44 and 43 percent, respectively For the 19 transactions thattook place within three months prior to the IPOs, the discounts were 39 and 38percent, respectively

Discounts on option transactions occurring between January 1980 and June

1995 were divided into fifth-, fourth-, and third-month analyses

Most of the transactions included in the Emory study involved options PHGanalyzed the discounts on option transactions that took place in the fifth, fourth,and third months prior to the date of the initial public offerings

• Fifth Month The mean and median discounts on the 32 option transactions that

took place in the fifth month prior to the IPOs for the aggregate Emory studieswere 55 and 51 percent, respectively The mean and median discounts on the 166option transactions that took place within the five months prior to the IPOs were

44 and 43 percent, respectively

• Fourth Month The mean and median discounts on the 31 option transactions

that took place in the fourth month prior to the IPOs for the aggregated Emory

Empirical Evidence of Marketability Discounts 293

studies were 52 and 51 percent, respectively The mean and median discounts onthe 134 option transactions that took place within four months prior to the IPOSwere 42 and 41 percent, respectively

• Third Month The mean and median discounts on the 45 option transactions

that took place in the third month prior to the IPOs for the aggregate Emorystudies were 41 and 40 percent, respectively The mean and median discounts onthe 103 option transactions that took place within three months prior to theIPOs were 39 and 37 percent, respectively

Discounts on option transactions occurring between January 1994 and June

1995 also were divided into fifth-, fourth-, and third-month analyses

For the Emory study period, January 1994 to June 1995, the mean and mediandiscounts on option transactions were 44 and 43 percent, respectively

• Fifth Month For the January 1994 to June 1995 study period, the mean and

median discounts on the eight option transactions that occurred in the fifthmonth prior to the IPOs were 53 and 49 percent, respectively The mean andmedian discounts on the 33 option transactions that took place within fivemonths prior to the IPOs were 44 and 43 percent, respectively

• Fourth Month For the January 1994 to June 1995 study period, the mean and

median discounts on the 12 option transactions that occurred in the fourthmonth prior to the IPOs were 47 and 48 percent, respectively The mean andmedian discounts on the 25 option transactions that took place within fourmonths prior to the IPOs were 42 and 38 percent, respectively

• Third Month For the January 1994 to June 1995 study period, the mean and

median discounts on the nine option transactions that took place three monthsprior to the IPOs were both 43 percent For the 13 option transactions that tookplace within three months prior to the IPOs, the discounts were 37 and 33 per-cent, respectively

Hitchner Study No 2

Hitchner performed a second analysis that was very similar to that performed byJohn Emory in his studies Hitchner reviewed the prospectuses of guideline compa-nies from February 1995 to June 1996 in the consulting industry that had gone pub-lic This analysis focused on transactions that had taken place within the companiesprior to their IPOs Hitchner found 23 transactions that had taken place among 14companies within 15 months of their IPO

The mean and median discounts on the 23 transactions that took place prior(up to 15 months) to the initial public offerings were 51 and 52 percent, respectively

• Fifth Month The mean and median discounts on the transactions that took place

in the fifth month prior to the IPOs were 49 and 53 percent, respectively Themean and median discounts on the transactions that took place within fivemonths prior to the IPOs were 44 and 36 percent, respectively

• Fourth Month The mean and median discounts on the transactions that took

place in the fourth month prior to the IPOs were 56 and 57 percent, respectively.The mean and median discounts on transactions that took place within fourmonths prior to the initial public offerings were 41 and 36 percent, respectively

• Third Month The mean and median discounts on the transactions that took

place in the third month prior to the IPOs were both 31 percent The mean andmedian discounts on the transactions that took place within three months prior

to the IPOs were 31 and 35 percent, respectively Exhibit 8.11 illustrates theanalysis of the guideline company transactions

Exhibit 8.11 Analysis of Transactions Occurring In Guideline Companies

_ _ _ _ _ Whittman Hart (1) 5/3/96 16 12/31/95 6.49 Option 59% 4 Carnegie Group (2) 12/4/95 8 3/1/95 *4.65 Option 42% 9 Cotelligent Group (3) 2/14/96 9 9/8/95 2.70 Option 70% 5 Data Processing Res (4) 3/6/96 14 1/15/96 9.00 Option 36% 2 Data Processing Res (5) 3/6/96 14 6/1/95 2.25 Option 84% 9 Data Processing Res (6) 3/6/96 14 3/1/95 *2.25 Purchase 84% 12 Integrated Systems (7) 4/18/96 5 1/31/95 1.52 Option 70% 15 Integrated Systems (8) 4/18/96 5 11/17/95 3.33 Option 33% 5 Microware (9) 4/3/96 10 5/2/95 3.13 Option 69% 11 Registry, Inc (10) 6/5/96 17 3/6/96 11.00 Option 35% 3 Registry, Inc (11) 6/5/96 17 4/1/96 *11.00 Option 35% 2 Registry, Inc (12) 6/5/96 17 5/1/96 *13.00 Option 24% 1 Ultradata (13) 2/16/96 10 7/31/95 6.00 Option 40% 7 Ultradata (14) 2/16/96 10 12/1/95 *7.25 Option 28% 3 Sykes (15) 4/30/96 18 12/31/95 8.67 Option 52% 4 APAC (16) 10/11/95 16 5/26/95 7.49 Option 53% 5 HCIA (17) 2/22/95 14 2/1/94 *10.50 Option 25% 13 HCIA (18) 2/22/95 14 4/1/94 *10.50 Option 25% 11 HCIA (19) 2/22/95 14 10/1/94 *10.50 Option 25% 5 Idx (20) 11/17/95 18 2/1/95 4.32 Option 76% 10 Mecon (21) 12/7/95 13 3/31/95 0.57 Option 96% 8 UUNet (22) 5/25/95 14 2/1/95 *6.00 Option 57% 4 UUNet (23) 5/25/95 14 1/1/95 *5.00 Option 64% 5

Three Months or Less 31% 35%

*Only month and year of transaction available Assumed the first of the month because specific day was not available.

Restricted Stock Studies

Additional support for the discount for lack of marketability can be found in thestudy of purchases of restricted securities by investment companies

Investment companies regularly purchase private placements of restricted rities Restricted securities may be issued and sold by a publicly traded companywithout prior registration with the Securities and Exchange Commission Thesesecurities typically cannot be resold for a minimum period of one year under theSEC Rule 144 guidelines

secu-Because of the restriction on the marketability of the securities, the investmentcompanies purchase the securities at prices lower than the price of a registered secu-rity of the same company The difference between the two prices represents the dis-count for the lack of marketability

In the 1970s, the SEC required investment companies to make their transactionrecords public The availability of the records made it possible for analysts to directlydetermine the lack of marketability discount on securities purchased by investmentcompanies and use it as a comparison for the discount on a closely held interest

Revenue Ruling 77-287

The ruling also discusses a study undertaken by the SEC, published in 1971 andcovering the period from January 1, 1966, through June 30, 1969.12The SEC ana-lyzed the purchases, sales, and holdings of restricted securities held by financial insti-tutions that disclosed the valuation of their holdings The average discount wasabout 26 percent for all companies

In Accounting Release No 113, the SEC acknowledged discounts for restrictedsecurities

Restricted securities are often purchased at a discount, frequently tial, from the market price of outstanding unrestricted securities of thesame class This reflects the fact that securities which cannot be readily sold

substan-in the public market place are less valuable than securities which can besold, and also the fact that by the direct sale of restricted securities, sellersavoid the expense, time and public disclosure which registration entails

The IRS, in Revenue Ruling 77-287, dealt with the issue of valuingrestricted stocks It was issued “to provide information and guidance

to taxpayers, Internal Revenue Service personnel, and others concernedwith the valuation, for Federal tax purposes, of securities that cannot

be immediately resold because they are restricted from resale pursuant

to Federal securities laws.”

ValTip

12 Securities and Exchange Commission, “Discounts Involved in Purchases of Common Stock

(1966 –1969),” Institutional Investor Study Report of the Securities and Exchange

Commission (Washington, DC: U.S Government Printing Office, March 10, 1971),

Document No 92-64, Part 5, pp 2444 – 2456.

Securities and Exchange Institutional Investor Studies. Securities andExchange Commission, “Discounts Involved in Purchases of Common Stock

(1966–1969),” Institutional Investor Study Report of the Securities and Exchange Commission (Washington, DC: U.S Government Printing Office, March 10, 1971),

Document No 92-64, Part 5, pp 2444–2456

Period of Study

_

Mean Discount of 25.8 percent 1966 –1969

The Securities and Exchange Commission reviewed purchases of restrictedsecurities by investment companies for the period January 1, 1966 through June

30, 1969 This study was published in March 1971 It compared the prices atwhich the transactions of restricted securities were made to the prices of publiclytraded stocks from the same companies The study included letter stocks traded onthe New York and American Stock Exchange as well as the over-the-counter (OTC)markets The mean discount for lack of marketability of the letter stocks was 25.8percent

The study analyzed discounts both by trading market as well as by sales of thecompany Of the OTC nonreporting companies, 56 percent had discounts over 30percent; 34 percent of the companies had discounts over 40 percent For companieswith sales between $1 million and $5 million, 54 percent had discounts over 30 per-cent; 34 percent of the companies had discounts over 40 percent

Other Restricted Stock Studies. Several additional studies since the 1971Institutional Investor Study have measured the DLOM using similar comparisonsbetween restricted securities and their publicly traded counterparts The results ofthese studies have generally averaged between 30 and 35 percent Many of thesestudies were conducted during the period when securities were restricted for twoyears The more important studies and their results are summarized in Exhibit 8.12

Hall and Polacek. Hall, Lance S., and Polacek, Timothy G., “Strategies for

Obtaining the Largest Valuation Discounts,” Estate Planning (January/February

marketabil-The minority interest discount and the lack of marketability discount are rate and distinguishable from each other The study identifies them as “based uponindependent financial principles and analyses.”

sepa-Silber. Silber, William L., “Discounts of Restricted Stock: The Impact of

Illiquidity on Stock Prices,” Financial Analysts Journal (July–August 1991), pp.

Silber compared the securities based on several characteristics, including the

“percentage discount on the restricted stock, dollar size of the offering and number

of restricted shares as a percentage of all common stock.” He also looked at “theearnings of the firm during the previous fiscal year, total revenues during the previ-ous fiscal year and market capitalization prior to the private placement.” Analysis

of these transactions showed an average price discount of 33.75 percent The counts ranged from 84 percent to a premium (negative discount) in one case of 12.7percent Further segregation of the data into discounts less than and greater than 35percent indicates that “firms with higher revenues, earnings and market capitaliza-tions are associated with lower discounts.”

Exhibit 8.12 Summary of Studies of Restricted Securities Transactions

Discount for

Securities Exchange Commission 1966 – 1969 26%

Columbia Financial Advisors Inc 1996 – 1997 21%

Columbia Financial Advisors Inc.c 1997 – 1998 13%

aMoroney did not state the exact time period of his study of restricted stocks, but it is within this time frame.

bThe author used the 35 percent mean discount of the Maher study as a base discount He then supports a higher discount based upon his analysis of the SEC letter stock study and other SEC studies.

cThe effect of the SEC Rule 144 change from a two-year waiting period to a one-year waiting period.

Using the relationships that he found in his analysis, Silber developed a tical model that described the discount as a function of the:

statis-• Credit-worthiness of the issuing company

• Marketability of the shares

• Cash flow

• Special (value-added) concessions to the investor

Silber defined the measurable “proxies” for each of the factors Earnings andrevenues were used to measure creditworthiness The amount of restricted sharesissued as a percent of total shares outstanding was used to measure marketability.Special provisions such as “guarantees of representation on the company’s board”

or “a customer relationship between investors and issuer,” also were included in themodel

Using the least squares statistical model, Silber defined the relationships amongthe factors His results indicate that:

• “The size of the price penalty [discount] varies with firm and issue istics.”

character-• The size of the block of restricted securities issued affects the size of the discountmore than the amount of revenues of the company

• As the amount of restricted securities issues increases, those securities becomeless liquid and the issuer will have to sell them at a greater discount

Silber concludes: “The results indicated that marketing a large block of uid securities requires significant prior concessions, even with firms with substan-tial creditworthiness Liquidity clearly has a significant impact on the cost of equitycapital.”

illiq-Stryker and Pittock. Stryker, Charles, and Pittock, William F., “Revenue

Ruling 77-287 Revisited,” SRC Quarterly Reports (Spring 1983), pp 1– 3.

to be 45 percent

According to the authors:

To be eligible for inclusion in our study, the private placement had toinvolve the common stock (or the common stock with purchase war-rants) of a United States corporation and had to occur as an arm’s-lengthtransaction between unrelated parties which did not affect control of thecorporation In addition, the corporation could not be in a state of bank-ruptcy; nor could it be a financial, insurance, or real estate company

Empirical Evidence of Marketability Discounts 299

Other criteria included the fact that the placement price could not be less than

a dollar per share and that adequate information had to exist about the placementand the corporation The discounts ranged from 7 to 91 percent

The authors also studied the effect on the discount caused by four determinants

of discounts that were outlined in Revenue Ruling 77-287:

1 Earnings

2 Sales

3 Trading market

4 Resale agreement provisions

“Profitability in the fiscal year preceding the placement did not seem to ence the discount; the 11 companies showing a profit in that year had a mediandiscount of 45 percent, while the 17 that were unprofitable had a median discount

influ-of 46 percent.” However, the earnings patterns influ-of the companies did have aneffect on the discounts “On the average, companies that were profitable in each

of the five years prior to the date of placement appeared to sell restricted stock atsubstantially smaller discounts from market than did those with two, three, orfour unprofitable years during the five-year period.” Companies that were prof-itable all five of the prior years had a median discount of 34 percent Those com-panies with two to four years of profitability had a median discount of 39 percent,whereas those with zero or one year of profitability had a median discount of 46percent

The magnitude of revenues for the companies also affected the discount centages Those companies with revenues from approximately $30 million to $275million had a discount of 36 percent whereas those companies that had revenue inthe range of $500,000 to $1.6 million had a discount of 48 percent

per-The authors concluded that of the 28 companies studied, there was not a nificant difference in the magnitude of the discount based on whether they weretraded on a major exchange or not “The fact that there did not seem to be a rela-tionship between the issuer’s trading market and discount might be attributable tothe development, since 1969, of the NASDAQ trading system.”

sig-In terms of resale agreement or registration provisions including trigger or gyback rights, the authors indicate that:

pig-the median discount for pig-the ten placements involving resale agreementprovisions was 53 percent, versus a median discount for all twenty-eightplacements of 45 percent, a result that appears to be at odds with theimplications of RR 77-287 It should be noted that the promulgation ofRule 144 in 1972, plus subsequent relaxations of this Rule, haveenhanced the marketability of restricted stock and thus made registrationrights less important

The authors also discuss other considerations:

• The length of time the stock was held by the owner and the various factors underRule 144

• The length of time it would take to dispose of the restricted stock since “Thelonger the time needed to dispose of the restricted stock, the greater the discount,ceteris parabis.”

• The financial fundamentals of the issuer such that “The sounder the tion of an issuer, the lower the discount tends to be.”

capitaliza-• The investor’s appraisals of the unrestricted stock being traded in the place: “one would analyze the issuer’s relative price: earnings multiples, dividendyields, and ratios of market price to tangible book value as compared with those

market-of comparable companies (rational investors require higher discounts from anissuer whose stock they believe is overpriced).”

• The trading volume and volatility of the unrestricted stock: “The greater thecompany’s trading volume, the greater the likelihood that upon expiration ofthe resale restrictions, the restricted stock can be sold publicly without disrupt-ing the market for the issuer’s unrestricted stock A purchase of restricted stockassumes less additional risk when the market for the issuer’s unrestricted stock

is stable.”

The authors go on to state that “In addition to being probative of discounts incases involving non-controlling restricted common stock interests issued in privateplacements, these factors are equally important in the valuation of non-controllingclosely held common stock, qualified option stock and other forms of restrictedownership interest.”

Maher. Maher, Michael J., “Discounts for Lack of Marketability for

Closely-Held Business Interests,” Taxes (September 1976), pp 562 – 571.

Period of Study

Median Discount of 33 percent 1969 –1973

The author researched the purchases of restricted securities by investment panies from 1969 to 1973 “The discounts were derived by comparing the cost tothe funds to the market value of unrestricted securities of the same class in the samecompanies on the acquisition date.” Maher determined that the mean discount ontransactions occurring in this time frame was approximately 35 percent The range

com-of discounts for the 34 transactions studied was 2.7 to 75.66 percent Further sis reveals that 68 percent of the transactions occurred at discounts of 30 percent ormore, 35 percent occurred at discounts of 40 percent or higher, and 21 percentoccurred at a discount of 50 percent or greater

analy-Maher acknowledges that the investment companies discounted the purchases

to take into account the costs of registering the stocks, but he argues that the applieddiscounts are considerably higher than the costs that investment companies wouldincur to register the stock

Maher justifies the 35 percent discount for lack of marketability by pointingout that investors give up the opportunity to invest in other more marketable instru-ments and that the investor “would continue to have his investment at the risk ofthe business until the shares could be offered to the public or another buyer isfound.”

Empirical Evidence of Marketability Discounts 301

Valuing Stock of a Closely Held Company,” Journal of Taxation (June 1972),

Using publicly available financial statements, the author compared the pricethat the investment companies paid for the restricted securities of a corporation tothe market price of publicly traded securities of the same corporation This studywas based on an analysis of publicly traded close-end investment companies thatspecialized in and reported on restricted securities and letter stocks of public com-panies In 1970 the four investment companies “had letter stock investments in thecommon stocks of 89 public companies.” Gelman analyzed these transactions anddetermined that the mean and median discount of all 89 stock purchases was 33percent

It is significant to note that:

• 36 percent of the stocks exhibited discounts greater that 40 percent

• 59 percent of the stocks exhibited discounts greater than 30 percent

• 84 percent of the stocks exhibited discounts greater that 20 percent

Stocks,” Taxes (March 1973), pp 144 –156.

Period of Study

Mean Discount of 35.6 percent, 1969 –1973

Median Discount of 33 percent 1969 –1973

Public records of the purchases of unregistered securities by investment panies provide a basis for determining the size of the lack of marketability discountsfor closely held securities Because the government restricts the sale of unregisteredstocks, they are less marketable than freely traded securities

com-Beginning in 1969, the SEC required that registered investment companiesmake public their internal restricted securities valuation methods and transactiondata (SEC Accounting Series Release No 113, dated October 21, 1969, andAccounting Series Release No 118, dated December 23, 1970) By the end of 1968,open-end and close-end registered investment companies held over $4.2 billion in

restricted equity securities A review of the prices at which investment companiespurchased 146 unregistered and restricted stocks reveals that the actual discount forthese securities was sometimes as great as 90 percent.

Moroney also investigated the published financial statements of the nies and reviewed the valuations prepared by the boards of directors of the firmsthat were required by law to make good-faith estimates of value Investment com-panies’ board of directors consider several factors when evaluating the value oftheir restricted securities holdings for their annual financial statement, includingthe size of the security block, the size of the issuer, and the issuer’s presence in themarket

compa-Of the 146 transactions reviewed, the mean discount based on the originalpurchase was 35.6 percent Of further interest is that 64 percent of the transactionsoccurred at a discount of 30 percent or greater, 40 percent occurred at a discount

of 40 percent or greater, and 23 percent occurred at a discount of 50 percent orhigher

Trout. Trout, Robert R., “Estimation of the Discount Associated with the

Transfer of Restricted Securities,” Taxes (June 1977), pp 381– 385.

analy-• Exchange listing

• Number of shares outstanding

• Percent control, which is the number of shares purchased divided by the sharesoutstanding

• Size of the purchase

• Value of the purchase

Trout enters actual transaction data for each of the variables and solves for thecoefficients of the variables These coefficients describe the relationship that thevariables have to the size of the lack of marketability discount

• Exchange Listing The exchange listing variable accounts for the fact that stocks

traded on larger exchanges are generally more marketable than those that arenot, and will have lower discounts Trout sets the variable to “one if the security

is listed on either the New York or the American Stock Exchange, and a value ofzero otherwise.” Analysis indicates that stocks traded on the above exchangeswill have an 8.39 percent lower discount than securities listed on smallerexchanges

• Number of Shares Outstanding “The number of shares outstanding is a proxy

for the marketability of the shares purchased.” Securities with a greater number

Empirical Evidence of Marketability Discounts 303

of shares outstanding will be more marketable and therefore have a lower count Analysis indicates that “the discount will be about four percentage pointssmaller for each additional million shares of common stock of the issue whichare outstanding.”

dis-• Percent Control The amount of control measures both the premium for the

privilege of owning a controlling interest in the securities as well as the discountfor disposing of a large block of the security The percent control has a smallnegative affect on the discount: “the discount should decline by a little less than

1 percentage point for each additional 1 percent of control involved in the chase.”

pur-• Size of the Purchase The size variable “reflects the reduced discount necessary

for a purchase of a small number of shares of a restricted security that could ily be sold.” The analysis “indicates that small purchases of stock should have a12.11 percentage point lower discount than purchases that amount to more than

eas-1 percent of the outstanding shares.”

• Value of the Purchase The value of purchase discount reflects “the value the

shares purchased would have if they were registered or unrestricted.” Analysisindicates that “the discount will increase by 4.75 percentage points for eachadditional million dollars of stock purchased.”

In summary, Trout’s model has a moderate ability to account for variations inobserved discounts The analysis indicates that the size of the discount is stronglyaffected by the discussed factors The model does not explain all of the variationsamong observed discounts, because other nontangible factors, such as purchaseagreements, the bargaining power of the seller, and the lack of an auction market,affect the discount size

Fifty Percent,” Taxes (January 1981), pp 25 – 31.

Discount of 50 percent or Greater

Arneson evaluated studies of purchases of letter stock by investment nies He referred to studies by Maher and Moroney that indicate the appropriatediscount for nonmarketability of an interest in a closely held company should bearound 35 percent Arneson agreed with this rate for restricted securities butpointed out that restricted securities of publicly traded companies are different frominterests in closely held businesses He sees enough dissimilarity between the twosecurities to argue that the discount rates on closely held securities should be abovethe 35 percent level

compa-Arneson’s support for higher discounts included such factors as:

• Costs of flotation

• Lack of a preestablished market

• Risk

• Inability to market because of company size and history

• Noncash costs of underwriting

• Timing and length of time necessary to go public

He concludes that the discount for lack of marketability for a closely-held pany should be closer to 50 percent or greater.

com-• Costs of Flotation Arneson evaluated the cost of flotation and determined that

the cost should include compensation to underwriters and other expenses Hefound that, on average, the compensation to underwriters was 8.41 percent andother expenses were 4.02 percent of gross proceeds (based on 1,599 offerings tothe general public through securities dealers) For companies whose size of issuewas between $2 million and $5 million, the underwriters’ compensation was8.19 percent and the other expenses were 3.71 percent It is important to notethat other expenses include federal revenue stamps, state taxes, listing fees, print-ing costs, and legal and accounting fees

Arneson goes on to note that in addition to the other expenses, there wasother noncash compensation in the form of warrants or options in many situa-tions He indicates that such compensation has been prevalent among smallequity issues He feels that “many closely-held companies would most likelyrequire such additional consideration, and in appraising the cost to market suchsecurities should be provided for.”

Arneson’s information comes from the Securities and Exchange Commission’s

“Costs of Flotation of Registered Issues, 1971-1972,” (December, 1974) He alsoreviews a related study called “An Empirical Analysis of the Flotation Costs of

Corporate Securities,” Journal of Finance (September 1975) and “Unseasoned Equity Financing,” Journal of Financial and Quantitative Analysis (June 1975).

The extra cost for warrants and options was approximately 12 percent

• Preexisting Market Using the same studies, Arneson presents evidence

concern-ing the wide difference in compensation paid to underwriters for stocks with noprevious market as opposed to stocks that already had established market posi-tions “On the average this amounted to 3.7 percent but varied with size and list-ing exchanges.” The study also indicated that the discounts were higher forstocks on regional exchanges and OTC compared to the New York StockExchange and American Stock Exchange

• Risk Arneson feels that a thorough analysis of the company and the industry in

which it operates is an important element in setting risk He feels that risk isaffected by the size of the company and that risk affects the costs of securitiesflotation Although he did not determine a specific factor, he indicated that riskcould be assessed on the basis of “an industry’s general market conditions, busi-ness risk of a particular company and its financial risk, leverage, margins and thelike.”

• Ability to Market “A serious weakness in utilizing flotational basis to determine

nonmarketability is that for very small companies, there is almost no possibilitythat an underwriting could be carried out and a public market created.” Arnesonquotes in an article by Gerald A Sears entitled “Public Offerings for Smaller

Companies,” published in the Harvard Business Review (September-October

1968), in which Sears lists the criteria for a company to market its stock cessfully: “The company should have a growth rate higher than its industry toattract investors Owner-managers accustomed to answering to no one in run-ning their businesses must be able to adjust to operating in a sometimes uncom-fortable spotlight of attention The effect of public disclosure must not be tocompromise a company’s business.”

suc-• Hidden but Real Costs “Another cost for a privately-held company going

pub-lic is an ongoing one of audits, shareholder reports and relations, S.E.C and statesecurity reports, transfer agent, shareholder meetings and the like For a smallcompany, these could represent a sizable additional annual expense.”

• Time and Timing “Lettered stock could reasonably expect to become registered

and thus freely tradable in two to three years; however, it could take longer for

a closely-held company to prepare itself and have its stock marketed.” Arnesongoes on to talk about the fact that the general condition of the marketplace alsocould dictate whether a company could go public Several factors outside a firmwill influence its ability to market the equity:

• General level of business activity

• Level of interest rates

• Level of stock prices

• Availability of funds in the money markets

Willamette Management Associates Study

Period of Study

_

Median Discount of 31.2 percent

1981–1984

In a study of 33 transactions involving purchases of restricted securities from

1981 through 1984, Willamette Management compared the prices at which therestricted securities were issued to the prices for comparable publicly traded stocksfrom the issuing company It found that the restricted securities sold at a median dis-count of 31.2 percent

“The slightly lower average percentage discounts for private placements duringthis time may be attributable to the somewhat depressed pricing in the public stockmarket, which in turn reflected the necessary economic conditions prevalent duringmost of the period of the study.”13

Management Planning Restricted Stock Studies.14 An independent businessappraisal firm, Management Planning, Inc (MPI) has compiled an analysis of thediscounts on restricted stocks as compared to their publicly traded counterparts thatincludes data from 1980 through 1995 MPI reviewed all reported private place-ments in that period, choosing transactions that met the following criteria:

• Restricted stock in the transaction had to have a publicly traded and actively heldcommon stock counterpart in the same company with the same rights as therestricted stock

• Data on the transaction had to be available

• Publicly traded common stock counterpart had to sell at a price of at least $2 pershare

• Company selling the stock must be domestic

13Shannon P Pratt, Robert F Reily, and Robert R Schweihs, Valuing a Business: The Analysis

and Appraisal of Closely Held Companies, 4th ed (New York: McGraw-Hill, Inc.), p 400.

14Christopher Z Mercer, Quantifying Marketability Discounts (Peabody Publishing, L.P., 1997), pp 350 – 355 (Used with permission.) Note: This study has been updated See Chapter 5 of Handbook of Advanced Business Valuation, Robert F Reilly and Robert P.

Schweihs, eds (New York: McGraw-Hill, Inc., 2000).

• The company selling the stock must not be described in disclosure documents asbeing in a developmental stage.

According to MPI, the criteria mitigate abnormalities in discount data that may

be caused by market inefficiencies for certain inactive stocks or speculative stocks.Over 200 private placements of restricted stock met the criteria MPI further elimi-nated any company “that suffered a loss in the fiscal year preceding the privatetransaction,” any company with revenues less than $3 million (a start-up company),and any transactions of stocks with known registration rights Only 49 of the orig-inal group of companies met the criteria Exhibit 8.13 summarizes the results of theMPI study

Exhibit 8.13 Management Planning Inc., Restricted Stock Study — Summary of Transaction Data

Factors with a Clear Correlation. A number of factors were reviewed in eachquartile to confirm whether they appeared to affect the restricted stock discount:

rela-Empirical Evidence of Marketability Discounts 307

companies with a history of lower price stability Earnings stability was measuredbased on the fiscal year net income data of the 10 years prior to the transaction date.Companies with more stable earnings have lower restricted stock discounts.Exhibit 8.14 illustrates the result of MPI’s analysis of the above factors Inranking revenues, earnings, market price/share, and earnings stability, the first quar-tile represents the higher end and the fourth quartile represents the lower end of therange For price stability, the first quartile represents the lower end and the fourthquartile represents the higher end of the range

Exhibit 8.14 Management Planning, Inc., Restricted Stock Study—Factors with Clear Correlation to

Restricted Stock Discounts 15

1st Quartile 2nd Quartile 3rd Quartile 4th Quartile

• Number of shares in block

• Time to sell according to SEC Rule 144 restrictions (dribble out period, the ber of three-month periods)

num-• Number of weeks trading volume to sell

• Block size/trading volume (percent), 10-year revenue

• 10-year earnings growth and revenue stability

The analysis indicated that these factors generally followed a predictable tern Companies with larger market capitalization tended to have lower discounts.Larger blocks of stock tended to have higher discounts The longer the periodrequired to sell the stock based on the Rule 144 restrictions, the higher therestricted stock discount tended to be The higher the block size as a percent ofannual trading volume, the higher the discount tended to be Companies with

pat-15Ibid., p 357.

greater revenue and earnings growth and revenue stability tended to have lowerdiscounts.

Exhibit 8.15 illustrates the result of MPI’s analysis of the above factors Inranking market capitalization, block size, weeks to sell, block size/trading volume(percent), revenue and earnings growth, and revenue stability, the first quartile rep-resents the higher end and the fourth quartile represents the lower end of the range.For the SEC Rule 144 three-month period, the first quartile represents the longestperiod and the fourth quartile represents the shortest

Exhibit 8.15 Management Planning, Inc., Restricted Stock Study—Factors with Some Correlation

to Restricted Stock Discounts 16

1st Quartile 2nd Quartile 3rd Quartile 4th Quartile

transactions from 1980 through April 1997 This study was initially reported in

Valuation Strategies17 in 2001 with a follow-up article in Business Valuation Update.18 All transactions were prior to the Rule 144 amendment in 1997 thatreduced the holding period from two years to one year The overall mean (average)discount in the study is 22.1 percent and the median discount is 20.1 percent Thestandard deviation of the sample is 16.0 percent The median discount for exchange-traded securities is 15.3 percent, while the median discount for over-the-countertraded securities is 22.4 percent

16Ibid., p 359.

17 Robak and Hall, “Bringing Sanity to Marketability Discounts: A New Data Source,”

Valuation Strategies, Vol 4, No 6 (July/August 2001).

18Robak, Espen, “FMV Introduces Detailed Restricted Stock Study,” Shannon Pratt’s

Business Valuation Update, Vol 7, No 11 (November 2001).

The FMV Study also provides an analysis of the 243 transactions by SIC Code.

As there are too few transactions per SIC code to be meaningful, the authorsgrouped the transactions into SIC code ranges The study concludes that financialdescriptors such as size, risk, profitability, and liquidity are the most importantdeterminants of the discount for the lack of marketability, not business type.Risk had a significant effect on the size of the discounts The study showed thatsmaller, less-profitable entities and those with a higher degree of balance sheet riskhad the highest discounts The study also found a correlation between the size of thediscount and the stock price The DLOM increases significantly with decreasingstock prices Other inferences drawn from the FMV study (including revenue,income, dividend payments, dollar block size, book value, market value, and trad-ing volume) also confirm the relationship between risk and the lack of marketabil-ity discount

Johnson Study. The Johnson study19 observed 72 transactions during theyears 1991 to 1995 The range of the discounts was from a negative 10 percent (apremium) to 60 percent The study points to an average discount of 20 percent,which is lower than past studies The author attributes the decline in the size of thediscounts to the increased number of investors who entered the market for restrictedstocks in this five-year period following the SEC adoption of Rule 144A, whichallowed qualified institutional investors to trade unregistered securities without fil-ing registration statements The holding period for restricted stocks in this study wastwo years

The study also considered the effect of such factors as profitability, size, action amount, and the holding period on the amount of the discount for lack ofmarketability The average DLOM was 16 percent when the company reported pos-itive earnings compared to 23 percent when the company reported a loss Thisspread in the average discount remained constant for each year net income wasexamined The relationship between the magnitude of the discount and the size ofthe company is clearly direct The average discount was 13 percent for companieswith sales greater than $200 million compared to 23.5 percent for companies withsales of less than $10 million

trans-Columbia Financial Advisors, Inc. Columbia Financial Advisors, Inc (CFAI)performed two studies; one examined only private equity placements over theperiod January 1, 1996, through April 30, 1997, and the other study examined onlyprivate common equity placements over the period January 1, 1997, throughDecember 31, 1998 The second study was notable in that it is the first study to con-sider DLOM after the 1997 Rule 144 change that reduced the holding period forrestricted stocks from two years to one

In the first study, CFAI analyzed 23 transactions and found an average discount

of 21 percent The discounts ranged from 0.8 to 67.5 percent; the median was 14percent The study offers this explanation of the decline in the size of DLOM fromthe earlier studies:

19 Johnson, Bruce, “Restricted Stock Discounts, 1991– 95,” Shannon Pratt’s Business

Valuation Update, Vol 5, No 3 (March 1999), pp 1– 3.

These discounts are generally lower than the discounts recorded in theearlier studies noted above which generally indicated discounts ofapproximately 35 percent The increase in volume of privately placedstock (Rule 144A) in the past several years offers an explanation Asactivity in a market increases, more and better information becomesavailable In addition, there are now more participants in the market forrestricted stocks due to Rule 144A and, therefore, increased liquidity.This would tend to decrease discounts because better information results

in less risk and thus a lower required rate of return The lower discounts

in this particular study may also reflect, to some degree, the market’santicipation of the SEC’s change in the holding period from two years toone year, although we have no way to verify this Since June 1995, theSEC proposed amendment to Rule 144 was published for public com-ment Therefore, knowledgeable private placement and Rule 144A mar-ket participants were most likely aware of the proposed changes.20

The average discount for the second study, after the Rule 144 holding periodwas shortened to one year, was 13 percent The range of discounts in the secondstudy, which analyzed 15 transactions, was 0 to 30 percent; the median was 9 per-cent According to CFAI, “The lower discounts in this study in all probability reflectthe market’s reaction to the SEC’s change in the holding period from two years toone year.”

The CFAI study also noted other market evidence to support declining counts following the Rule 144 holding period change Tetra Tech, Inc., a publiclytraded environmental engineering firm, is active in industry acquisitions and typi-cally uses its restricted stock for acquisitions The Tetra Tech Form 10-K for the fis-cal year ending September 30, 1999, included the following statement in thefootnotes to its September 30, 1999, financial statements: “The Company valuesstock exchanged in acquisitions based on extended restriction periods and economicfactors specific to the Company’s circumstances During fiscal 1998 and 1999, stockexchanged in acquisitions was discounted by 15 percent During fiscal 1997, the dis-count on stock exchanged in acquisitions ranged from 16 to 28 percent.”

dis-The CFAI study concluded that while discounts for restricted stocks are ing, “the studies conducted after 1990 are not relevant for purposes of determiningdiscounts for lack of marketability for privately held stock, because they reflect theincreased liquidity in the market for restricted securities Such increased liquidity isnot present in privately held securities.”

declin-Overall Observations of Studies

The following list presents some interesting observations after reviewing theseempirical studies:

• The smaller the company (revenues, earnings, market capitalization), the largerwas the discount for lack of marketability

• Issuers of restricted stock may be better credit risks

20 Aschwald, Kathryn F., “Restricted Stock Discounts Decline as Result of 1-Year Holding Period — Studies After 1990 ‘No Longer Relevant’ for Lack of Marketability Discounts,”

Shannon Pratt’s Business Valuation Update, Vol 6, No 5 (May 2000), pp 1– 5.

• Purchasers of restricted stock are institutional investors whose investment goalsand criteria are far different from those of the individual purchaser of a closelyheld business interest.

• Institutional investors have different levels of risk perception and risk tolerancefrom purchasers of closely held business stock

• Purchasers of restricted securities usually intend to market the purchased ties in the future and assume a ready market will exist at that time Purchasers

securi-of stock in closely held companies have little or no expectation to market thestock in the future; if they expect to market the stock, they assume a limited mar-ket will exist for them to do so

• Investments of venture capital companies in OTC nonreporting companies mostclosely resemble purchases by closely held business owners

• Venture capital investments are generally of relatively short duration, suggestingeven higher discounts for the typically longer positions in closely held businessstock

• When an analyst applies a discount to a closely held company interest that isequal to the discount observed in restricted stock of a publicly traded company,the implication is that the restricted stock is comparable to the closely held stock

• Blind reliance on empirical studies or discounts allowed by the courts is simplistic as each valuation has its own unique facts and circumstances that must

over-be reflected in the selection of discounts

• Valuation analysts who rely solely on empirical studies without analysis mayunderstate discounts and overstate value

• Valuation analysts often fail to support discounts with sound reasoning and sidered analysis

con-• In the valuation of stock in most closely held businesses, the average discounts

observed in the restricted stock studies may be considered the minimum discount

applicable in many situations

QUANTITATIVE TOOLS

Investor’s Discounted Cash Flow Models

John C Harper, Jr., and J Peter Lindquist wrote one of the early articles on the use

of a “shareholders’” DCF model In their article they present a straightforwardexample21:

21 John C Harper, Jr., and J Peter Lindquist, “Quantitative Support for Large Minority

Discounts in Closely Held Corporations,” The Appraisal Journal (April 1983).

Let us demonstrate by a simple but realistic example of how this count is calculated and the impact it can have on today’s value of a share

dis-of stock A friend dis-of John Smith’s is approaching retirement and hasoffered to sell Smith his 10 percent common stock interest in AcmeServices, Inc., which is controlled by members of the William Jones fam-ily What can Smith afford to pay for this stock?

Today’s value: Smith analyzes the performance of the company

using the Revenue Ruling 59-60 guidelines, then discusses his opinionswith Bill Jones, current president of the company They agree that $100per share is a fair value if 100 percent of the stock were to be sold today

The article also presents that the company will grow 10 percent per year for thenext 10 years at which time Jones is to retire and “may” sell the company Smithused a 25 percent annual return on investment given the risks of a private companyinvestment

If the sale of the company is expected to be in the tenth year, then a buyershould not pay any more than $28, or a 72 percent discount from the original $100.The expected or anticipated year of sale can be most difficult to determine as thecontrolling shareholder’s age, health, mental well-being, and “exit strategy” allaffect the decisions to sell

This example shows that a minority interest with very little market is near

worthless Furthermore, the discount that we see in this example may be a combined discount of both lack of control and lack of marketability because the $100 per

share price is an “enterprise” or controlling value, and the present value in the tenthyear of $28 may represent “cash equivalent” or marketable minority interest value,thus including both discounts

Quantitative Marketability Discount Model

In 1997 Z Christopher Mercer published a book entitled Quantifying Marketability Discounts that expanded on the concepts presented in the

Harper/Lindquist article Mercer’s book presents a model for analyzing ity discounts and includes excellent overviews of restricted stock studies, IPO stud-ies, and Tax Court cases

marketabil-The quantitative marketability discount model (QMDM) model requires fivekey inputs:

• Marketable minority value of the stock

• Expected growth rate of a marketable minority shareholder interest

• Expected holding period

• Required rate of return for a nonmarketable minority interest

• Expected dividend payments

Some analysts have observed that the discount derived in this approach mayappear to combine discounts both for lack of control and marketability Mercer,

however, disagrees In Business Valuation, Discounts and Premiums, he states:

A number of appraisers have suggested that the QMDM may be ing elements of the minority interest discount as well as the marketabil-

captur-ity discount There has been a recent exchange on this issue in Shannon Pratt’s Business Valuation Update in vol 7, no 3 (March 2001) pp 7-

10 and vol 7, no 5 (May 2001) pp 9-10 Assuming, as I do, that it isappropriate for appraisers to make normalizing adjustments in the devel-opment of marketable minority valuation indications, the QMDM cap-tures the appropriate marketability discount The rationale for my

position on normalizing adjustments is outlined in Dr Pratt’s book, Cost

of Capital—Estimation and Applications, in Appendix D which he asked

me to write relating to the use of ValuSource PRO Software Someappraisers assume that such normalizing adjustments for discretionaryowner compensation and expenses are inappropriate in minority interestappraisals because they reflect elements of control not available tominority shareholders They further assume that the diminution of valueresulting from the “leakage” of discretionary cash flows reflects elements

of a minority interest discount Under these assumptions, which I do not

believe to be correct, the QMDM captures elements of the minorityinterest discount.22

Option Pricing Models

In 1993 David B Chaffe III published an article about his theory that the Scholes pricing model could be used to determine the amount of a marketability dis-count.23Mr Chaffe uncovered relationships in the comparison of his computation

Black-of the marketability discount with that Black-of the transaction data He found that theEuropean option, which is exercisable only at the end of the option period, could be

an appropriate model for the SEC Rule 144 holding period of restricted shares.Substituting certain inputs of the model to express conditions of a restricted stock,

he was able to produce results similar to those of the restricted stock studies His

analysis was presented in Business Valuation Review, December 1993, “Option

Pricing as a Proxy for Discount for Lack of Marketability in Private CompanyValuations.”

22Pratt, Shannon P., Business Valuation Discounts and Premiums (New York: John Wiley &

Sons, Inc., 2001), p 184.

23 David B Chaffe III, “Option Pricing as a Proxy for Discount for Lack of Marketability in

Private Company Valuations,” Business Valuation Review (December 1993).

The QMDM represents continued theoretical development of the cept of the marketability discount Some appraisers have adopted someform of the framework for analyzing discounts that Mercer has pre-sented but most agree that if used, it should be in conjunction with theuse of traditional discount studies

con-ValTip

Measuring the Amount of Discount for Lack of Marketability

Each method of determining a DLOM has its strengths and weaknesses.Determining the amount of the marketability discount to be applied to closely heldsecurities by reference to either the restricted stock or IPO studies requires carefulscrutiny of the studies themselves Recently these studies have been challenged as totheir applicability to marketability discounts for closely held securities by both thecourts and other experts The DCF models, particularly the QMDM, have not yetgained acceptance in the courts Accordingly, the reader must understand these par-ticular criticisms before adopting any of these methodologies for determining a dis-count for lack of marketability

Factors Influencing Marketability of the Investment

In the landmark Mandelbaum case (see end of chapter for case summary), anumber of factors were considered by the court in their analysis of the magnitude

of the marketability of the Company These factors, which are explained in the casesummary, included:

• Financial statement analysis

influ-• Accessibility and reliability of financial information

• Compiled statements are less reliable than audit or review statements

• Manual internal accounting systems are generally less reliable and less sible

acces-• Number of shareholders

• Companies with many shareholders may be more likely to enter into a action to satisfy diverse owner interests

trans-• Concentration of control owners

• Control owners may dominate businesses and operate them to meet their ownends with little consideration for the needs of minority owners

• Number of potential buyers

• A large number of interested purchasers may improve the possibility of atransaction

• Access to capital marketplace

• Low leverage businesses may be more appealing to prospective purchasers

Quantitative Tools 315

• Size of the business

• Larger businesses may be more easily sold or financed and possess broaderappeal than smaller businesses

• Volume of comparable private transactions

• Businesses in an industry that is experiencing high merger and acquisitionactivity may be more marketable

• Owners with adversarial relationships or an inconsistent business philosophy

• Owners who are unable to agree may make the business less marketable

• Desirability of the business

• Businesses in “hot” industries may be more marketable because they tend toattract interest

• Existence of restricted stock agreements

• Shareholder agreements may prevent free transferability and limit ketability of stock

mar-• Existence of noncompete agreements

• Businesses that fail to limit the mobility of critical personnel may be less ketable

mar-• Yield

• Businesses with a track record of consistent high profitability are usually moreeasily transferable

• Liquidity of control owners

• The existence of other liquid assets on the part of the owners may reduce thedesire or need to transfer the business

• Quality and competence of management team

• Businesses with competent, experienced management may be more appealing

to a broader range of potential purchasers

• Existence and effect of pending litigation

• Businesses with potentially costly legal issues (i.e., environmental) are not asdesirable in the marketplace

• Size of block of stock

• Owners of large blocks may have influence on corporate governance

• Existence and extent of contractual restrictions

• Financing agreements may limit compensation of control owners or the ity to declare and pay dividends

abil-• Degree and effect of industry regulations

• Industry regulation can restrict the control owner where minority shareholdersmight otherwise be helpless

• Effects of state law

• Percentage control required to undertake major corporate actions (i.e sale ofassets) can be more favorable in some states

• Existence of swing vote attributes

• Swing votes can lessen the discount

• Relationship between controlling and noncontrolling shareholders

• Harmonious relationships may reduce discounts, whereas adversarial tionships may increase discounts

rela-• Existence of shareholder agreements that grant control to certain ers for certain activities (if transferable)

sharehold-When valuing a closely held company, care, reasonableness, and sound fessional judgment must be employed when applying discounts Furthermore, theparticular facts and circumstances of each valuation must be the final determinate

pro-of discounts A thorough understanding pro-of both the subject company and theunderlying data used in the discount studies are important for defensible valua-tion conclusions The marketability factors as presented should not be consideredexhaustive nor are they applicable in each valuation Any particular closely heldcompany may have a unique discount issue that must be taken into consideration.Exhibit 8.16 is a summary example of a possible DLOM chart, here using 35percent, the general average of several restricted stock studies, as the starting point.This is for presentation purposes only

OTHER DISCOUNTS

In addition to the discounts for lack of control and marketability, thereare several other potential discounts Some analysts consider these dis-counts in the calculation of a discount or capitalization factor whileothers separately quantify and apply the discounts

ValTip

Exhibit 8.16 DLOM Adjustment Example

Impact on Marketability Discount Warrants An Warrants An Warrants A

Above Average Average Below Average

Marketability Adjustment Factors Discount Discount Discount

Other Factor 3, etc. 

While discounts for lack of control and lack of marketability apply to the vastmajority of valuations, the following discounts are taken less frequently as a sepa-rately quantified and displayed discount.

Restrictive Agreement Discounts

A review of any buy-sell and/or restrictive agreement within a closely held tion typically reveals various stockholder rights, including income and dividendpreferences, liquidation preferences, voting rights, and limitations of the sale ofstock It also may include an actual stock price or a protocol or method for deter-mining the price

corpora-In some instances, the sale price is dictated The effect of these agreements isthe difference in price between an unrestricted ownership interest and the restrictedinterest giving rise to a shareholder level discount The more severe the restrictions,the higher the discount The Tax Courts have periodically suggested that restrictiveagreements be considered but that they may not necessarily set value Usuallyrestrictive agreements are of greater importance in an estate tax valuation than a gifttax valuation

Information Access and Reliability Discount

Smaller companies, free of SEC regulations and the restrictions associated withpublic oversight, can produce scanty and unreliable financial information Aninvestor considering an investment in such a company would discount any infor-mation believed to be suspect or unreliable If a company being valued is being com-pared to publicly traded companies, adjustments to the financial statements orvaluation multiples (e.g., depreciation, leverage, taxes, nonrecurring items, and non-operating assets) may be necessary

If there is additional risk associated with uncertainty in the underlying data, itmay be appropriate to apply a discount The magnitude of such a discount would

depend entirely on the facts and circumstances of each individual situation.Furthermore, if the proper financial adjustments are made, a discount may not beappropriate.

Liquidation Costs Discount

Certain costs, such as brokers’ fees, state and local transfer taxes, and holdingperiod interest, would be incurred to realize the property’s fair market value It hastherefore been argued that these costs should be used to reduce the value of theproperty in the estate; some analysts take a discount

Trapped Capital Gains Discount

At the very least, a trapped capital gains discount should be considered if tion is imminent and the entity holds assets with unrealized appreciation The IRSoutlined its position in TAM 9150001.24 In general, the TAM stated that if theimmediate liquidation of the subject assets is not contemplated, the capital gains tax cannot be used to reduce the value of the estate Obviously, many tax practi-tioners disagree with this assumption Furthermore the courts have accepted these

liquida-discounts in several recent cases including Estate of Artemus Davis,25Eisenberg v Commissioner,26and Dunn v Commissioner.27

Key Person/Thin Management Discount

Key person and thin management discounts are based on the premise that the tribution of an individual (or small group of individuals) to a business is so signifi-cant that it is almost certain that present and future earnings levels would beadversely affected by their loss This is not an unusual situation in many smallerclosely held companies Revenue Ruling 59-60 deals with this issue by stating: “Theloss of the manager of a so-called one-man business may have a depressing effectupon the value of the stock of such business, particularly if there is a lack of trainedpersonnel capable of succeeding to the management of the enterprise.” The selection

con-An ongoing disagreement between the IRS and many tax practitionersrevolves around the treatment of the costs related to liquidating theassets in the estate

ValTip

24 IRS TAM 9150001 (August 20, 1991).

25Estate of Davis v Comm., 110 T.C 530 (1998).

26Estate of Eisenberg v Comm., 155 F.3d 50 (2d Cir 1998).

27Estate of Dunn v Comm., U.S Court of Appeals, 5th Cir., No 00-60614, August 1, 2002.

of a discount to reflect the loss of a key manager or a thin management structuremay be tempered by the effects of life insurance policies that are in existence as ofthe date of the valuation.

Investment Company Discount

It is not unusual for investment companies to sell on the basis of their assets cally real estate and securities) rather than their earnings Revenue Ruling 59-60states “the value of the stock of a closely held investment in a real estate holdingcompany, whether or not family owned, is closely related to the value of the assetsunderlying the stock For companies of this type, the appraiser should determine thefair market values of the assets of the company.”

(typi-An analysis of publicly traded investment real estate companies and publiclytraded closed-end funds reveals that minority interests in investment companies typi-cally sell at a discount from their respective pro rata share of the firm’s net assetsrestated at fair market value The application of this entity-level discount would adjustfor the shareholders’ indirect ownership of these assets and their inability to force thesale, liquidation, or merger of these assets Investment company discounts range any-where from 10 to 60 percent, depending on the facts and circumstances of each case

At first glance, the investment company discount in its purest form may be sidered a minority interest discount; however, an investment company discount adjust-

con-ment has been recognized by the courts for application to a majority interest In Estate

of Folks,28the court recognized that different investment company discounts mightapply to different ownership percentages for the same company The court opined that

a 50 percent discount was allowable for a minority interest and a 40 percent discountwas allowable for a majority interest (less than control) Note that the court alsoallowed an additional marketability discount for the minority interest

In Estate of Dougherty,29 the court decided that a 35 percent discount wasallowable for nonmarketability and operating and liquidation costs The decedentheld a 100 percent beneficial interest in a trust that owned a 100 percent interest in

a company that owned primarily real estate and other nonliquid assets

28Estate of T John Folks, Jr., T.C Memo 1982-43.

29Estate of Albert L Dougherty, T.C Memo 1990-274.

A key person or thin management entity-level discount would beappropriate in the valuation of a closely held company where an owner

or employee is responsible for generating a significant portion of thebusiness’s sales or profits This key person may be a revenue generator,possess technical knowledge, or have close relationships with suppliers,customers, or banks

ValTip

Blockage Discounts and Market Absorption

Where there is only a limited market for the shares, offering a large block canhave a depressing consequence on the value of the shares of stock

Treasury Regulation Section 20.2031–2 states the following:

The size of the block of stock to be valued in relation to the number ofshares changing hands in sales may be relevant in determining whetherselling prices reflect the fair market value of the block to be valued If theblock of stock is so large in relation to the actual sales on the existingmarket that it could not be liquidated in a reasonable time withoutdepressing the market, the price at which the block could be sold as suchoutside the usual market, as through an underwriter, may be a moreaccurate indication of value than market quotations

The following factors, among others, should be considered in determining theblockage discount to be applied to blocks of public stocks:

• Size of the block in relation to the total shares outstanding

• Size of the block in relation to the daily trading volume

• Volatility of the stock

• General, economic, and industry trends

• Alternatives for disposing the stock

• Length of time necessary to dispose of the stock without affecting the currentprice

For example, a large block of similar real estate holdings within a single graphical area may create oversupply and may be more difficult to sell over a rea-sonable period of time than one property Where there is a limited market for a

geo-Blockage or market absorption discounts also can be considered whenvaluing other assets, such as real estate In the valuation of a closelyheld real estate investment holding company, a discount for potentialmarket absorption should be considered

Other Discounts 321

certain type of property, offering a large block of properties could depress the ket and lower the prices that otherwise could have been obtained It is simply a mat-ter of supply and demand

mar-The following factors, among others, are considered when valuing a large block

of real estate placed on the market on any given day:

• Number of properties and square footage of properties that are being valued

• Geographical concentration

• Type of property (e.g., apartments, office buildings, etc.)

• Total supply of that type of property within the same geographical area

• Length of time to dispose of the real estate without affecting the price

• Whether the market is stagnate or appreciating

• Market and real estate trends

Nonhomogeneous Assets Discount

A nonhomogeneous assets discount is applicable to an unusually diverse collection

of assets or businesses within the subject company being valued A small companywith limited access to capital and a small management team may have difficultymanaging such a broad spectrum of assets The discount will measure underutiliza-tion of assets or lack of synergy among assets

or possibly liquidation A thorough understanding of the business costs relative toits industry is required to quantify a lack-of-diversification discount Care should betaken with any other approach to value that may already incorporate this discount.For example, this discount could be included implicitly in a capitalization rate or amarket multiple

Although these discounts are most likely included in either the discount rate ormarket multiple, it may be necessary to make an additional adjustment for a small-company risk discount and a company-specific risk discount

Small-Company Risk Discount

The degree of comparability between the closely held subject company and its licly traded counterparts must be evaluated

pub-Merger, acquisition, and financial data are available that indicate that theprices paid for smaller, closely held companies can be lower than the prices paidfor their larger, publicly traded counterparts Furthermore, studies indicate thatrates of return required for investing in small companies can be higher than therates of return required on much larger, publicly traded, diversified companies.This is important since the higher the rate of return required, the lower the finalvalue This adjustment is usually made in the discount or cap rate (See Chapter 5.)

A small-company risk discount may be separate from a marketability discountand a minority discount Depending on how the discount was determined, thisadjustment may incorporate the differences in information access and reliability andlack of adequate succession management.

The data from some of these studies are calculated primarily from control uation multiples from acquisitions of companies Therefore, a minority discountwould be applied if a minority value were desired A discount for a key person orthin management may not be applicable because the prices paid for the closely heldcompanies used in the study may have already been reduced to reflect this situation,although this would not be the case in every company Lack of marketability andinformation access discounts must be carefully considered since prices paid for thecompanies that make up the studies were probably set and/or adjusted based onsome level of due diligence and perception of marketability on the part of the buyer

val-Company-Specific Risk Discount

The risk premium for unsystematic risk attributable to the specific company beingvalued should account for additional risk factors specific to the company that maynot be reflected in the comparable companies This adjustment is usually made inthe discount or cap rate (See Chapter 5.)

Firm-specific risk factors may include:

• Litigation

• Reliance on a few customers

• Limited supply of sources

• Old technology

• Riskier business

When a smaller closely held company is being compared to a largerpublicly traded company, an adjustment for size may be appropriate.ValTip

Small companies often have a limited access to capital, limited ability

to weather a market downturn, limited resources to develop and ket new products, and so on Smaller companies also can have a highercost of capital than larger companies

mar-ValTip

DISCOUNTS AND PREMIUMS SUMMARY

When valuing a closely held company, care, reasonableness, and sound valuationjudgment must be employed when applying discounts The particular facts and cir-cumstances of each valuation must be considered for the final determination of dis-counts Experts must understand and properly apply the results of the variousstudies that they relied on and applied to the subject company The blind applica-tion of discounts, without a thorough understanding of the subject company ascompared to the underlying data used for the discounts, can lead to misleading val-

uation results For additional information on discounts and premiums see Business Valuation Discounts and Premiums by Shannon P Pratt (New York: John Wiley &

Sons, Inc., 2001)

Care should be exercised to avoid overlaps or “double discounting”with thin management discounts, small-company risk discounts, lack-of-diversification discounts, or others

ValTip

ADDENDUM — TAX COURT CASES

(THE OLDIES BUT GOODIES)

There are a number of significant cases that have dealt with the issues related to counts applicable to closely held companies The following case outlines wereselected due to their extensive presentation of these issues See Chapter 13 for addi-tional and more recent cases Please note that some of the experts’ testimony dis-cussed here may have been affected by poor direction, ineffective legal trial strategy,

dis-or other factdis-ors beyond their control

Bernard Mandelbaum et al v Comm.

Date of Opinion: June 12, 1995

Dates of Valuation: December 31, 1986, December 16, 1987, December 23,

1988, December 15,1989, February 1, 1990, and December 30, 1990

Type of Business: Women’s Apparel Retail Stores

Property Valued: Gifts of minority common stock

IRS Value: 30 percent DLOM for all valuation dates

Taxpayer Value: 75 percent DLOM for December 31, 1986; 75 percent

for December 16, 1987; 75 percent for December

23, 1988; 75 percent for December 15, 1989; 70 cent for February 1, 1990; and 70 percent for December 30, 1990

per-Court’s Opinion: 30 percent DLOM for all valuation dates

Main Areas of Dispute: Magnitude of the discount for lack of marketability

Cite

T.C Memo 1995-255

Background

This is a gift tax case with valuation dates of December 31, 1986, December 16,

1987, December 23, 1988, December 15, 1989, February 1, 1990, and December

30, 1990 The Mandelbaum family was the sole shareholder The company, Big

M, was a privately held S corporation for all the gift dates except in 1986, when

it was a C corporation The company operates women’s apparel retail stores inNew York, New Jersey, Pennsylvania, Delaware, Maryland, and Virginia Big Mhad been in business since 1950 It operated 105 stores in 1986 and 122 in 1990.The company had total revenue of $145 million in 1986 and $261 million in1989

Both the taxpayer (Petitioner) and the IRS (Respondent) stipulated to the freelytraded or minority marketable values of the stock Both sides also agreed that a dis-count for lack of marketability was appropriate The sole remaining dispute wasover the magnitude of the discount

Addendum 325

Taxpayer _

1 Financial statement analysis

• Type of financial statement opinion (audit opinion)

• Soundness of company’s capitalization (strong capitalization)

• Ratio of the company’s assets to liabilities (solid asset-to-liability ratio)

• Company’s net worth and future earning power (substantial net worth, enue and earnings)

rev-• Quality of the company’s revenue and earnings (strong cash position)

• Company’s goodwill (recognized name)

Court’s opinion: Below-average marketability discount

2 Company’s dividend policy

• Big M’s low dividend payout ratio was not a factor since the company hadstrong earnings and sufficient cash The company could be more attractive as

a growth stock as opposed to an income stock

Court’s opinion: Below-average marketability discount

3 Nature of company, its history, its position in the industry, and its economic look

out-• Big M was not the leader in the industry

• Big M had diversified operations and was very profitable

• The company had a bright future

Court’s opinion: Below-average marketability discount

4 Company’s management

• Strong management team that was proven, experienced, and well known inindustry It tended to act in the best interest of the company, as opposed to itsown interests

Court’s opinion: Below-average marketability discount

5 Amount of control in transferred shares

• The court distinguished between minority and marketability discounts

• None of the gifts represented control

Court’s opinion: Average marketability discount

6 Restrictions on transferability of stock

• Buy/sell language within a shareholder agreement was agreed to be able and legal

enforce-• Since there was no formula or price in the agreement for the stock value, thecourt did not feel it was a major factor

• Restrictions (right of first refusal) were not severe enough to warrant a largediscount

• The court felt it would not limit the number of buyers but would only governthe order in which buyers must stand in line to buy the stock

Court’s opinion: Above-average to average marketability discount

7 Holding period for the stock

• The length of time to hold the stock was considered

• The court agreed that market risk tends to increase the longer the holdingperiod, thus decreasing marketability

• The taxpayer’s expert assumed a holding period of 10 to 20 years

• The IRS expert assumed a holding period of two years

• The court rejected both assumptions

Court’s opinion: Neutral marketability discount

8 Company’s redemption policy

• The court focused on a single stock redemption 12 to 16 years prior to ation dates

valu-• It felt an investor would look favorably on this

Court’s opinion: Below-average marketability discount

9 Costs associated with making a public offering

• The court felt that the discount would be affected by whether the buyer wouldbear the costs of registering the stock

Court’s opinion: Above-average to average marketability discount

These nine factors are presented as an example of using elements that tribute to or detract from marketability to arrive at a discount amount While the

con-Addendum 327

concept is solid, the selection of factors can be an issue It is important to select tors that are not already considered in the underlying valuation analysis so as toavoid “double counting.” For example, factors such as the quality of the financialstatement analysis, the nature of the company, and the quality of management mayalready be included in the calculation of the discount rate applied to the company’scash flow

fac-It may be better not to “score” or assign specific values to the factors that affectmarketability Most experts generally state that this factor or that factor will war-rant an above- or below-average marketability discount

Jane O Kosman v Comm.

Date of Opinion: March 11, 1996

Date of Valuation: September 30, 1986 and March 31, 1987

Type of Business: Banking

Name of Company: Kosman, Inc (Scottsbluff National Bank and Western

National Bank)Property Valued: Value of shares (52 percent) of common stock

IRS Value:

September 30, 1986 Voting stock $294/share; nonvoting stock $282/shareMarch 31, 1987 Voting stock $294/share; nonvoting stock $282/shareTaxpayer Value:

September 30, 1986 Voting stock $116.24/share; nonvoting stock

$100.74/shareMarch 31, 1987 Voting stock $131.76/share; nonvoting stock

$114.19/shareCourt’s Opinion:

September 30, 1986 Voting stock $164.85/share; nonvoting stock

$156.06/shareMarch 31, 1987 Voting stock $185.58/share; nonvoting stock

$175.69/shareMain Areas of Dispute: Discounts including minority interest, lack of mar-

ketability, and nonvoting stock Proper use of parable companies when using the market approach Multitiered or layered discounts

in 1986 Kosman, Inc., was the holding company that owned a 32 percent interest

in Scottsbluff National Corp., which owned 100 percent of Scottsbluff NationalBank (SNB), and a 10 percent interest in Western National Bank (WNB) Both sidesretained experts Grant Thornton valued the stock for the taxpayer Three expertsprepared a joint report for the IRS

Taxpayer’s Position

• Relied on prior transactions that approximated book value

• Looked at publicly traded bank holding companies that had operations inNebraska Rejected most of them due to size, geographical diversity, and loanportfolio

• Applied a 10 percent discount for minority interest, 25 percent for lack of ketability, and 10 percent for lack of voting power at the holding company level

mar-IRS Position

• Used a discounted cash flow approach with a 14 percent discount rate for SNBand 15 percent for WNB

• Projected after-tax earnings over five years Basis for discount rate was Standard

& Poor’s 500 small capitalized companies

• Used the public company market approach at 1.25 times book value for SNB

• Relied on out-of-state banks for comparables

• Applied a 15 percent minority discount and 10 percent lack-of-marketability count to the value of SNB

• Applied a 20 percent minority discount and 15 percent lack-of-marketability count to the value of WNB

dis-• Applied a 10 percent discount for minority interest, 10 percent for lack of ketability, and 4 percent for lack of voting power at the holding company level

mar-Court’s Opinion

• “Respondent’s experts estimated that shares of First National of Nebraska stocktraded at 86 percent of its book value per share on December 31, 1986 Theynoted that First National of Nebraska was larger, more diversified, more prof-itable, and had better income growth than Scottsbluff National Corp They saidthat the market would value Scottsbluff National Corp at a lower percentage ofbook value per share than First National of Nebraska Despite that conclusion,respondent’s experts estimated, using the market method that ScottsbluffNational Corp stock would sell at 125 percent of book value per share Theydid not explain this inconsistency.”

• The court addressed the use of out-of-state comparables: “Respondent’s expertsdid not adequately address whether economic conditions in those bank marketsand in northwestern Nebraska were similar.”

• The court felt that respondent’s experts’ use of a 14 percent discount rate forSNB did not recognize the economic outlook for SNB

• The court did not rely on prior sales of stock because “With one exception, thesales on which respondent relies involved former employees, directors, or theirfamilies The shareholders received higher prices for their shares because of theirassociation with the corporation.”

• The court put more weight on respondent’s experts’ use of the discounted cashflow method than their capitalization of earnings method

• Each side relied on various studies to determine discounts

• Applied 10 percent discount for minority interest, 15 percent for lack of ketability and 4 percent for lack of voting power at the holding company level