Providing Expert Guidance Since 1982 2010 Business Valuation Workshop Society of LCPAs Presented by: Vanessa Brown Claiborne President & Chief Executive.

Providing Expert

Guidance Since 1982

2010 Business Valuation Workshop

Society of LCPAs

Presented by:

Vanessa Brown Claiborne President & Chief Executive Officer

and

Riley BusenlenerAssistant Vice-President

Thursday, October 21, 2010

http://www.poetproductions.com/

http://www.poetproductions.com/

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Table of Contents

I. IntroductionII. Lack of Marketability for Noncontrolling Ownership

Interests in Closely Held BusinessesA. Restricted Stock StudiesB. Pre-Initial Public Offering StudiesC. 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 MarketabilityVI. Court Decisions on DiscountsVII. Questions

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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.

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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.

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I. Introduction

"Levels of Value" Chart

25% of $8

20% of $8

Source: Business Valuation Resources, L.L.C., page 2-26

$12.00 per share

$8.00 per share

$6.00 per share

$4.40 per share

Acquistion value

Control value

Minority marketable value

Restricted stock of public company

Private stock

20% acquisition premium

20% minority interest discount

25% control premium

$10.00 per share

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I. Introduction

• Levels of Ownership

Source: Hitchner, page 384

51% operating control

50% - 50% ownership

Control Interests

Minority Interests

Control Interests

Minority Interests

Less than 50%, but the largest block of stock ownership

Less than 50%, but with swing vote powers

Less than 50%, but with cumulative voting powers

Pure minority interests

100% ownership

Ownership sufficient to liquidate, merge, etc.

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Table of Contents

I. IntroductionII. Lack of Marketability for Noncontrolling

Ownership Interests in Closely Held BusinessesA. Restricted Stock StudiesB. Pre-Initial Public Offering StudiesC. Other Studies




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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.

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10

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.

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• Reasons for issuing restricted stock– Consideration for acquisitions

– Private placements to raise capital

– Compensation

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• 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.

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• 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.

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• 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

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• 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.

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• 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

Size of Discount No. of Stocks % of TotalLess than 15.0% 5 6%15.0 - 19.9 9 10%20.0 - 24.9 13 15%25.0 - 29.9 9 10%30.0 - 34.9 12 13%35.0 - 39.9 9 10%40.0 and Over 32 36%Total 89 100%

Gelman Study: Distribution of Price Discounts

Source: Milton Gelman, "An Economist-Financial Analyst's Approach to Valuing Stock of a Closely Held Company," Journal of Taxation , June 1972, p. 354.

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• 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.

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• 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%

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• 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%.

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• 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%.

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• 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.

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• 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.

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• 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.

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• 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.

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• 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%.

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• Management Planning, Inc. Study (continued)

Low High

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%

Management Planning Study: Analysis of Restricted Stock Discounts by Revenue Size

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.

Average Discounts

Standard Deviations

Average Revenues ($

Millions)

Percent of Sample

RevenuesRange of Discounts

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• 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.

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• 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.

Total Net Income

Average Discount

Total SalesAverage 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.

Johnson Study

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• 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).

Earlier Period Later PeriodNumber of Transactions 23 15Average Discount 21% 13%Median Discount 14% 9%Highest Discount 67.5% 30.0%Lowest Discount 0.8% 0.0%

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Study ReferenceYears Covered

in StudyAverage Price

Discount

Prior to 1990SEC Institutional Investor Study All Companies 1966-1969 25.80% Nonreporting OTC Companies 1966-1969 32.60%Milton Gelman 1968-1970 33.00%Robert Trout 1968-1972 33.45%Robert E. Moroney 1969-1972 35.60%J. Michael Maher 1969-1973 35.43%Standard Research Consultants* 1978-1982 45.00%Willamette Management Associates* 1981-1984 31.20%William L. Silber 1981-1988 33.75%

After 1990FMV Study 1980-1997 22.10%Management Planning Study 1980-1996 27.00%Johnson Study 1991-1995 20.00%Columbia Financial Advisors Study 1996-1997 21.00%

After April 29, 1997Columbia Financial Advisors Study 1997-1998 13.00%

Average Discount 30.46%

* Median discount

Summary of Restricted Stock Studies

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• 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.

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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.

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• 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%.

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• Robert W. Baird & Company Studies (continued)

StudyNumber of IPO Prospectuses

Reviewed

Number of Qualifying

TransactionsMean Discount

Median Discount

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%

All 9 Studies 2,333 363 47% 44%

Robert W. Baird & Company Studies: The Value of Marketability as Illustrated in IPO's

*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.

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• Robert W. Baird & Company Studies (continued)

Days Mean DiscountMedian Disount

No. of 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

Robert W. Baird & Company StudiesDiscounts versus Time between Transactions and IPO

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.

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• 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.

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• 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.

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• 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).

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• 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.

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• 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.

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Time of Transactions Before IPO

1-90 Days 91-180 Days 181-270 Days 271-365 Days 1-2 Years

1999 ResultsNumber of Transations 148 174 103 91 174Median Discount 30.8% 53.9% 75.0% 76.9% 82.0%








1999-2006 ResultsNumber of Transations 393 611 458 429 749Median Discount 27.3% 37.5% 51.9% 61.7% 68.0%

Source: The Valuation Advisors' Discount for Lack of Marketability Database .

Valuation Advisors' Study: Transaction Summary Results by Year from 1999-2006

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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%.

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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).

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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.

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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 Corresponding QMDM AssumptionsForecast Period Empirical Study X

Projected Interim Cash Flows (during forecast period)

Expected Distribution / Dividend YieldExpected Growth in Distributions / DividendsTiming (Mid-Year or End of Year)

Projected Terminal Value (at end of forecast period)

Growth in Value over Holding PeriodPremium or Discount to Marketable Value

Discount Rate Range of Required Holding Period ReturnsSource: BVR 2008 ed., page 3-16

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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)

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• 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.

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• 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.

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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.

Year Median P/ENo. of transactions

reporting P/EMedian P/E

No. of transactions reporting P/E

1990 17.1 117 13.2 361991 15.9 93 8.5 231992 18.1 89 17.6 151993 19.7 113 22.0 141994 19.8 184 22.0 181995 19.4 239 15.5 161996 21.7 288 17.7 311997 25.0 389 17.0 831998 24.0 362 16.0 2071999 21.7 434 18.4 1742000 18.0 379 16.0 1302001 16.7 261 15.3 802002 19.7 161 16.6 832003 21.2 198 19.4 1072004 22.6 188 19.0 1082005 24.4 230 16.9 1272006 23.7 294 21.4 652007 24.9 300 21.6 642008 22.1 130 10.6 512009 18.1 98 18.4 22

Source: Mergerstat Review, www.mergerstat.com.

Median P/E* Offered Public versus Private 1990 - 2009Acquisitions of Public Companies Acquisitions of Private Companies

* Excludes negative P/E multiples and P/E multiples larger than 100.

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• 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

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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

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• “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.

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• 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 non-dividend-paying common stocks.

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• 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.

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• 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.

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• 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.

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• 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.

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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.

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V. Quantifying the Discount for LOM

Marketability Adjustment Factors

Warrants an Above Average Discount

Warrants an

Average Discount

Warrants a Below Average Discount

Starting Point 35% 35% 35%

History and Outlook + -Financial Factors + -Management + -Holding Period + -Redemption Policy + -Transfer of Control + -Restrictions on Transfer + No Change -Cash Distribution Policy + -Information Access and Reliability + -Cost of Public Offering + -Other Factor 1 + -Other Factor 2 + -Other Factor 3, etc. + -

Ending Point > 35% 35% < 35%

Source: Hitchner, page 425

Calculation of the Lack of Marketability Discount based on the Evaluation of Individual Factors Affecting Marketability

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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.

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• 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

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• 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

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• 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)

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• 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.”

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• 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.

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• 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.

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• 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.

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• 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.

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VII. Questions

Vanessa Brown Claiborne President & Chief Executive Officer

[email protected]

Riley BusenlenerAssistant Vice-President

[email protected]

Chaffe & Associates, Inc.Tel: (504) 524-1801Fax: (504) 524-7194

201 St. Charles Ave. Suite 1410New Orleans, LA 70170

Questions?

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Works Cited

Chaffe, David B. III. “Option Pricing as a Proxy for Discount for Lack of Marketability in Private Company Valuations,” Business Valuation Review (December 1993).

Emory, John D. "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.

Emory, John D. 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.

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.

Hitchner, James R. Financial Valuation: Applications and Models, 2nd ed. (New Jersey: John Wiley & Sons, Inc., 2006)

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)

Seaman, Ronald M., FASA. “DLOM is Valuation-Date Specific, New Study on LEAPS Put Options Shows,” Business Valuation Resources, Vol. 15, No. 5, May 2009,1.

Staff of Business Valuation Resources, L.L.C. BVR’s Guide to Discounts for Lack of Marketability, 2008 ed. (Oregon: Business Valuation Resources, L.L.C., 2008)

The Valuation Advisors' Discount for Lack of Marketability Database.

http://www.mergerstat.com/



Providing Expert Guidance Since 1982 2010 Business Valuation Workshop Society of LCPAs Presented by: Vanessa Brown Claiborne President & Chief Executive.

Documents

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