Providing
Expert
Guidance Since
1982
2010 Business
Valuation Workshop
Society of LCPAs
Presented by:
Vanessa Brown Claiborne
President & Chief Executive Officer
and
Riley Busenlener
Assistant Vice-President
Thursday, October 21, 2010
Table of Contents
I.
II.
Introduction
Lack of Marketability for Noncontrolling Ownership
Interests in Closely Held Businesses
A.
B.
C.
Restricted Stock Studies
Pre-Initial Public Offering Studies
Other Studies
III.
Lack of Marketability for Controlling Ownership
Interest in Closely Held Businesses
IV. Factors Affecting Lack of Marketability and Illiquidity
Discounts
V. Quantifying the Discount for Lack of Marketability
VI. Court Decisions on Discounts
VII. Questions
2
I. Introduction
• Marketability
– The capability and ease of transfer or salability of an
asset, business, business ownership interest, or security.
• Liquidity
– The degree to which an asset, business, business
ownership interest, or security can readily be converted
into cash without significant loss of principal.
– For noncurrent assets, liquidity generally refers to
marketability.
3
I. Introduction
• Lack of Marketability
– The principal economic factor causing a lack of marketability
(“LOM”) discount is the increase in risk caused by the inability to
quickly and efficiently return the investment to a cash position.
• More specifically, discounts are applied when valuing businesses
because of the extreme contrasts between the ability to sell closely
held business ownership interests as compared with publicly traded
stock.
– Discounts for noncontrolling business ownership interests tend to
range from 30 to 50% from their publicly traded counterparts,
while discounts for controlling interests generally range from 0 to
20%.
– Every valuation is unique and should be analyzed on the basis of
the individual facts and circumstances.
4
I. Introduction
"Levels of Value" Chart
$12.00 per share
Acquistion value
20% acquisition premium
$10.00 per share
Control value
25% control
premium
20% minority
interest discount
$8.00 per share
Minority marketable value
25% of $8
$6.00 per share
Restricted stock of public company
20% of $8
$4.40 per share
Private stock
Source: Business Valuation Resources, L.L.C., page 2-26
5
I. Introduction
• Levels of Ownership
100% ownership
Control
Interests
Ownership sufficient to liquidate, merge, etc.
Control
Interests
51% operating control
50% - 50% ownership
Less than 50%, but the largest block of stock ownership
Minority
Interests
Less than 50%, but with swing vote powers
Less than 50%, but with cumulative voting powers
Pure minority interests
Source: Hitchner, page 384
6
Minority
Interests
Table of Contents
I.
II.
Introduction
Lack of Marketability for Noncontrolling
Ownership Interests in Closely Held Businesses
A.
B.
C.
Restricted Stock Studies
Pre-Initial Public Offering Studies
Other Studies
III.
Lack of Marketability for Controlling Ownership
Interest in Closely Held Businesses
IV. Factors Affecting Lack of Marketability and Illiquidity
Discounts
V. Quantifying the Discount for Lack of Marketability
VI. Court Decisions on Discounts
VII. Questions
7
II. LOM for Noncontrolling Ownership Interests
• There are two types of empirical studies used to
quantify valuation adjustments associated with the
lack of marketability of noncontrolling ownership
interests in closely held businesses:
– Restricted Stock Studies
• Studies that measure the difference between the private price
of a restricted and the publicly traded stock price of the
security the same company.
– Pre-IPO Studies
• Studies based on the difference between the initial pubic
offering (IPO) price of a company and transactions in the same
company’s stock prior to the IPO.
8
Table of Contents
I.
II.
Introduction
Lack of Marketability for Noncontrolling
Ownership Interests in Closely Held Businesses
A.
B.
C.
Restricted Stock Studies
Pre-Initial Public Offering Studies
Other Studies
III.
Lack of Marketability for Controlling Ownership
Interest in Closely Held Businesses
IV. Factors Affecting Lack of Marketability and Illiquidity
Discounts
V. Quantifying the Discount for Lack of Marketability
VI. Court Decisions on Discounts
VII. Questions
9
II.A. Restricted Stock Studies
• Definition of restricted stocks
– Restricted stocks are stocks of public companies that
are restricted from public trading under SEC Rule 144.
– They are the same in all aspects as freely tradable
securities (dividends, voting rights, liquidation rights,
etc.).
– Although they cannot be sold on the open market, they
can be bought by qualified institutional investors. Thus
the restricted stock studies compare the price of a trade
in restricted shares of a public company with the public
market price on the same date.
10
II.A. Restricted Stock Studies
• Reasons for issuing restricted stock
– Consideration for acquisitions
– Private placements to raise capital
– Compensation
11
II.A. Restricted Stock Studies
• History of Restricted Stock Restrictions
– Until 1990, sales of restricted stocks were registered with the SEC,
and the minimum holding period was two years. Discounts
averaged 35%.
– In 1990, the SEC removed the requirement to register sales of
restricted stocks, which resulted in more trading of restricted
stocks (greater liquidity), and thus lower discounts, averaging in
the mid-20s.
– In 1997, the SEC lowered the minimum holding period for
restricted stocks from two years to one year. This resulted in a
further reduction in discounts for restricted stock trades. One
study had an average discount below 20%.
– The “dribble out” rule: Once the minimum holding period is up,
holders of restricted stock may ‘dribble out’ into the public market
a maximum of 1% of the shares outstanding or 1% of the trading
volume, whichever is greater, per quarter.
12
II.A. Restricted Stock Studies
• History of Restricted Stock Studies
– The history of restricted stock study discounts closely
reflects the history of restricted stock regulations.
• Up until 1990, most studies showed average discounts of about
33% to 35%.
• After 1990 (the year the SEC loosened restrictions), average
discounts dropped to the mid-20s.
• After 1997 (the year the SEC reduced the minimum-required
holding period from two years to one year), average discounts
dropped to the teens or low 20s.
13
II.A. Restricted Stock Studies
• SEC Institutional Investor Study (1966 – 1969)
– Analyzed the discount at which transactions in
restricted stock occurred compared with the prices of
identical but unrestricted stock on the open market.
– Study found that the size of discount is related to
degree of marketability of the traded shares, with
discounts lowest for NYSE companies, followed by
American Stock Exchange companies, OTC SEC
reporting companies, and then OTC non-reporting
companies.
– Average discount was 25.80% for all companies and
32.60% for non-reporting OTC companies
14
II.A. Restricted Stock Studies
• SEC Institutional Investor Study (continued)
– Subsequent to the SEC’s restricted stock study, the IRS
issued Revenue Ruling 77-287 to address the issue of
valuing restricted stocks.
• It was issued “to provide information and guidance to
taxpayers, Internal Revenue Service personnel, and others
concerned with the valuation, for Federal tax purposes, of
securities that cannot be immediately resold because they are
restricted from resale pursuant to Federal securities laws.”
• The Ruling specifically references the SEC Institutional
Investor Study.
15
II.A. Restricted Stock Studies
• Gelman Study (1968 - 1970)
– Milton Gelman studied the prices paid for restricted securities by
four closed-end investment companies specializing in restricted
securities investments.
– In 89 transactions between 1968 and 1970, Gelman found that:
• Both arithmetic average and median price discounts were 33%
• Almost 60% of the purchases were at price discounts of 30%
or higher
Gelman Study: Distribution of Price Discounts
Size of Discount
Less than 15.0%
15.0 - 19.9
20.0 - 24.9
25.0 - 29.9
30.0 - 34.9
35.0 - 39.9
40.0 and Over
Total
No. of Stocks
% of Total
5
9
13
9
12
9
32
89
6%
10%
15%
10%
13%
10%
36%
100%
Source: Milton Gelman, "An Economist-Financial Analyst's Approach to Valuing
Stock of a Closely Held Company," Journal of Taxation , June 1972, p. 354.
16
II.A. Restricted Stock Studies
• Trout Study (1968 – 1972)
– Robert Trout created a multiple regression model that
provided an estimate of the price discount appropriate
for a private company’s stock.
– Analyzed 60 letter stocks purchased by mutual funds
from 1668 to 1972.
– Found an average price discount of 33.45% for
restricted stock from freely traded stock.
– Companies listed on national exchanges had lower
discounts on their restricted stock transactions than did
companies with stock traded OTC.
17
II.A. Restricted Stock Studies
• Maroney Study (1969 – 1972)
– Robert E. Maroney analyzed prices paid in 146
transactions for restricted securities by 10 registered
investment companies.
– The range of discounts was from 10% to 90%.
– Average discount for the 146 transactions studied was
35.6% and the median discount was 33.0%
18
II.A. Restricted Stock Studies
• Maher Study (1969 – 1973)
– J. Michael Maher compared prices paid by mutual
funds for restricted stock with prices paid for their
unrestricted counterparts.
• The mean price discount was 35.43%.
– Maher further eliminated the top and bottom 10% of
purchases in an effort to remove especially high and
low risk situations.
• Results were almost identical with the outliers removed, with a
mean price discount of 34.73%.
19
II.A. Restricted Stock Studies
• Standard Research Consultants (1978 – 1982)
– Analyzed recent private placements of common stock
to test the SEC study.
– Studied 28 private placements of restricted common
stock.
• Price discounts ranged from 7 to 91%.
• Median discount was 45%.
20
II.A. Restricted Stock Studies
• Willamette Management Associates Study (1981 –
1984)
– Analyzed private placements of restricted stocks.
– Identified 33 “arm’s length” transactions in restricted
stock for which the price of the restricted shares could
be compared directly with the price of trades in
identical but unrestricted shares of the same company at
the same time.
• Median price discount was 31.2%.
– Depressed pricing the in the public stock market in the
early 1980’s was most likely the cause of the lower
average price discount.
21
II.A. Restricted Stock Studies
• Silber Study (1981 – 1988)
– William L. Silber studied 69 private placements of
common stock by publicly traded companies.
• Average price discount was 33.75%.
• Silber found that the size of the price discount tended to be
higher for private placements that were larger as a percentage
of the shares outstanding.
• Also found that the size of the company, as measured by
revenue, had small effect on the price discount.
22
II.A. Restricted Stock Studies
• FMV Opinions, Inc. Study (1980 – 1997)
– Examined over 243 restricted stock transactions.
• All transactions were prior to the Rule 144 amendment in 1997.
• The overall mean discount was 22.1% and the median discount was
20.1%.
• The standard deviation of the sample was 16.0%.
• The median discount for exchange traded securities was 15.3%.
• The median discount for over-the-counter traded securities was
22.4%.
– FMV also analyzed the 243 transactions by SIC code.
• Study concluded that industry is not especially important in
determining discounts.
• Size, risk,and liquidity are the most important determinants of the
discount for the LOM.
23
II.A. Restricted Stock Studies
• FMV Opinions, Inc. (continued)
– FMV Opinions recently introduced The FMV DLOM
Calculator at BVMarketData.com.
• The Calculator utilizes data in The FMV Restricted Stock
Study and applies the same methodology FMV Opinions uses
in-house to calculate the discount for LOM.
• Based on a variety of financial metrics of the appraiser’s
subject company, the Calculator streamlines the process for
determining a discount for lack of marketability by automating
the comparative analysis with restricted stock issuers and
adjusting for market volatility and the additional illiquidity of
private company stock.
• The Calculator also allows users to inflation-adjust all
underlying restricted stock data.
24
II.A. Restricted Stock Studies
• Management Planning, Inc. Study (1980 – 1986)
– Compared the prices paid in 53 private placements of
restricted stock with the same company’s freely traded,
stock market price.
•
•
•
•
Average lack of marketability discount was 27%.
Median lack of marketability discount was 25%.
Discounts ranged from 0% to 58%.
There was a clear size effect with smaller companies having
larger discounts.
– Average discount for companies with revenues under $10 million
was 32.9%.
25
II.A. Restricted Stock Studies
• Management Planning, Inc. Study (continued)
Management Planning Study: Analysis of Restricted Stock Discounts by Revenue Size
Percent of
Sample
Average
Revenues ($
Millions)
Average
Discounts
Standard
Deviations
Under $10 million
28.6%
6.6
32.9%
15.6%
2.8%
57.6%
$10 - $30 million
22.4%
22.5
30.8%
11.2%
15.3%
49.8%
$30 - $50 million
20.4%
33.5
25.2%
15.1%
5.2%
46.3%
$50 - $100 million
16.3%
63.5
19.4%
7.3%
11.6%
29.3%
Over $100 million (adjusted)*
8.2%
224.9
14.9%
10.5%
0.0%
24.1%
Overall sample averages
95.9%
47.5
27.7%
14.1%
0.0%
57.6%
Over $100 million (actual calculation)*
4.1%
187.1
25.1%
17.9%
0.0%
46.5%
Revenues
Range of Discounts
Low
High
NOTE: Excludes Sudbury Holdings, Inc., whose private placement consisted of 125% of the pre-transaction shares outstanding. Excludes Starrett housing Corp.
which is one of the five most thinly tranded companies in the sample.
26
II.A. Restricted Stock Studies
• Johnson Study (1991 – 1995)
– Bruce Johnson studied 72 private placement
transactions during the first half-decade after the Rule
144 restrictions were relaxed.
• Average price discount of 20%.
• Results ranged from a 10% premium to a 60% discount.
27
II.A. Restricted Stock Studies
• Johnson Study (continued)
– Johnson analyzed four factors that influenced the size
of the discount:(1) positive net income, (2) sales
volume, (3) transaction value, and (4) net income
strength.
Johnson Study
Total Net
Income
Average
Discount
Total Sales
Average
Discount
Transaction
Size
Average
Discount
Net Income
Margin
Average
Discount
Negative
22.5%
$0 to $10M
23.5%
$0 to $5M
26.7%
Negative
22.5%
$0 to $1M
26.0%
$10M to $50M
19.4%
$5M to $10M
20.9%
0% to 5%
23.7%
$1M to $10M
18.1%
$50M to $200M
17.7%
$10M to $25M
17.0%
5% to 10%
15.2%
Over $10M
6.3%
Over $200M
13.0%
Over $25M
10.8%
Over 10%
11.6%
Source: Bruce A. Johnson, "Quantitative Support for Discounts for Lack of Marketability," Business Valuation Review , December 1999, pp. 152-55.
28
II.A. Restricted Stock Studies
•
Columbia Financial Advisors Study (1996-1997
& 1997-1998)
– Study was divided into two parts:
1. Examined only private equity placements from January 1,
1996, through April 30, 1997 (before the reduction in the
Rule 144 holding period).
2. Examined only private common equity placements from May
1, 1997, through December 31, 1998 (after the one-year
holding period became effective on April 29, 1997).
Number of Transactions
Average Discount
Median Discount
Highest Discount
Lowest Discount
Earlier Period
Later Period
23
21%
14%
67.5%
0.8%
15
13%
9%
30.0%
0.0%
29
II.A. Restricted Stock Studies
Summary of Restricted Stock Studies
Years Covered
in Study
Average Price
Discount
Prior to 1990
SEC Institutional Investor Study
All Companies
Nonreporting OTC Companies
Milton Gelman
Robert Trout
Robert E. Moroney
J. Michael Maher
Standard Research Consultants*
Willamette Management Associates*
William L. Silber
1966-1969
1966-1969
1968-1970
1968-1972
1969-1972
1969-1973
1978-1982
1981-1984
1981-1988
25.80%
32.60%
33.00%
33.45%
35.60%
35.43%
45.00%
31.20%
33.75%
After 1990
FMV Study
Management Planning Study
Johnson Study
Columbia Financial Advisors Study
1980-1997
1980-1996
1991-1995
1996-1997
22.10%
27.00%
20.00%
21.00%
After April 29, 1997
Columbia Financial Advisors Study
1997-1998
13.00%
Average Discount
30.46%
Study Reference
* Median discount
30
II.A. Restricted Stock Studies
• Implications for using restricted stock study data as
guidance to quantify lack of marketability discounts for
closely held minority interests (BVR 2008 ed., page 1-4):
– Only restricted stock studies prior to 1990 are relevant for
estimating average discounts for marketability for closely held
company interests.
– The post-1990 restricted stock studies are still relevant for
identifying factors that impact the differential level of the discounts
for lack of marketability.
– Because of the “dribble out” rule, blocks of restricted stock that
constitute the largest percentage of the shares outstanding are most
relevant for comparison with closely help stock valuations.
31
Table of Contents
I.
II.
Introduction
Lack of Marketability for Noncontrolling
Ownership Interests in Closely Held Businesses
A.
B.
C.
Restricted Stock Studies
Pre-Initial Public Offering Studies
Other Studies
III.
Lack of Marketability for Controlling Ownership
Interest in Closely Held Businesses
IV. Factors Affecting Lack of Marketability and Illiquidity
Discounts
V. Quantifying the Discount for Lack of Marketability
VI. Court Decisions on Discounts
VII. Questions
32
II.B. Pre-IPO Studies
• Definition of a pre-IPO transaction
– A pre-IPO transaction is a transaction involving a
private company stock prior to an Initial Public
Offering (IPO).
• Pre-IPO studies
– Pre-IPO studies compare the price of the private stock
transaction with the public offering price. The
percentage below the public offering price at which the
private transaction occurred is a proxy for the discount
for lack of marketability.
33
II.B. Pre-IPO Studies
• Robert W. Baird & Company Studies (1980 –
2000)
– Eight studies conducted by John D. Emory.
– Studied IPOs in which Baird & Company either
participated or received prospectuses.
– Analyzed IPOs to determine the relationships between:
• the price at which the stock was initially offered to the public;
and,
• the price at which the latest private transaction occurred up to
five months prior to the IPO.
– The mean price discount for all nine studies (363
transactions) was 47%, and the median discount was
44%.
34
II.B. Pre-IPO Studies
• Robert W. Baird & Company Studies (continued)
Robert W. Baird & Company Studies: The Value of Marketability as Illustrated in IPO's
Number of IPO
Number of
Median
Study
Prospectuses
Qualifying
Mean Discount
Discount
Reviewed
Transactions
1997 - 2000*
92
53
54%
54%
1995 -1997
732
91
43%
42%
1994 -1995
318
46
45%
45%
1991 -1993
443
54
45%
44%
1990 -1992
266
35
42%
40%
1989 -1990
157
23
45%
40%
1987 -1989
98
27
45%
45%
1985 - 1986
130
21
43%
43%
1980 - 1981
97
13
60%
66%
2,333
363
47%
44%
All 9 Studies
*1997-2000 study was for dot.com companies - not comparable to other studies.
Source: John D. Emory, "The Value of Marketability as Illustrated in Initial Public Offerings of Common Stock (Eighth in a Series)
November 1995 through April 1997," Business Valuation Review , vol.16, no. 3 (September 1997): 125; John D. Emory Sr., F.R.
Dengel, III and John D, Emory Jr., "The Value of Marketability as Illustrated in Dot.com IPOs: May 1997 - March 2000, Business
Valuation Update , vol. 6, no. 7 (July 2000): 1-2. Emory Business Valuation, LLC.
35
II.B. Pre-IPO Studies
• Robert W. Baird & Company Studies (continued)
Robert W. Baird & Company Studies
Discounts versus Time between Transactions and IPO
Median
No. of
Days
Mean Discount
Disount
Transactions
0 - 30
30%
25%
18
31 - 60
40%
38%
72
61 - 90
42%
43%
162
91 - 120
49%
50%
161
121 - 153
55%
54%
130
Total
543
Source: Emory, John D. Sr., F.R. Dengel III, and John D. Emory Jr., "Discounts for
Lack of Marketability Emory Pre-IPO Studies 1980-2000 as Adjusted October 10,
2002," Business Valuation Review (December 2002), pp. 190-91; Business Valuation
Resources , Vol. 9, No. 4, April 2003, p. 3.
36
II.B. Pre-IPO Studies
• Willamette Management Associates Studies (1975
– 2000)
– Studied prices of private stock transactions relative to
those of subsequent offerings of stock of the same
companies.
– Source documents were SEC registration statements
(Form S-1 & Form S-18)
– Attempted to include only transactions that were on an
arm’s length basis.
– Transactions analyzed took place from 1 to 36 months
before IPO.
37
II.B. Pre-IPO Studies
• Willamette Management Associates Studies
(continued)
– Compared P/E multiple of each private transaction with
the subsequent public offering P/E multiple.
• Companies that had no meaningful earnings were eliminated.
• P/E multiples were adjusted for differenced in the industry aver
P/E multiple between the time of the private transaction and
the public offering.
38
II.B. Pre-IPO Studies
• Willamette Management Associates Studies
(continued)
– Formula used to derive the discount for the private
transaction price from the public offering price:
(P/Eo – P/Ep ((IP/Eo)/(IP/Ep))) / (P/Eo)
P/Eo = Price per share of the public offering
P/Ep = Price per share of the private transaction
IP/Eo = Industry price index at time of offering
IP/Ep = Industry price index at time of private transaction
– Between 1975 and 1997, studies found mean discounts
that ranged from 28.9% (1991) to 56.8% (1979), and
median discounts that ranged from 31.8% (1991) to
73.1% (1984).
39
II.B. Pre-IPO Studies
• Willamette Management Associates Studies
(continued)
– Criticisms
• The results are impossible to verify because Willamette
Management will not provide data or calculations.
• There is a self-selection bias in the determination of
“qualifying transactions,” resulting in an overestimation of the
discount for lack of marketability by excluding “troubled”
companies.
• Impossible to know if all transactions were at arm’s-length.
40
II.B. Pre-IPO Studies
• Valuation Advisors (1999 – 2006)
– Analyzed transactions by length of time that the private transaction
occurred prior to the IPO.
•
•
•
•
•
1-90 days prior
91-180 days prior
181-270 days prior
271-365 days prior
1-2 years prior
– No adjustments.
– Findings support the hypothesis that the holding period is a major
factor affecting the magnitude of the discount for LOM.
– Valuation Advisors maintains a Pre-IPO LOM database that is
updated monthly. The database has over 3,900 transactions. A
license to use the database can be purchased on the company’s
website.
41
II.B. Pre-IPO Studies
Valuation Advisors' Study: Transaction Summary Results by Year from 1999-2006
Time of Transactions
1-90 Days
91-180 Days
181-270 Days 271-365 Days
Before IPO
1999 Results
Number of Transations
Median Discount
2000 Results
Number of Transations
Median Discount
2001 Results
Number of Transations
Median Discount
2002 Results
Number of Transations
Median Discount
2003 Results
Number of Transations
Median Discount
2004 Results
Number of Transations
Median Discount
2005 Results
Number of Transations
Median Discount
2006 Results
Number of Transations
Median Discount
1999-2006 Results
Number of Transations
Median Discount
1-2 Years
148
30.8%
174
53.9%
103
75.0%
91
76.9%
174
82.0%
129
28.7%
176
45.1%
116
61.5%
91
68.9%
141
76.6%
15
14.7%
17
33.2%
18
33.4%
17
52.1%
48
51.6%
9
6.2%
13
17.3%
7
21.9%
16
39.5%
36
55.0%
12
28.8%
22
22.3%
24
38.4%
21
39.7%
44
61.4%
37
16.7%
74
22.7%
63
40.0%
59
56.3%
101
57.9%
18
14.8%
59
26.1%
58
41.7%
62
46.1%
99
45.5%
25
20.7%
76
20.8%
69
40.2%
72
46.9%
106
57.2%
393
27.3%
611
37.5%
458
51.9%
429
61.7%
749
68.0%
Source: The Valuation Advisors' Discount for Lack of Marketability Database .
42
Table of Contents
I.
II.
Introduction
Lack of Marketability for Noncontrolling
Ownership Interests in Closely Held Businesses
A.
B.
C.
Restricted Stock Studies
Pre-Initial Public Offering Studies
Other Studies
III.
Lack of Marketability for Controlling Ownership
Interest in Closely Held Businesses
IV. Factors Affecting Lack of Marketability and Illiquidity
Discounts
V. Quantifying the Discount for Lack of Marketability
VI. Court Decisions on Discounts
VII. Questions
43
II.C. Other Studies
• D.B.H. Chaffe III Study (1993)
– Mr. Chaffe, founder of Chaffe & Associates, estimated
the cost of a put option as a proxy for measuring
discounts for marketability, saying that the purchase of
a put option, in effect, equated to the purchase of
marketability.
– He used the Black-Scholes pricing model to determine
the amount of a marketability discount.
• Found that the European option, which is exercisable only at
the end of the option period, was an appropriate model for the
SEC Rule 144 holding period of restricted shares.
• The study supports a discount between 28% and 41% where
restrictions on the put option lapse in two years or less.
• At a four-year period, the range is 32% to 49%.
44
II.C. Other Studies
• Ronald Seaman’s LEAPS Study (2006, 2008)
– LEAPS: Long-Term Equity Anticipation Securities
• Exchanged listed options that grant the holder of the option the
right, but not the obligation, to buy, in the case of a call, or to
sell, in the case of a put, a specified amount of the underlying
asset at a predetermined price on or before a given date.
• A form of insurance against price fluctuations in publicly
traded stocks.
• Cost of a LEAPS put option, expressed as a percentage of the
price of the stock, measures the cost of price protection against
a loss in value.
• Objective of the study (conducted in 2006 and again in 2008)
was to determine what factors influenced the costs of price
protection (or the size of discounts for LOM).
45
II.C. Other Studies
• Ronald Seaman’s LEAPS Study (continued)
– Findings
• Discounts change over time and are not constant in size.
– Median discount for companies in 2006 study was 14.9% for the
18-month LEAPS put option and 17.4% for the 30-month option,
an increase of 3.5%.
– In the 2008 study, the median discount for all companies
increased to 33.5% for the 14-month option and 40.6% for the
26-month option, an increase of 7.2%.
• Discounts vary by industry and company size. The smaller the
company, in revenues or assets, the larger the discount.
• The greater the risk, as measured by the company’s beta, the
greater the discount.
– Discount for LOM analysis should be valuation date
specific.
46
II.C. Other Studies
• Christopher Mercer’s Quantitative Marketability Discount
Model (QMDM)
– Introduced in 1994, the QMDM is a shareholder-level discounted
cash flow model that is designed to help the valuation expert
determine an appropriate marketability discount based on the
investment characteristics of each subject illiquid interest of a
closely held enterprise.
– To use the QMDM, the appraiser must make the the following
assumptions:
DCF Assumptions
Forecast Period
Corresponding QMDM Assumptions
Empirical Study X
Projected Interim Cash Flows (during forecast
period)
Expected Distribution / Dividend Yield
Expected Growth in Distributions / Dividends
Timing (Mid-Year or End of Year)
Projected Terminal Value (at end of forecast
period)
Growth in Value over Holding Period
Premium or Discount to Marketable Value
Discount Rate
Range of Required Holding Period Returns
Source: BVR 2008 ed., page 3-16
47
Table of Contents
I.
II.
Introduction
Lack of Marketability for Noncontrolling Ownership
Interests in Closely Held Businesses
A.
B.
C.
Restricted Stock Studies
Pre-Initial Public Offering Studies
Other Studies
III. Lack of Marketability for Controlling Ownership
Interest in Closely Held Businesses
IV. Factors Affecting Lack of Marketability and Illiquidity
Discounts
V. Quantifying the Discount for Lack of Marketability
VI. Court Decisions on Discounts
VII. Questions
48
III. LOM for Controlling Ownership Interests
• In federal estate tax cases and marital property
cases it is often necessary to agree on the cash
equivalent value for a controlling business
ownership interest.
• The courts have used language such as the
following:
– “Even controlling shares in a nonpublic corporations
suffer from lack of marketability because of the absence
of a ready private placement market and the fact that
flotation costs would have to be incurred if the
corporation were to publicly offer its stock.” (Pratt,
page 440)
49
III. LOM for Controlling Ownership Interests
• Illiquidity Factors Affecting Controlling
Ownership Interests
– Unlike the owner of publicly traded securities, the
owner of a controlling ownership interest in a closely
help business cannot:
• call a securities broker,
• sell that ownership interest in seconds at a predetermined price
and with a nominal transaction commission, and
• realize the cash proceeds of the same in three business days.
50
III. LOM for Controlling Ownership Interests
• The controlling owner of a closely held business
who wishes to liquidate his or her controlling
ownership interest faces the following transactions
considerations:
–
–
–
–
–
Uncertain time horizon to complete the offering or sale.
Cost to prepare for and execute the offering or sale.
Risk concerning eventual sale price.
Noncash and deferred transaction proceeds.
Inability to hypothecate.
51
III. LOM for Controlling Ownership Interests
Historically the
average P/E
multiple for the
acquisitions of
private
companies has
been
significantly
lower than the
average P/E
multiple for the
acquisition of
public
companies.
Median P/E* Offered Public versus Private 1990 - 2009
Acquisitions of Public Companies
Acquisitions of Private Companies
Year
Median P/E
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
17.1
15.9
18.1
19.7
19.8
19.4
21.7
25.0
24.0
21.7
18.0
16.7
19.7
21.2
22.6
24.4
23.7
24.9
22.1
18.1
No. of transactions
reporting P/E
117
93
89
113
184
239
288
389
362
434
379
261
161
198
188
230
294
300
130
98
* Excludes negative P/E multiples and P/E multiples larger than 100.
Source: Mergerstat Review, www.mergerstat.com.
52
Median P/E
13.2
8.5
17.6
22.0
22.0
15.5
17.7
17.0
16.0
18.4
16.0
15.3
16.6
19.4
19.0
16.9
21.4
21.6
10.6
18.4
No. of transactions
reporting P/E
36
23
15
14
18
16
31
83
207
174
130
80
83
107
108
127
65
64
51
22
III. LOM for Controlling Ownership Interests
• There are a number of possible reasons for this
consistent and significant acquisition pricing
differential:
– Exposure to the market
– The quality of financial accounting and other
information
– The size effect
53
Table of Contents
I.
II.
Introduction
Lack of Marketability for Noncontrolling Ownership
Interests in Closely Held Businesses
A.
B.
C.
Restricted Stock Studies
Pre-Initial Public Offering Studies
Other Studies
III.
Lack of Marketability for Controlling Ownership
Interest in Closely Held Businesses
IV. Factors Affecting Lack of Marketability and
Illiquidity Discounts
V. Quantifying the Discount for Lack of Marketability
VI. Court Decisions on Discounts
VII. Questions
54
IV. Factors Affecting LOM and Illiquidity Discounts
• The following are some of the factors that affect
the degree of marketability (Pratt, page 446):
–
–
–
–
–
–
–
–
“Put” Rights
Dividend Payments
Potential Buyers
Size of Interest
Prospect of Public Offering or Sale of the Business
Information Access and Reliability
Restrictive Transfer Provisions
Company Characteristics: Size, Performance, and Risk
55
IV. Factors Affecting LOM and Illiquidity Discounts
• “Put” Rights
– Most powerful factor that could reduce or eliminate a
discount for lack of marketability.
– A put is a contractual right that entitles the holder, at his
or her option, to sell the ownership interest to a
specified party at some time or under some specified
circumstances, at the price specified in the contract.
– A put guarantees a market under specified
circumstances.
56
IV. Factors Affecting LOM and Illiquidity Discounts
• Dividend Payments
– Stocks with no or low dividends suffer more from lack
of marketability than stocks with high dividends.
– If stock pays no dividend, the holder is dependent
entirely on the future ability to sell the stock to realize
any return.
– The higher the dividend, the greater the return the
holder realizes without regard for sale of the stock.
– Dividend-paying preferred stocks typically have a
lower discount for lack of marketability than nondividend-paying common stocks.
57
IV. Factors Affecting LOM and Illiquidity Discounts
• Potential Buyers
– The existence of several potential buyers or even one
strong potential buyer could reduce the discounts for
lack of marketability.
• Size of Interest
– Larger blocks tend to have larger discounts for
marketability than do smaller blocks.
• The larger the block, the fewer potential buyers.
• More difficult to finance a large block transaction.
58
IV. Factors Affecting LOM and Illiquidity Discounts
• Prospect of Public Offering or Sale of the Business
– An imminent public offering or sale of the business
could decrease the discount for lack of marketability.
• However, these occurrences are almost never certain.
• Additionally, it is difficult to quantify the discount due to this
particular factor because much of the empirical evidence that
illustrates the discount is taken from companies that
subsequently went public.
– A business being committed to remaining private and in
the hands of current control owners for the foreseeable
future would tend to increase the discount for lack of
marketability.
59
IV. Factors Affecting LOM and Illiquidity Discounts
• Information Access and Reliability
– The degree to which information is made available to
noncontrolling equity owners and the reliability of that
information affects the discount for lack of
marketability.
• “An important basis for for illiquidity discounts is the
difficulty faced by prospective purchasers in obtaining
information.” (Pratt, page 447)
• Restrictive Transfer Provisions
– Any provision that limits the right of the holder to
transfer the stock would tend to increase the amount of
the discount for lack of marketability.
60
IV. Factors Affecting LOM and Illiquidity Discounts
• Company Characteristics: Size, Performance, and
Risk
– Companies with a history of losses and high leverage
tend to issue shares at higher discounts than companies
with more stable financial conditions.
– Discounts tend to be larger for companies with:
• High stock price volatility
• Unstable earnings
• A reliance on a speculative or unproven product line
– Smaller companies tend to have larger discounts.
61
Table of Contents
I.
II.
Introduction
Lack of Marketability for Noncontrolling Ownership
Interests in Closely Held Businesses
A.
B.
C.
Restricted Stock Studies
Pre-Initial Public Offering Studies
Other Studies
III.
Lack of Marketability for Controlling Ownership
Interest in Closely Held Businesses
IV. Factors Affecting Lack of Marketability and Illiquidity
Discounts
V. Quantifying the Discount for Lack of Marketability
VI. Court Decisions on Discounts
VII. Questions
62
V. Quantifying the Discount for LOM
• Determining the LOM discount to be applied to
closely held securities by reference to empirical
studies and/or prior cases requires careful scrutiny
of the studies/cases to ensure that they are
appropriate for the particular valuation.
• The particular facts and circumstances of the
subject company are the most important
determinant of discounts.
• A thorough understanding of the subject company
and the underlying data used in empirical studies
and/or prior cases are important for defensible
valuation conclusions.
63
V. Quantifying the Discount for LOM
Calculation of the Lack of Marketability Discount based on the
Evaluation of Individual Factors Affecting Marketability
Marketability Adjustment Factors
Warrants
an Above
Average
Discount
Warrants
an
Average
Discount
Warrants
a Below
Average
Discount
35%
35%
35%
+
+
+
+
+
+
+
+
+
+
+
+
+
No Change
-
> 35%
35%
< 35%
Starting Point
History and Outlook
Financial Factors
Management
Holding Period
Redemption Policy
Transfer of Control
Restrictions on Transfer
Cash Distribution Policy
Information Access and Reliability
Cost of Public Offering
Other Factor 1
Other Factor 2
Other Factor 3, etc.
Ending Point
Source: Hitchner, page 425
64
Table of Contents
I.
II.
Introduction
Lack of Marketability for Noncontrolling Ownership
Interests in Closely Held Businesses
A.
B.
C.
Restricted Stock Studies
Pre-Initial Public Offering Studies
Other Studies
III.
Lack of Marketability for Controlling Ownership
Interest in Closely Held Businesses
IV. Factors Affecting Lack of Marketability and Illiquidity
Discounts
V. Quantifying the Discount for Lack of Marketability
VI. Court Decisions on Discounts
VII. Questions
65
VI. Court Decisions on Discounts
• There is a substantial amount of precedent related
to the lack of marketability discounts with respect
to federal gift taxes, estate taxes, and income
taxes.
• The topics of illiquidity and lack of marketability
arise in many other litigation contexts, including
shareholder disputes, marital dissolution cases,
and damages matters.
66
VI. Court Decisions on Discounts
• Bernard Mandelbaum, et al. v. Commissioner Reviews Lack of
Marketability Factors
– The case involved the valuation of minority blocks of Big M, Inc., a
closely held chain of women’s apparel retail stores, for gif tax
purposes.
– Court cited nine factors to be considered when selecting a discount for
lack of marketability.
• Financial Statement Analysis
• Company’s Dividend Policy
• The Nature of the Company, Its History, Its Position in the Industry, and
Its Economic Outlook
• Company’s Management
• Amount of Control in Transferred Shares
• Restrictions of Transferability of Stock
• Holding Period for Stock
• Company’s Redemption Policy
• Costs Associated with Making a Public Offering
67
VI. Court Decisions on Discounts
• Estate of Barge v. Commissioner Considers Lack
of Marketability Factors
– Factors considered by the Tax Court when reviewing
the lack of marketability discount:
•
•
•
•
•
Base Value
Expected Holding Period
Expected Growth Rate of Value
Expected Dividends or Distributions
Required Holding Period Return
68
VI. Court Decisions on Discounts
• Okerlund v. United States Approves Pre-IPO
Studies
– Court of Federal Claims case (IRS v. tax-payer)
– To support discounts for lack of marketability on two
valuation dates, both parties’ experts used data that
relied on restricted stock studies and pre-IPO studies.
• Although the data were similar, there was a 15% gap between
the respective experts’ discount for LOM conclusions for both
dates (30% for the IRS, 45% for the tax-payer)
69
VI. Court Decisions on Discounts
• Okerlund v. United States Approves Pre-IPO Studies
(continued)
– The Court found that the tax-payer expert’s analysis was more
detailed and persuasive and thus concluded a 40% discount for
LOM for one date and 45% for the other.
– The Court commended tax-payer’s experts for emphasizing the
pre-IPO studies. The Court said:
• “According to Dr. Pratt (the tax-payer’s expert), the discounts
observed in restricted stock studies reflect the existence of a public
market for the stock once the temporary restrictions lapse. For a
variety or reasons, … purchasers of restricted stock ‘generally expect
to be able to resell the stock in the public market in the foreseeable
future.’ Pre-IPO discounts, on the other hand, are based on purely
private transactions before a company enters the public market, a
situation more comparable to closely held companies.”
70
VI. Court Decisions on Discounts
• McCord v. Commissioner
– Tax-payer's expert claimed that a 35% marketability
discount was appropriate based on his analysis of the
following restricted stock studies:
• Silber study
• Standard Research Consultants study
• Hertzel & Smith study
– The expert also testifies that pre-IPO studies, including
the Willamette Management Associates study and the
Emory studies, supported this discount.
– The Court rejected the pre-IPO studies and identified
several flaws in the reasoning and methodology used in
the tax-payer’s expert’s restricted stock study analysis.
71
VI. Court Decisions on Discounts
• McCord v. Commissioner (continued)
– The IRS expert determined a 7% discount based on the
expert’s own study of 88 private placements (the “Bajaj
study”).
– The Tax Court found that of the 88 private placements,
only the 29 middle placements were useful.
• Using these, the Court concluded a 20% discount for LOM.
– There was no rebuttal to the IRS’ discount for LOM
evidence in this case.
72
VI. Court Decisions on Discounts
• Howard v. Shay Upholds 50% discount for LOM
– Appraiser applied a 50% discount for LOM on the sale of a block
of ESOP stock constituting about 38% of the outstanding stock.
– This discount reflected the facts that:
• The company’s stock was not publicly traded, and
• the ESOP plan participants did not have the right to “put” the stock to
the company.
– In successfully defending the suit brought by beneficiaries for
alleged undervaluation, the appraiser used the Willamette pre-IPO
database, isolating transactions constituting 25% to 49.9% of the
outstanding stock.
– This case resulted in the largest discount for LOM that a court has
ever accepted.
73
VI. Court Decisions on Discounts
• Summary
– Many recent court decisions have failed to reflect the
full impact of lack of marketability, due primarily to
weak evidence presented.
– The levels of discounts allowed in most judicial
decisions still seem to be below what the empirical
evidence related to arm’s-length transactions tend to
suggest.
74
VII. Questions
Questions?
Vanessa Brown Claiborne
Riley Busenlener
President & Chief Executive Officer
vbrown@chaffe-associates.com
Assistant Vice-President
riley@chaffe-associates.com
Chaffe & Associates, Inc.
Tel: (504) 524-1801
Fax: (504) 524-7194
201 St. Charles Ave. Suite 1410
New Orleans, LA 70170
75
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Review (December 1993).
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April 1997," Business Valuation Review, Vol.16, No. 3 (September 1997): 125.
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Business Valuation Update, Vol. 6, No. 7 (July 2000): 1-2. Emory Business Valuation, LLC.
Emory, John D. Sr., F.R. Dengel III, and John D. Emory Jr. "Discounts for Lack of Marketability Emory Pre-IPO Studies 1980-2000 as Adjusted
October 10, 2002," Business Valuation Review (December 2002), pp. 190-91; Business Valuation Resources, Vol. 9, No. 4, April 2003, 3.
Gelman, Milton. "An Economist-Financial Analyst's Approach to Valuing Stock of a Closely Held Company," Journal of Taxation, June 1972, 354.
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Johnson, Bruce A. "Quantitative Support for Discounts for Lack of Marketability," Business Valuation Review, December 1999, 152-55.
Mergerstat Review 2010. (Newark: FactSet Mergerstat, LLC, 2010) www.mergerstat.com.
Pratt, Shannon P., Alina V. Niculita. Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th ed. (New York: McGraw-Hill,
Inc., 2008)
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The Valuation Advisors' Discount for Lack of Marketability Database.
76