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(Text Version Below)
Discount for Lack of Marketability
Job Aid for IRS Valuation Professionals
September 25, 2009
Developed by Engineering/Valuation Program DLOM Team:
Mike Gregory, ASA, AVA
Engineering Territory Manager Issue Champion
Sue Kurzweil, CPA, ASA
National Business Valuation Issue Coordinator Project Manager
Jeff Myers, ASA, AVA
Engineering Team Manager Team Member
Laura Goldberg, AVA
Engineer Team Member
Ernie DeRosa, AVA
Financial Analyst Team Member
James McCann, ASA
Financial Analyst Team Member
Aberdeen Sabo, Estate Tax Attorney Advisor
Disclaimer
This job aid is meant to provide information to IRS Valuation Analysts when
considering the Discount for Lack of Marketability (DLOM). Always read Section
E, Evaluation and Recommendations, in conjunction with Section D, Summary of
Approaches to DLOM. Note that while certain of the studies reviewed may
indicate large discounts, such discounts are not appropriate in all facts and
circumstances. The Valuation Analyst must have a clear understanding of the
facts and circumstances of each interest to be valued, use professional judgment
in choosing a DLOM just as is done for all other parts of a valuation, and apply a
reasonableness test. In other words, the Analyst must get behind the data used
to support a DLOM choice rather than simply using summary statistics and
resulting conclusions developed by somebody else.
The job aid does not make any bright line selections or exclusions as to what
approach to DLOM is best in any given set of circumstances—that is up to the
Valuation Analyst's professional judgment.
Acknowledgements
The DLOM Team would like to extend their thanks to the following IRS valuation
professionals who reviewed drafts of this job aid:
Monty Careswell, CPA, ASA, CVA Team 1855, Denver, CO
Paul Elkins, CPA, CVA Team 1876, King of Prussia, PA
James Peacock, AVA Team 1831, Austin, TX
Terry Savill, AVA Team 1833, Fort Worth, TX
Also like to thank Counsel reviewers as coordinated through Steve Blum, and
Engineer Manager Jack Jolly who handled the design and upload to the intranet.
Table of Contents
DLOM Job Aid
A. EXECUTIVE SUMMARY ........................................................................................1
B. INTRODUCTION...................................................................................................3
C. GENERAL MARKETABILITY DISCOUNT INFORMATION.............................................5
1. MARKETABILITY DEFINED 5
2. FACTORS INFLUENCING MARKETABILITY IDENTIFIED 6
3. WILLING SELLER CONSIDERATION 8
4. MARKETABILITY OF MINORITY VS. CONTROLLING INTERESTS 9
5. SAMPLE INITIAL IDR ITEMS ON MARKETABILITY 10
D. SUMMARY OF APPROACHES TO DLOM .............................................................12
1. BENCHMARK APPROACHES 12
a) Restricted Stock Studies 12
b) Pre-Initial Public Offering (Pre-IPO) Studies 19
c) Restricted Stock Equivalent Analysis 23
d) Cost of Flotation 25
e) Mandelbaum Factors, Judge Laro, 1995 27
2. SECURITIES-BASED APPROACHES 30
(a) Long-Term Equity Anticipation Securities (“LEAPS) – Robert Trout, 2003,
and Ronald Seaman, 2005 30
(b) The Longstaff Study, Journal of Finance, December 1995 32
(c) The Chaffee Study 35
(d) Bid-Ask Spread Method to Determine DLOM 36
3. ANALYTICAL APPROACHES 39
(a) Karen Hopper Wruck 41
(b). Hertzel and Smith 43
(c). Bajaj, Denis, Ferris and Sarin 46
(d). Ashok B. Abbott 50
4. OTHER APPROACHES 54
(a) QMDM (Christopher Mercer) 54
(b) NICE (William Frazier) 56
(c) NERA (David Tabak) 59
(d) Partnership Profiles (Partnership Spectrum) 62
(e) Public vs. Private P/E Ratios in Acquisitions (MergerStat) 65
E. EVALUATION AND RECOMMENDATIONS ..............................................................68
1. APPROACHING MARKETABILITY DISCOUNT AS A REVIEWER 68
2. APPROACH MARKETABILITY DISCOUNT AS A VALUATOR 68
3. DEALING WITH MARKETABILITY DISCOUNT IN A REPORT REVIEW UNDER CERTAIN
SPECIFIC SITUATIONS – TYPICAL REPORT LANGUAGE FOR GETTING STARTED 69
a) Use of Pre-IPO studies to support DLOM 69
b) Use of simple average or median from Restricted Stock Studies 70
c) Use of analytical study results without getting behind data 73
d) Use of study results not supported by market data 74
e) Reliance solely on court decisions 75
4. SOURCES AVAILABLE TO IRS VALUATION ANALYSTS 76
Table of Contents
DLOM Job Aid
F. SUMMARY AND CONCLUSIONS...........................................................................78
G. BIBLIOGRAPHY ................................................................................................79
TABLE 1 ANALYSIS OF SEC INSTITUTIONAL INVESTORS RESTRICTED STOCK STUDY .84
TABLE 2 ANALYSIS OF MPI RESTRICTED STOCK STUDY ..........................................85
EXHIBIT A—REVIEW FMV RESTRICTED STOCK MODEL...........................................86
EXHIBIT B—PRE-IPO STUDIES ..............................................................................95
EXHIBIT C–ANALYTICAL APPROACH REVISITED ......................................................98
EXHIBIT D—DLOM FILES ON SHARED FOLDER ....................................................106
Access to studies and articles:
The DLOM Team has attempted to provide access to most of the DLOM studies
and articles discussed in this job aid.
• Website—where the author has a website, a link to that site is included in
the job aid.
• Electronic—where we were able to get an electronic copy it is available on
the Engineer shared folder that is part of the IRS intranet. Access is
limited to those who have been granted permission. See Engr Prog
Shared Folder\DLOM Team. For those who do not have access, please
contact Jack Jolly.
• Other—some studies/articles were not converted to electronic format due
to size or perceived limited interest. If needed, contact a DLOM Team
member for its availability.
A. Executive Summary
DLOM Job Aid page 1
A. Executive Summary
In June 2008 a team was formed for the purpose of exploring and developing
information to assist valuators in the Internal Revenue Service Large and Mid-
Size Business (LMSB) Engineering Program in dealing with the Discount for Lack
of Marketability (DLOM) as such is used in valuation reports. Among the activities
to be undertaken by the team was the clarification of the definition of Discount for
Lack of Marketability, exploration of the state of the art in estimating this
discount, analysis of current estimating models, review of court commentaries,
and documentation of any concerns with the use of the various approaches
considered. The team’s focus was to define the issues around DLOM and to
develop pro forma IDR’s and audit techniques to assist valuators in the field. This
information should be of value not only to our own personnel but also to our
valuation customers.
Background: Initially, the team was charged with assisting Howard Lewis,
Engineering Program Manager, who had been asked to act as a moderator for a
summit on DLOM by Judge David Laro in September, 2008. At the end of August
2008, Howard Lewis retired. In October 2008 LMSB Field Specialists
reorganized and the position of Program Manager was eliminated. However,
given the convening of this private sector summit, it was anticipated that there
would be renewed energy devoted to this issue. The development work of this
team was to take into account outcomes of the September 2008 summit and
provide guidance to our employees. Mike Gregory, Engineering Territory
Manager, was asked by Howard Lewis to initiate this process on behalf of the
Engineering Program. Mike Gregory championed the work of the team and Sue
Kurzweil, National Engineering Business Valuation Team Lead from
Independence, Ohio was selected as the Project Manager. A conference
between Howard Lewis and Mike Gregory on May 30, 2008 caused the drafting
of the charter that initiated this project.
Objective: The team researched the state of art in DLOM starting by defining
DLOM and differentiating it from such related areas as Discount for Lack of
Liquidity (DLOL) and Discount for Lack of Control (DLOC). We reviewed longstanding
methods for estimating DLOM. We explored the models in recent
professional journals, discussed the pro’s and con’s of these models, explored
their strengths and weaknesses and looked for elements of reconciliation among
the models where possible. As a result of this initial work, the team developed
pro forma IDR’s and audit techniques regarding the more common approaches
being used in the valuation community. Our hope was to provide a quality, timely
analysis that will assist employees in the field working DLOM issues.
Approach: It is recognized that the DLOM issue is primarily factual in nature.
However, it is also recognized that many of the aspects of this issue have been
explored by the courts and the courts have defined, in part, what facts may be
A. Executive Summary
DLOM Job Aid page 2
given weight in determining the DLOM on a given case. Therefore, the LMSB
Engineering Program and Estate & Gift Tax Program (E & G) of the Small
Business and Self-Employed (SBSE) division are key players in the need for this
analysis. Annually, Estate Tax Attorney Christopher Bird compiles a listing of key
cases on E & G issues. His willingness to provide a current summary analysis on
this topic was vital to the work of our team.
The information provided in this document is thought to address issues on the
most current approaches to DLOM. Any model or estimating technique can be
misused and abused. The commentary that follows addresses various
approaches and models associated with the quantification of a DLOM as of the
date of this report. Further updates and changes to these models or techniques
could render some of these comments obsolete.
Conclusion: This Job Aid is meant to provide a background and context for the
Discount for Lack of Marketability as such is commonly applied in business
valuation analyses and reports. It reviews past and existing practices and
attempts to provide insight into the strengths and weaknesses of these practices.
It is not meant to provide a cookbook approach to evaluating a marketability
discount as proposed by a taxpayer or to setting a proposed marketability
discount in the case of an independent governmental appraisal. It is emphasized
that, all background and existing practices aside, the establishment of a Discount
for Lack of Marketability is a factually intensive endeavor that is heavily
dependent upon the experience and capability of the valuator. By bringing the
included material together in one document, we are striving to make the job of
the IRS valuation analyst easier. We do not mean to provide guidance as to
reasonable levels of marketability discounts that would prevail in all situational
contexts or to imply that the IRS has any policy per se in the evaluation or the
determination of such discounts.
B. Introduction
DLOM Job Aid page 3
B. Introduction
The application of the Discount for Lack of Marketability (DLOM) can result in a
significant value reduction as compared to the pro rata value of a business
interest. Frequently, this discount is the subject of controversy in IRS valuation
work, particularly in Estate & Gift Tax cases. Today’s valuation practitioners
utilize numerous studies, methods and models as the source for DLOM as it is
applied to a specific subject interest. These studies, methods and models can be
complex, can indicate widely diverse conclusions, and may be appropriate in only
certain limited situations. The business valuation profession does not identify
acceptable or unacceptable methods for estimating marketability discounts,
although some individual practitioners have their own preferences and frequently
disagree as to the best approach. Research in DLOM continues for improved
data sources and theory. Some of this research is published primarily as an
academic pursuit but is untested in practice.
The purpose of this job aid is to assist IRS valuation analysts in their examination
of and their independent determination of DLOM and to help them to better
understand the numerous available approaches. First, we will identify the current
state of DLOM studies and methods—ranging from the SEC Restricted Stock
study prepared in 1971 to the Liquistat database announced in 2007. We will
endeavor to explain the intent of the approaches most widely relied upon by
practicing valuators as to how each estimates DLOM. We will identify the
parameters used in a given approach, the strengths and weaknesses of the
approach,, the view of the valuation community concerning the approach, and
what the courts have had to say about the approach, if anything. The job aid also
provides initial IDR questions for examination of DLOM and some sample report
language for reviewers to consider in situations where it’s clear that the approach
being used by the taxpayer is in error.
The DLOM Team formed to consider discounts for lack of marketability includes:
Name Role POD
Mike Gregory, ASA,
AVA Issue Champion
Engineering Territory
Manager St. Paul, MN
Sue Kurzweil, CPA,
ASA Project Manager
National Business
Valuation Issue
Coordinator Independence, OH
Jeff Myers, ASA,
AVA
Research
Analyst
Engineering Team
Manager Columbus, OH
Laura Goldberg,
AVA
Research
Analyst Engineer Plantation, FL
Ernie DeRosa, AVA
Research
Analyst Financial Analyst New York, NY
James McCann,
ASA
Research
Analyst Financial Analyst San Francisco, CA
Aberdeen Sabo Advisor Estate Tax Attorney Independence, OH
B. Introduction
DLOM Job Aid page 4
While the team worked together on this project, members developed specific
portions:
• Laura Goldberg—Benchmark Approaches
• Ernie DeRosa—Securities-Based Approaches
• Jeff Myers—Analytical Approaches
• James McCann—Other Approaches
Access to studies and articles:
The DLOM Team has attempted to provide access to most of the DLOM studies
and articles discussed in this job aid.
• Website—where the author has a website, a link to that site is
included in the job aid.
• Electronic—where we were able to get an electronic copy it is
available on the Engineer shared folder that is part of the IRS
network. Access is limited to those who have been granted
permission see Engineering Program National Shared folder for
information on mapping the network drive to your computer. For
those who do not have access, please contact Jack Jolly.
• Other—some studies and articles were not converted to electronic
format due to size or perceived limited interest. If needed, contact
a DLOM Team member to see if it is available in paper format.
C. General DLOM Information
DLOM Job Aid page 5
C. General Marketability Discount Information
1. Marketability Defined
Marketability is defined in the International Glossary of Business Valuation Terms
as “the ability to quickly convert property to cash at minimal cost”1. Some texts go
on to add “with a high degree of certainty of realizing the anticipated amount of
proceeds”.2
A Discount for Lack of Marketability (DLOM) is “an amount or percentage
deducted from the value of an ownership interest to reflect the relative absence
of marketability.”3
Given two identical business interests, a higher price will be paid by investors in
the market for the business interest that can be converted to cash most rapidly,
without risk of loss in value. An example is publicly-traded stock on the New York
Stock Exchange, where the owner can order the sale and the proceeds are
deposited in a bank account in three days.
In the alternative, a lesser price is expected for the business interest that cannot
be quickly sold and converted to cash. A primary concern driving this price
reduction is that, over the uncertain time frame required to complete the sale, the
final sale price becomes less certain and with it a decline in value is quite
possible. Accordingly, a prudent buyer would want a discount for acquiring such
an interest to protect against value loss in a future sale scenario.
What to remember about DLOM:
• DLOM is appropriate when the subject interest is non-marketable, yet the
prior steps in the valuation process result in a marketable value.
• DLOM is not appropriate if the prior valuation process has already taken
marketability concerns into consideration.
• DLOM is applied after the minority interest discount or control premium
where such is appropriate to a valuation problem.
• DLOM should be determined on its own factors and not combined with
other discounts.
Marketability vs. Liquidity
What is liquidity? Liquidity is the ability to quickly convert property to cash or pay
a liability.4
1 International Glossary of Business Valuation Terms, as adopted in 2001 by American Institute of
Certified Public Accountants, American Society of Appraisers, Canadian Institute of Chartered Business
Valuators, National Association of Certified Valuation Analysts, and The Institute of Business Appraisers.
2 Shannon P. Pratt, Alina V. Niculita, Valuing a Business, The Analysis and Appraisal of Closely Held
Businesses, 5th ed (New York: McGraw Hill, 2008), p.39.
3 International Glossary.
C. General DLOM Information
DLOM Job Aid page 6
Said another way, Liquidity is the ability to readily convert an asset, business,
business ownership interest or security into cash without significant loss of
principal. Compare Liquidity to the definition of Marketability: the capability and
ease of transfer or salability of an asset, business, business ownership interest or
security.
A Discount for Lack of Liquidity (DLOL) is an amount or percentage deducted
from the value of an ownership interest to reflect the relative inability to quickly
convert property to cash.
How does Liquidity differ from Marketability? These terms are often used
interchangeably, although there is a technical distinction between them.
Marketability indicates the fact of “Salability”, while Liquidity indicates how fast
that sale can occur at the current price.
• If it’s liquid, it’s marketable
• If it’s non-marketable, it’s illiquid
• Being illiquid does not necessary mean non-marketable – it may still be
sellable but not quickly or without loss of value
Some distinguish marketability and liquidity as follows: “…with marketability
focusing on finding the appropriate market, preparing the property for sale and
executing the trade, and liquidity focusing on realizing cash proceeds.”5
We define liquidity here because some of the studies or methods discussed in
the job aid make a distinction between DLOM and DLOL.
2. Factors Influencing Marketability Identified
Factors that can have an influence on marketability are numerous. A
prominent Tax Court case set forth factors for consideration of DLOM. The
Mandelbaum Factors were set out in Mandelbaum v. Comm., TC Memo
1995-255 (1995), with the opinion written by Judge Laro. The factors and
the analysis that go with them are considered by many valuators to form a
good conceptual basis for thinking about and quantifying DLOM.
Some common factors that have been identified in various studies as impacting
marketability are listed below and are modeled after the Mandelbaum factors.
The first set of factors relate to the characteristics of the subject company. The
second set of factors relate to the characteristics of the subject interest.
Subject Company Factors
• Value of subject corporation's privately traded securities vs. its publicly
traded securities (or, if the subject corporation does not have stock that is
4 International Glossary.
5 Pratt, Valuing a Business, p.39.
C. General DLOM Information
DLOM Job Aid page 7
traded both publicly and privately, the cost of a similar corporation's public
and private stock)
• Dividend-paying (or distribution) ability and history
• Dividend yield
• Attractiveness of subject business
• Attractiveness of subject industry
• Prospects for a sale or public offering of the company
• Number of identifiable buyers
• Attributes of controlling shareholder, if any
• Availability of access to information or reliability of that information
• Management
• Earnings levels
• Revenue levels
• Book to market value ratios
• Information requirements
• Ownership concentration effects
• Financial condition
• Percent of shares held by insiders
• Percent of shares held by institutions
• Percent of independent directors
• Listing on a major exchange
• Active vs. passive investors
• Registration costs
• Availability of hedging opportunities
• Market capitalization rank
• Business risk
Subject Interest Factors
• Restrictive transfer provisions
• Length of the restriction period
• Length of expected holding period
• Offering size as a % of total shares outstanding
• Registered vs. unregistered
• General economic conditions
• Prevailing stock market conditions
• Volatility of stock
In Mandelbaum, the landmark case for marketability, Judge Laro set out various
factors to be considered in determining DLOM.
...Ascertaining the appropriate discount for limited marketability is a
factual determination. Critical to this determination is an
appreciation of the fundamental elements of value that are used by
an investor in making his or her investment decision. A
nonexclusive list of these factors includes: (1) The value of the
C. General DLOM Information
DLOM Job Aid page 8
subject corporation's privately traded securities vis-a-vis its publicly
traded securities (or, if the subject corporation does not have stock
that is traded both publicly and privately, the cost of a similar
corporation's public and private stock); (2) an analysis of the
subject corporation's financial statements; (3) the corporation's
dividend-paying capacity, its history of paying dividends, and the
amount of its prior dividends; (4) the nature of the corporation, its
history, its position in the industry, and its economic outlook; (5) the
corporation's management; (6) the degree of control transferred
with the block of stock to be valued; (7) any restriction on the
transferability of the corporation's stock; (8) the period of time for
which an investor must hold the subject stock to realize a sufficient
profit; (9) the corporation's redemption policy; and (10) the cost of
effectuating a public offering of the stock to be valued, e.g., legal,
accounting, and underwriting fees.6
These “Mandlebaum Factors” are often used by valuators and are
regularly seen in court cases where DLOM is an issue. For more on
Mandelbaum, refer to the Benchmark studies at D.1.e. in this job aide
(Mandelbaum Factors, Judge Laro, 1995).
3. Willing Seller Consideration
In determining/justifying marketability discounts, many appraisers only consider
the willing buyer. However, common sense and the courts have emphasized that
a willing seller must also be considered. In considering the market for a subject
interest, the applicable market in which a hypothetical willing buyer may be found
need not be one that includes the general public. The courts have determined
that it is sufficient if there are potential buyers among those closely connected
with a corporation.
• In Luce v. US, 4 Cl. Ct. 220-221 & 222 (53 AFTR 2d 84-1565, 84-1 USTC
13549), in addition to the corporation itself and its controlling stockholders
there was a further market for the shares among the other managerial
employees. Thus there was no need for a 30% discount in order for the
hypothetical seller to find a willing buyer.
• In Rothgery v. US, 201 Ct. Cl. 183,189, the court held that the decedent's
son would have been a willing buyer of the shares from any hypothetical
seller and that this was a market sufficient to negate any need for a
discount to sell the shares.
• In Couzens v. CIR, 11 BTA 1164 (1928), the court stated "we do not
construe a fair market as meaning that the whole world must be a
potential buyer, but only that there are sufficient available persons able to
buy to assure a fair and reasonable price in light of the circumstances
affecting value".
• In Estate of Jephson v. Comm., 87 T.C. 297, (a case involving cash and
6 Mandelbaum v. Comm., T.C. Memo 1995-255, 36.
C. General DLOM Information
DLOM Job Aid page 9
marketable securities held in a partnership) the court stated that "In our
opinion, neither the decedent nor her estate nor a hypothetical seller
would have sold the stock of either company for less than that which could
have been realized through liquidation. We further believe that a
hypothetical purchaser would be willing to pay such an amount. The
hypothetical purchaser, by purchasing the companies, would have
brokerage fees that otherwise would have to be paid to acquire
approximately $9 million of marketable securities."
• Also see: Estate of Goldstein v. Comm., 33 T.C. 1932,1037 (1960); Smith
v. Comm., 46 BTA 340-41 (1942); and Worcester County Trust Co. v.
Comm., 134 F.2d 578 (1st Cir. 1943).
4. Marketability of Minority vs. Controlling Interests
There is little dispute that minority interests in non-publicly traded entities lose
value due to lack of marketability. However, the issue of applying a discount for
lack of marketability to a controlling interest is a controversial issue7 amongst
valuators. Some believe that there should be little or no discount for lack of
marketability on a controlling interest, while others believe there should be a
discount applied. Most agree that any marketability discount for a controlling
interest should be less than the discount for a minority interest in the same entity.
The controlling interest owner will be able to sell his or her business interest in
one of two ways: a public offering or a private sale. As Pratt discusses in
Valuing a Business, the following factors will have to be considered:
• Uncertain time horizon to complete the offering or sale;
• Costs to prepare and execute the offering or sale (legal, accounting,
administrative, brokerage)
• Risk as to eventual sales price
• Non-cash and deferred transaction proceeds
• Inability to hypothecate8
Because of these considerations, the controlling interest owner may not be able
to sell the interest quickly or with certainty as to the ultimate sales price.
Therefore, it follows that the controlling interest may not be fully marketable.
Among valuators who apply DLOM to controlling interests, it is generally agreed
that DLOM of a controlling interest is less than that for a minority interest.
Court cases where DLOM was considered and allowed on a controlling interest:
• Estate of Andrews v. Comm., 79 TC 938 (1982)
• Estate of Simpson v. Comm., TCM 1994-207
• Gray v. Comm., TCM 1997-67
7 Pratt, Shannon, Business Valuation Discounts and Premiums, (NY: John Wiley & Sons, 2001), p.167.
8 Pratt, Reilly, Schweihs, Valuing a Business, Fourth Edition., p.413.
C. General DLOM Information
DLOM Job Aid page 10
5. Sample Initial IDR Items on Marketability
The evaluation of the appropriateness of a discount for lack of marketability
requires the collection and analysis of a substantial amount of information about
the entity involved and the subject interest in that entity whose marketability is
being considered. We provide below a list of typical inquiry areas that can be put
forth in Information Document Requests toward the end of collecting such
information. The bracketed notes below each item offer commentary about that
item’s relevance in evaluating its contribution to the lack of marketability and/or
lack of liquidity determination.
a. History of dividend payments [cash dividends are a “liquid” return on
investment, which might lower lack of marketability risk]
b. Salaries and bonuses paid to the Officers of the company, over the five
years leading up to the valuation date [especially in companies that don’t
pay dividends, Officers’ compensation can provide cash flow to
shareholders, which might lower lack of marketability risk]
c. Compensation and/or fees paid to the Directors of the company, over the
five years leading up to the valuation date [especially in companies that
don’t pay dividends, Directors’ fees can provide cash flow to shareholders,
which might lower lack of marketability risk]
d. List of all marketable securities (description, number, cost value) shown
on the latest financial statements [cash-equivalent securities might lower
liquidity risk on a company-wide basis]
e. List of all non-marketable securities and investments (description, number,
cost value) shown on the latest financial statements [can provide
information on how long it might take to liquidate non-marketable assets]
f. Breakdown of adjusted cost basis for each of the marketable and Nonmarketable
assets owned by the company on the valuation date [can
provide information on built-in capital gains tax expense to liquidate the
company]
g. Indicate if the adjusted cost basis of any of the company’s marketable or
non-marketable assets reflects a carry-over cost basis, pursuant to a
Section 1031 (or similar type) tax-deferred exchange [can provide
information on whether the company pursues available tax-deferral
strategies]
h. Current list of shareholders/partners showing the name of each
shareholder/partner and the class and number of shares owned by each
shareholder as of the valuation date [can provide information on relative
ownership distribution and total number of shareholders]
C. General DLOM Information
DLOM Job Aid page 11
i. Copies of notes receivable (and/or notes payable) between the company
and any shareholders, over the five years leading up to the valuation date
[loans to/from shareholders might be relevant to evaluating lack of
marketability risk]
j. Company articles of incorporation and amendments, by-laws and
amendments or partnership agreements and amendments [by-laws might
address restrictions or procedures for transfer of shares]
k. Copy of all shareholder agreements (such as buy/sell agreements, stock
option agreements stock purchase agreements, etc.) that have been in
effect during the five years prior to the valuation date [shareholder
agreements might address restrictions or procedures for transfer of
shares]
l. All documents pertaining to any sale of the company, a division or unit of
the company, or shares (interests) in the company during the five years
prior to the valuation date [recent sales/transfers might be might be
relevant to evaluating lack of marketability risk]
m. Board of Directors Meeting Minutes, for five years leading up to valuation
date [Board meetings might address shareholder requests for sale/transfer
of shares]
n. Complete financial statements of the company for the five fiscal or
calendar years prior to the valuation date, including balance sheets,
income statements and cash flow statements [can provide additional
information for evaluating lack of marketability risk]
o. Complete income tax returns for the five fiscal or calendar years prior to
the valuation date, including any audit adjustments [tax returns might
include details that are not stated within the regular financial statements]
p. Brief history and/or description of the company or the company’s business
(may already be included in an appraisal report) [can provide additional
information for evaluating lack of marketability risk]
q. Brief statement of duties of subject shareholder’s participation in company
operations [can provide additional information for evaluating lack of
marketability risk]
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 12
D. Summary of Approaches to DLOM
There have been numerous approaches taken by researchers and practitioners
for determining the appropriateness of allowing a discount for lack of
marketability in the valuation of a business interest and in estimating the
magnitude of such a discount. For discussion purposes, we have classified these
approaches into four categories:
1. Benchmark study approaches,
2. Security-based approaches,
3. Analytical approaches and
4. Other approaches.
These categories are discussed individually in this section of the job aid.
1. Benchmark Approaches
The so-called benchmark study approaches come in two primary forms – those
that estimate appropriate DLOM amounts based on restricted stocks and those
that base the DLOM estimate on Initial Public Offering (IPO) pricing as compared
to the price of earlier privately traded transactions. There are then certain
derivative approaches that have spun out of the basic approaches. We start our
discussion with the first of the primary categories -- restricted stocks. We then
cover Pre-IPO studies and conclude this section with brief discussions of certain
approaches derived from the benchmarks.
a) Restricted Stock Studies
Background
Restricted stock9 has been used over many years by members of the
business valuation community to quantify the discount for lack of
marketability. The restricted stock studies have been cited and analyzed in
numerous court decisions, sometimes with favorable consideration by the
court and sometimes with no real consideration at all. The premise behind
the restricted stock studies is that the effect of lack of marketability can be
quantified by comparing the sale price of publicly traded shares to the sale
9 According to the Securities Act of 1933 (Section 230.144), restricted stock is unregistered common stock of a
corporation identical in every respect to its publicly traded shares, except that it has not been registered, and is
therefore, not freely tradable. Because the holder of restricted common stock is prohibited from selling any of the stock
for full year (1997-2008, thereafter holding period is six months) and has additional constraints on the amounts that
may be sold for an additional year, the restricted stock is significantly less liquid (and therefore less valuable) than its
unrestricted counterpart.
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 13
price of so-called restricted shares of the same company that are identical
in all rights and powers except for their ability to be freely marketed. This
restriction on marketability for the restricted shares is time-limited but does
act to affect the ability of the holder to trade the shares during the
restriction period. Under SEC rules this restriction period has been either
one or two years depending upon the time of issuance of the shares.
Many different researchers have collected data on restricted stocks and
have compared them to their publicly traded counterparts beginning in
1966. The studies conducted have included various time periods for
collecting the data and have generated a number of summary statistics to
describe the data analyzed.
In recent years, as the discipline of business valuation has continued to
evolve, the valuation communities and the courts have taken an
increasingly critical view of simply beginning with a summary statistic from
a group of studies and going from there, either by accepting the statistic
as is or adjusting it without a believable explanation. Attention has turned
instead to getting behind the data itself and deriving an appropriate
discount from the data as such relates to the case at hand. This evolution
needs to be understood by the valuator and duly considered in using
restricted stock studies as an approach to DLOM.
Restricted stock studies are published, empirical studies, the most often
cited of which are indicated below. These studies analyze market data
during 1966-1996 in which public company stock prices were viewed
relative to the prices of such companies’ restricted stock issues. Because
SEC restricted stock rules prior to 1997 required investors to hold such
stock for at least two years (and after 1997 to the present for at least one
year), the difference between prices at which restricted stocks were issued
relative to freely traded stocks of the same company are considered a
proxy for a marketability discount for non-publicly traded stock. This
analogy is considered to be appropriate since non-publicly traded stocks
are also limited in their immediate marketability. Each of the reviewed
restricted stock studies is provided in electronic format on the Engineer
shared folder (see instructions to access at see Engineering Program
National Shared folder for information on mapping the network drive to
your computer. A summary of these studies is provided on the next page.
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 14
Restricted Stock Studies
Attempting to Measure the Marketability
Discount for Private Firms
Empirical Study
(full citation below)
Time Period
Covered
Average
Discount
SEC overall average (a) 1/66 – 6/69 25.8
SEC nonreporting OTC companies (a) 1/66 – 6/69 32.6
Gelman (b) 1/68 – 12/70 33.0
Trout (c) 1/68 – 12/72 33.5
Moroney (d) 1/69 – 12/72 35.6
Maher (e) 1/69 – 12/73 35.4
Standard Research Consultants (f) 10/78 – 6/82 45.0 (median)
Willamette Management Associates (g) 1981 – 1984 31.2 (median)
Silber (h) 1/81 – 12/88 33.8
FMV Opinions, Inc. (i) 1/79 – 4/92 23.0
Management Planning, Inc (j) 1/80 – 12/96 27.1
Bruce Johnson Study (k) 1/91 – 12/95 20.0
Columbia Financial Advisors (l) 1/96 – 4/97 21.0
Columbia Financial Advisors (l) 5/97 – 12/98 13.0
(a) Discounts Involved in Purchases of Common Stock (1966-1969), Institutional Investor Study Report of the Securities
and Exchange Commission, H.R. Do. No. 92-64, Part 5, 92nd Congress, 1st Session, 1971, 2444- 2456.
(b) Gelman, Milton, An Economist Financial Analyst’s Approach to Valuing Stock of a Closely Held Company,
Journal of Taxation, June 1972, 353-354.
(c) Trout, Robert R., Estimation of the Discount Associated with the Transfer of Restricted Securities, Taxes, June
1997, 381-384.
(d) Moroney, Robert E., Most Courts Overvalue Closely Held Stocks, Taxes, March 1993, 144-154.
(e) Maher, Michael J., Discounts for Lack-of-marketability for Closely Held Business Interests, Taxes,
September 1976, 562-71.
(f) Pittock, William F., and Stryker, Charles H., Revenue Ruling 77-287 Revisited, SRC Quarterly Reports, Spring
1983.
(g) Willamette Management Associates study (unpublished)
(h) Silber, William L., Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices, Financial Analysts
Journal, July-August 1991, 60-64.
(i) Hall, Lance S., and Timothy C . Polacek, “Strategies for Obtaining the Largest Valuation Discounts,” Estate
Planning, January/February 1994. pp. 38-44.
(j) Oliver, Robert P. and Roy H Meyers, “Discounts Seen in Private Placements of Restricted Stock: The
Management Planning, Inc., Long-Term Study (1980-1996)” (Chapter 5) in Robert F, Reilly and Robert P.
Schweihs, eds, The Handbook of Advanced Business Valuations (New York: McGraw-Hill, 2000).
(k) Johnson, Bruce, "Restricted Stock Discounts, 1991-95", Shannon Pratt’s Business Valuation Update, Vol. 5,
No. 3, March 1999, pp. 1-3. “Quantitative Support for Discounts for Lack of Marketability.” Business Valuation
Review, December, 1999, pp. 152-155.
(l) CFAI Study, 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.
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 15
As can be seen from this data, the measures of central tendencies for
these various studies would imply DLOM amounts of from a low of 13% to
somewhere in the vicinity of the mid-40% decile . This is a wide range in
terms of central tendency and indicates the probability of a much wider
range across the individual data points. Further, the sample sizes in these
studies are small, most involving less than 100 individual data points such
that the reliability of the summary statistics is subject to considerable data
variation. This factor emphasizes the need to get into the data itself
instead of staying at the summary level.
Summary:
• Authors of restricted stock studies have examined transactions in
the shares of public and private companies.
• Restricted shares have some form of agreed upon or legal
restrictions related to marketability.
• The studies exhibit average means and medians of 31.4% and
33%, therefore many analysts use a discount of about 35% or
attach a subjective premium to the average discount to account for
the perceived greater illiquidity of a private company’s stock versus
the restricted stock.
• The DLOM concluded by the more recent restricted stock studies
are smaller than the DLOM concluded by the older restricted stock
studies. One explanation for this phenomenon is the increase in
volume of privately placed stock under Securities and Exchange
Commission (SEC) Rule 144(a) in the past several years. Also, a
change in the minimum investment holding period required by the
SEC under Rule 144 from two years to only one year-took place as
of April 29, 1997.
• Effective February 15, 2008 the SEC changed Rule 144 by
shortening the holding period even further for restricted securities
for small companies.
• The key to this DLOM approach is the importance of understanding
the various marketability studies, how they relate to the subject
interest being valued, and whether the ultimate marketability
discount that is reasonable for the situation is below, equal to, or
above the discounts (or range of discounts) suggested by the
studies.
Areas of Focus
In discussing this approach with taxpayer or taxpayer’s appraiser, the following
areas of focus should be explored:
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 16
• Has Taxpayer’s appraiser considered separation of “lack of marketability”
from other effects (e.g. blockage) that might be contributing to discounts
observed in the Restricted Stock Studies data?
• Has Taxpayer’s appraiser addressed variance and/or range of discounts
observed in the Restricted Stock Studies data?
• On what basis has Taxpayer’s appraiser determined that any particular
“average” or “median” discount from the Restricted Stock Studies data is
applicable to the subject company?
• On what basis has Taxpayer’s appraiser adjusted the average or median
discount data for factors applicable to the subject company?
• If Taxpayer’s appraiser is using specific restricted stock transactions from
a database, on what basis has Taxpayer’s appraiser estimated those
particular restricted stock transactions to be applicable to the subject
company?
Strengths
• The advantage of using restricted stock studies is that the stock is
identical to its freely traded counterpart, except for the duration of
the resale restriction, and contemporaneous pricing data is
available showing differences in price between liquid and illiquid
shares.
• These studies are commonly relied upon by business valuators
because restricted stock studies were one of the few areas where
early concentrated research was conducted and actual numerical
values were produced. Considerable raw data was available for
analysis and many different independent analysts worked the data
and produced numerical results.
• Historically, these types of studies were the ones most often
accepted by the Tax Court (however, this tendency is being
challenged in recent times).
Weaknesses
• Lack of Current Market Data
The most compelling criticism of existing studies is that they rely on
historical market data. A discount for lack of marketability is
applied as part of the valuation process to estimate the fair market
value of an asset or security. With some of the data in the studies
reaching back to 1966, it may not reflect the dynamics of current
market conditions.
• Change in Holding Period for Restricted Stocks
It is imperative that the expected holding period of the subject
company stock be compared to the restricted stock study holding
period being used. All except the last two studies use market data
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 17
pre-April 1997, reflecting the then-current law requiring a two-year
holding period prior to sale by an investor of Rule 144 issued
restricted stock. The SEC, effective April 1997, amended Section
144 to require only a one-year holding period by investors, implying
a lower discount for lack of marketability. The current law, effective
February 2008, now requires only a six month holding period by
investors of small companies, however no new restricted stock
studies have been published, as of yet.
• The studies imply an unusually high return on investment in small
company restricted stock.
• Reliance on averages of restricted stock studies.
Using measures of central tendency without an examination of the
underlying data leads to the opportunity for mischaracterization of
the true restricted stock trading patterns. For example:
• The Maher Study discount range was 3% - 76%.
• The Johnson Study range was from a 10% premium to a 60%
discount.
The parameters underlying the studies vary by study; some key
parameters are listed below:
1) Exchange on which the stock trades
2) Size of block as a percent of shares outstanding
3) Size of company issuing the restrictive shares
Prevalence in Professional Practice
• Very commonly relied upon in business valuation reports.
• Now seeing trend towards deeper analysis of subject versus the
underlying stock in studies—getting behind the data instead of
staying at the summary level
What the Courts say about this Approach:
Courts rejected the use of the average restricted stock study results in
favor of performing a detailed, comprehensive comparison with underlying
restricted stock data.
�� Temple v. U.S, No 903-CV-165 (March 10, 2006)
“The better method is to analyze the data from the restricted stock
studies and relate it to the gifted interests in some manner...”
�� Peracchio v. Comm., T. C. Memo. 2003-280 (September 25, 2003)
Paraphrasing: while restricted stock data is helpful in determining a
discount for lack of marketability, merely referencing the average
discount found in a study or a group of studies, is insufficient.
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 18
NOTE: IRS Estate and Gift Tax Program webpage offers
summaries of E&G court cases prepared by IRS Estate Tax
Attorney Chris Bird. This resource can be accessed at:
http://sbse.web.irs.gov/EG/Tech_Page1.htm .
Two components to restricted stock study data: a market access
component (liquidity), and a holding period component.
• Holman v. Comm., 130 TC 170 (May 27, 2008)
The Tax Court accepted the expert’s use of restricted stock studies
in determining DLOM appropriate to gifts of family limited
partnership interests. The holding period component deals with the
SEC Rule 144 required holding period for a restricted stock sale.
Holman concluded that the hypothetical purchaser would demand
and get a price concession to reflect the market access component
of the marketability discount but would get little if any price
concession to reflect the holding period component of that discount.
FMV Restricted Stock Database—Analysis
The FMV Restricted Stock database of transactions is available for purchase,
and is utilized by valuators to estimate DLOM on privately-held business
interests. IRS Engineer, Tom Kelley, AVA, completed an analysis10 of the 475
transactions in the FMV Restricted Stock database in 2009. The purpose was a)
to analyze the FMV model for determining DLOM on private equity, and b) to
determine whether it is possible to develop a statistically valid regression-based
model to determine the DLOM. The conclusions drawn are:
1) FMV Opinions’ model is flawed insofar as explanation of the DLOM’s on
the restricted stock transactions in their database;
2) Valuators cannot confidently rely on FMV’s model when determining
DLOM’s on restricted stocks, much less on interests in private equity; and
3) Neither FMV’s model nor multivariate regression analysis can be applied
to FMV’s database to confidently determine the DLOM on private equity.
FMV Opinions and its principals continue to heavily promote their two-step
approach utilizing their database in contributions to various valuation publications
and with presentations at various seminars and meetings. Thus, it is likely that
we will continue to see this approach used by various practitioners. Before
accepting this approach, the reader should familiarize themselves with Tom
Kelley’s analysis and conclusions and be sure that the result being put forth
makes sense in the overall context of the valuation assignment.
10 February 18, 2009 memo from Tom Kelley with the subject, “Update: FMV Opinion’s Model and
Database”. Copy is provided as an Exhibit to this job aid.
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 19
Please refer to the Exhibits in this job aid for information on the process Tom
Kelley followed in reaching his conclusions Exhibit A—Review FMV Restricted
Stock Model.
b) Pre-Initial Public Offering (Pre-IPO) Studies
Background
The pre-IPO studies are the second large group of studies within the
“Benchmark Studies” category. These studies analyze identical stock of
the same company and compare price points before the stock is publicly
traded and at the point that a liquidity event such as an IPO occurs.
Various authors have performed studies using various measuring periods
in an attempt to get a stable and reliable pre-IPO stock price for
comparison to the price set for the IPO. These measurement points have
ranged from several days prior to the IPO to several months prior to the
IPO. The pre-IPO studies have derived measures of central tendency for
DLOM in the area of 30+% to 60+%. Generally, pre-IPO results lead to
discount choices higher than those implied by the restricted stock studies.
Traditionally many valuators would consider the results of both the
restricted stock studies and the pre-IPO studies, consider the summary
statistics and then select a DLOM for use in some subjective matter based
on all of these studies. In more recent times, the pre-IPO studies have
fallen somewhat from favor due to a significant number of problems
identified in their use. The decision in McCord v. Comm., 120 T.C. 358
(2003), pretty much totally rejected the pre-IPO studies as a useful
approach to DLOM. A recent court decision, Bergquist v. Comm., 2008
TNT 142-8, has potentially breathed some life back into the pre-IPO
studies but this case is a very factually specific case with an extraordinary
set of conditions that cannot easily be generalized to other cases.
A pre-IPO study examines arm's-length sale transactions in the stock of a
closely held company that has subsequently achieved a successful initial
public offering of its stock. In a pre-IPO study, the DLOM is quantified by
analyzing (with various adjustments) the difference between the public
market price at which a stock was issued at the time of the IPO and the
private market price at which a stock was sold prior to the IPO. Three sets
of such studies are identified and discussed below:
o Willamette Management Associates
o John Emory
o Valuation Advisors
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 20
Studies have shown average discounts of the pre-IPO price from the
offering price of around 40% to 45%. Pre-IPO studies have also shown
substantial dispersion of the discounts around their sample means
Willamette Management Associates (WMA): WMA performed a series
of studies on the prices of private stock transactions relative to those of
public offerings of stock of the same companies. The studies covered the
years 1975 through 1997. See a summary of the studies in Exhibit B
(Exhibit B--Pre-IPO Studies). The median discounts ranged from a low of
31.8% for 1991 private transactions to 73.1 % for 1984 private
transactions.
Robert W. Baird & Company Studies (Emory): John D. Emory of Robert
W. Baird & Company conducted another series of pre-IPO studies11. The
studies covered various time periods from 1981 through 2000. The basic
methodology employed in each of the eight studies was identical. The
population of companies in each study consisted of initial public offerings
during the respective time period in which Baird & Company either
participated or for which prospectuses were received. The prospectuses of
over 4,000 offerings were analyzed to determine the relationship between
(1) the price at which the stock was initially offered to the public and (2)
the price at which the latest private transaction occurred up to five months
prior to the IPO. The mean discount for all nine studies is 46%. See a
summary in Exhibit B (Exhibit B--Pre-IPO Studies).
Valuation Advisors' Lack of Marketability Discount Study was
developed by Brian Pearson of Valuation Advisors, LLC (VAL), and
compares the initial public offering (IPO) stock price to pre-IPO common
stock, common stock option and convertible preferred stock prices. These
market based transactions demonstrate the lack of marketability discount
afforded by the pre-IPO instruments because of their illiquidity when
issued by a privately held company.
A summary of Pearson’s 1999 Pre-IPO study is available online at
http://www.valuationpros.com/ipo_1999.html , the 2000 study at
http://www.valuationpros.com/ipo_2000.html and 2001 at
http://www.valuationpros.com/ipo.html .
Areas of Focus
In discussing this approach with taxpayer or taxpayer’s appraiser, the following
areas of focus should be explored:
11 John D. Emory, "Discounts for Lack of Marketability, Emory Pre-IPO Discount Studies 1980-2000 as
Adjusted October 10, 2002”, Business Valuation Review, Vol.21 No.4 (December, 2002).
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 21
• Has Taxpayer’s appraiser considered separation of “lack of marketability”
from other effects (e.g. management compensation) that might be
contributing to discounts observed in the Pre-IPO Studies data?
• Has Taxpayer’s appraiser addressed variance and/or range of discounts
observed in the Pre-IPO Studies data?
• On what basis has Taxpayer’s appraiser determined that any particular
“average” or “median” discount from the Pre-IPO Studies data is
applicable to the subject company?
• On what basis has Taxpayer’s appraiser adjusted the average or median
discount data for factors applicable to the subject company?
• If Taxpayer’s appraiser is using specific pre-IPO transactions from a
database, on what basis has Taxpayer’s appraiser estimated those
particular pre-IPO transactions to be applicable to the subject company?
Summary
In general, the Pre-IPO studies provide measures of central tendency for
DLOM that are higher than those provided by the restricted stock studies.
A difficulty in conducting and analyzing these studies is in determining the
proper measuring point for the pre-IPO pricing so as not to pick up bias
from the market’s perception that an IPO or a sale of some other kind is in
the wind. One must be cautious as to going too far back, however,
because market conditions in general and for the company in specific
could have changed markedly over time, especially if the company is
small and in a highly competitive industry.
Strengths
• Empirical evidence, market data
• Broad time period coverage
Weaknesses
• Not contemporaneous – too much time gap often exists between pre-IPO
transaction and public offering. Private transactions studied were between
5 months and 3 years prior to the IPO, providing a strong argument that
factors other than marketability alone led to the price increase.
• Pre-IPO companies rapidly evolving – significant changes
(difference in pre & post company) as many transactions involved
companies in early stage of development
• Pre-IPO companies affected by changes in economic conditions
• Data includes only firms with successfully completed IPO’s. No
information included on candidate companies where IPO doesn’t
eventually take place
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 22
• Pre-IPO transactions tend to be under-priced (most IPOs involve
high growth companies) to fully subscribe the offering
• Pre-IPO transactions almost always involve related-party
transactions (employees and company, service providers and
company, etc) and do not reflect arms-length terms.
• There are indications that the Willamette Management Associates
Studies 1999 and 2000 data may be skewed due to the dot.com
"bubble"
• Frequently viewed as inflating DLOM
Important parameters for this approach
1) Price stock initially offered to the public
2) Price at which latest presumably unaffected, private transaction
occurred prior to IPO (time period varies by study)
Prevalence in professional practice
Not as common in practice as Restricted Stock studies after McCord case
where pre-IPO studies were rejected; decision in Bergquist could bring
new life.
What the Courts say about this approach
There have been numerous court decisions where the Pre-IPO approach
to DLOM was considered. Among these are the following:
• Estate of Gallo (T.C. Memo 1985-363, 50 T.C.M. (CCH) 470
• Estate of Hall 92 T.C. 312 (1989)
• Howard v. Shay (1993 U.S. Dist. LEXIS 20153 (C.D. Cal.1993),
rev’d and remanded, 100 F.3d 1483 (9th Cir. 1996), cert. denied,
520 U.S. 1237 (1997)
• Okerlund v. United States (53 Fed. Cl. 341 (Fed. Cr. 2002), motion
for new trial Denied, 2003 U.S. Claims LEXIS 42 (Fed. Cl. 2003)
• McCord V. Commissioner 120 T.C. No. 13 (2003) decision
effectively disavowed the pre-IPO studies approach
�� Rejected the use of pre-IPO studies to determine the
appropriate discount
En banc decision – entire Tax court examines controversy
No dissent regarding rejection
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 23
• Bergquist v. Commissioner 131 T.C. No. 2 ( 2008)
�� 2008 charitable contribution case allowed expert’s report that
relied on the Pre-IPO Approach without discussion of the
approach.
�� According to the Court, the taxpayer’s expert “[has] not
pointed to, nor do we find, significant flaws in respondent’s
expert’s analysis or in the studies he relied upon that would
suggest his report is unreliable, and we adopt [the IRS’s
expert’s] discounts and conclusions of value.”
�� It is critical that facts be developed and valuation is based on
specific facts for the subject company.
c) Restricted Stock Equivalent Analysis12
This approach is a recent attempt to refine the traditional restricted stock
studies approach to consider the real differences existing between the
marketability of the restricted stock of publicly traded companies and the
stock of companies that are not publicly traded and that, therefore, do not
have only a limited period of lack of marketability. It derives a proposed
DLOM as a two step process starting with the so-called “Restricted Stock
Equivalent DLOM”.
1) Estimate the “Restricted Stock Equivalent Value” for application to
the publicly traded stock
2) Add an increment to the restricted stock equivalent value to
account for difference in marketability of the restricted stock of
public companies versus the subject private stock
This approach to DLOM is fully described in a number of papers authored
by Espen Robak and Lance Hall of FMV Opinions.
The essence of this approach is that straight restricted stock analysis
misses the true characterization of DLOM for private companies because
it relies totally on data relating to public companies, even though it focuses
on the restricted stock of those companies. Per its supporters, private
companies are even less marketable than the restricted stock of public
companies and thus an extra increment of discount is appropriate. The
proponents of this approach quantify this increment using data collected
on a substantial number of restricted stock transactions by using the
discount difference between the largest block sizes of purchased
12 Espen Robak, “Liquidity and Levels of Value: A New Theoretical Framework,” BV Update, October,
2004.
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 24
restricted stock and the smallest block sizes of such stock as an indicator
of the additional marketing risk faced by private companies.
Conceptually the approach proceeds as follows:
1) To get the restricted stock equivalent value, select restricted stocks
with characteristics as close to your subject as possible in terms of
risk and distributions
2) Proxy for risk includes:
• Size (as measured by assets, resources, or estimated prediscount
market value of equity)
• Profitability (as measured by dollar amount of some level of
profitability or percent of profitability)
• Balance sheet risk (as measured by some measure of
leverage or pre-discount estimated market value of equity to
book value of equity)
3) Distributions are usually measured as the proportion of dividends or
withdrawals paid out as a percentage of the pre-discounted market
value of equity
4) Estimating the Private Company Incremental Discount
• Large blocks of restricted stock relative to total shares
outstanding are much closer to private equity than the typical
smaller block of restricted stock
• Silber Study13 of restricted stock
• Fewer prospects in the pool of potential buyers
• Longer period to feed out into public market under the
SEC dribble out rule
5) Difference between the average discount on the sample of small
block restricted stocks with the characteristics similar to the subject
and the average discount for a large block of stock would be the
private stock liquidity increment to the discount
This approach is treated in more detail in Exhibit A to this job aid including
a statistical analysis by IRS Engineer Tom Kelley14. The conclusions
drawn are:
1) FMV Opinions’ model is flawed insofar as explanation of the DLOM’s on
the restricted stock transactions in their database;
13 William L. Silber, “Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices,” Financial
Analysts Journal, July-August 1991, pp. 60-64.
14 February 18, 2009 memo from Tom Kelley with the subject “Update: FMV Opinions’ Model and
Database”.
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 25
2) Valuators cannot confidently rely on FMV’s model when determining
DLOM’s on restricted stocks, much less on interests in private equity; and
3) Neither FMV’s model nor multivariate regression analysis can be applied
to FMV’s database to confidently determine the DLOM on private equity.
FMV Opinions and its principals continue to heavily promote their two-step
approach utilizing their database in contributions to various valuation publications
and with presentations at various seminars and meetings. Thus, it is likely that
we will continue to see this approach used by various practitioners. Before
accepting this approach, the reader should familiarize themselves with Tom
Kelley’s analysis and conclusions and be sure that the result being put forth
makes sense in the overall context of the valuation assignment.
The approach is relatively new and has not had any significant vetting in
the practitioner community or by the courts.
Areas of Focus
In discussing this approach with taxpayer or taxpayer’s appraiser, the following
areas of focus should be explored:
• Has Taxpayer’s appraiser considered separation of “lack of marketability”
from other effects (e.g. blockage) that might be contributing to discounts
observed in the Restricted Stock Equivalent data?
• Has Taxpayer’s appraiser addressed variance and/or range of discounts
observed in the Restricted Stock Equivalent data?
• On what basis has Taxpayer’s appraiser determined that any particular
“average” or “median” discount from the Restricted Stock Equivalent data
is applicable to the subject company?
• On what basis has Taxpayer’s appraiser adjusted the average or median
discount data for factors applicable to the subject company?
• If Taxpayer’s appraiser is using specific restricted stock equivalent
transactions from a database, on what basis has Taxpayer’s appraiser
estimated those particular restricted stock transactions to be applicable to
the subject company?
d) Cost of Flotation15
The flotation cost approach quantifies the discount for lack of marketability
in terms of the costs required to achieve marketability. The DLOM is thus
15 Cost of Floatation of Registered Issues 1971-1972, Washington, DC: Securities and Exchange
Commission, 1974. See also The Costs of Going Public, Jay R. Ritter, Journal of Financial Economics,
Vol. 19, No. 2 (December 1987), pp. 269-81.
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 26
the cost to underwrite a public offering of the stock as a percentage of the
estimated traded price that would result from such an offering. Certain
observations on this approach follow:
• Costs include the legal, accounting, and investment banking fees
necessary to underwrite and place an issue with investors and
typically includes a high degree of due diligence
• 1972 SEC study indicated flotation costs of 21.2% for 270 stock
issues up to $1 million and 12.2% for 1,008 stock issues of $1 to
$10 million
• Not applicable to minority interests since cannot cause a public
offering
• A second way to estimate illiquidity cost for controlling interest is to
look at expense of selling the business
• Deemed to be only a portion of the DLOM
• Does not reflect the risk associated with uncertain holding period
for a non-marketable investment
The approach is easily applied and a wealth of data is available. However,
it does not reflect the risk associated with the uncertain holding periods
that are typical for an illiquid investment in private equity and therefore,
does not quantify the entire DLOM. It is also not applicable to minority
interests which are the most frequent interests in question when a
discount for lack of marketability is to be estimated.
Areas of Focus
In discussing this approach with taxpayer or taxpayer’s appraiser, the following
areas of focus should be explored:
• Has Taxpayer’s appraiser considered separation of “costs of reaching
marketability” from other effects (e.g. other expenses) that might be
contributing to discounts observed in the Flotation Costs data?
• Has Taxpayer’s appraiser addressed variance and/or range of discounts
observed in the Flotation Costs data?
• On what basis has Taxpayer’s appraiser determined that any particular
“average” or “median” discount from the Flotation Costs data is applicable
to the subject company?
• On what basis has Taxpayer’s appraiser adjusted the average or median
discount data for factors applicable to the subject company?
• If Taxpayer’s appraiser is using specific floatation costs transactions from
a database, on what basis has Taxpayer’s appraiser estimated those
particular flotation cost transactions to be applicable to the subject
company?
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 27
e) Mandelbaum Factors, Judge Laro, 1995
The Mandelbaum Factors were set out in a Tax Court case16 of the same
name decided by Judge Laro as an approach to adjusting the discount for
lack of marketability achieved by traditional means such as the
Benchmark Studies for the specific facts and circumstances of the
valuation problem actually being considered. The factors and the analysis
that go with them have since been cited in several following court
decisions and are considered by many valuators to form a good
conceptual basis for thinking about and quantifying DLOM. The courts
have emphasized, however, the process defined in Mandelbaum as
opposed to the actual quantitative result that was achieved in that case.
Summary:
Per Judge Laro, the following factors should be addressed as they pertain
to a discount for lack of marketability for the subject company.
1. Private vs. public sales of stock
In the event that a company has observable transactions between
third parties that involve both their publicly traded stock and
restricted shares, this point has important application. If the subject
shares do not have a publicly traded counterpart, review of the
restricted stock studies can serve as an important reference.
2. Financial Statement Analysis
Financial statement analysis would include historical and projected
trends in profitability, leverage, distributions, liquidity, and volatility
of these and other measures.
3. Company’s Dividend Policy
Investors in non-marketability securities prefer distributions as they
provide elements of capital recovery and capital gain
4. Nature of the Co. (History, Position in Industry, Economic
Outlook)
Investors gravitate to positive results and shy away from risk
5. Company’s Management
Intangibles such as management contribute to operational and
financial success and help to ensure favorable returns
6. Amount of Control in Transferred Shares
Control or related influence will typically be perceived as reducing
risk
7. Restrictions on Transferability of Stock
Specific clauses that are viewed as unattractive and tend to
increase discounts:
16 Mandelbaum v. Commissioner, T.C. Memo 1995-255 (1995)
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 28
a) Right of First Refusal – many limited partnership
agreements provided that a limited partner can only
sell and transfer an interest subject to first offering to
sell that interest to the partnership or its partners.
These provisions are onerous as they impair an
interest’s marketability by discouraging third party
offers.
b) Transferee Restrictions – such as limits on transfer to
“permitted transferees” reduce the universe of
potential buyers and generally lengthen the time
horizon to liquidate the investment
8. Holding Period for Stock
The key is whether such holding period is discretionary or
mandated. Restrictions on holding are clearly perceived as
negative by investors. But for non-marketable securities, the loss of
vital timing in being able to liquidate an investment can be regarded
as a substantial negative to a prospective investor that is faced with
an uncertain time horizon and outlook, including impacts of overall
capital markets
9. Company’s Redemption Policy
Put rights or expectations of near term monetization events reduce
the risk to an investor
10. Costs Associated with Making a Public Offering
While public offerings are under the control of the corporation or
majority owner, these provisions only related to marketability. Even
marketable securities can be impacted by severe liquidity discounts
during bear markets,
Areas of Focus
In discussing this approach with taxpayer or taxpayer’s appraiser, the following
areas of focus should be explored:
• Has Taxpayer’s appraiser considered each of the Mandelbaum Factors in
the estimation of the discount for lack of marketability?
• On what basis has Taxpayer’s appraiser determined the relative
importance of each of the Mandelbaum Factors towards the estimation of
the discount for lack of marketability?
• On what basis has Taxpayer’s appraiser adjusted the average or median
discount data for effects from each of the Mandelbaum Factors?
Strengths
• Raises importance of the skilled application of difference/similarities
of benchmark studies to subject company
• Similarity to precepts underlying Rev. Ruling 59-60, 1959-1 CB 237
D. Summary of DLOM Studies/Methods
Benchmark
DLOM Job Aid page 29
Weaknesses
• Attempt to cover all ten Mandelbaum factors might be difficult unless
experienced
• Insufficient information to analyze and provide opinion on all factors
Prevalence in professional practice
• Increasingly common; how factors are applied and the magnitude
of the effect on marketability discount is problem
What the Courts say about this Approach
The Mandelbaum approach has received a considerable amount of
attention among business valuation practitioners and in the courts. Among
the lessons learned are that:
(1) Detailed data developed first hand by the testifying expert, as
opposed to medians cited from studies performed by others, are
required to sustain discount opinions
(2) The courts recognize there are reasons to go above or below the
medians, but they will do so only when presented with soundly
reasoned and empirically supported arguments
(3) One size discount should not apply to all
(4) Blanket approaches using historical averages are not
sustainable; a case-specific analysis is needed
For example, in the Estate of Jelke v. Commissioner, T.C. Memo 2005-
131, reversed and remanded, 507 F.3rd 1317 (11th Cir. 2007), cert. den.
129 S. Ct. 168 (2008), the court said that they found the factors
considered in Mandelbaum to be a helpful guide to determining the
marketability discount and in structuring their own Mandelbaum-type
analysis. Thus, the court followed a Mandelbaum process but did not
blindly endorse the original Mandelbaum result.
D. Summary of DLOM Studies/Methods
Securities-Based Approaches
DLOM Job Aid page 30
2. Securities-Based Approaches
The security-based approaches to estimating the Discount for Lack of
Marketability are based on theoretical option pricing models (e.g. Longstaff,
Chaffee) and from observing illiquidity demonstrated by traded stock prices (bidask-
spread) and option prices (LEAPS).
(a) Long-Term Equity Anticipation Securities (“LEAPS) – Robert
Trout, 2003, and Ronald Seaman, 2005
Background
Long-Term Equity Anticipation Securities or (“LEAPS”), which are publicly traded,
are long-term put options on stocks of public companies.
Robert Trout originally published the LEAPS study in September 200317 and
Ronald Seamen updated the study in June 200518, September 200719 and March
200920. A LEAP is a long-term put option with a term of approximately 1.5 to 2.0
years. An investor, therefore, can buy protection against stock price declines by
purchasing a LEAP put option. The LEAP studies examined the cost of
purchasing the LEAP puts. The DLOM is then calculated as the cost of the put
option divided by the stock price. The authors segmented the data by a safety
rank measured by the Value Line Investment Survey with 1 representing the
least risk and 5 representing the most risk.
Summary:
The authors concluded that the observed DLOM derived from the LEAPS studies
should be viewed as a benchmark minimum price when applied to privately held
companies. They viewed the derived discounts as minimum price discounts since
a. The market value of the companies offering the underlying securities was
much larger than the value of a privately held company
17 Robert R. Trout, “Minimum Marketability Discounts,” Business Valuation Review, September 2003 pp.
124-126.
18 Ronald M. Seaman, “Minimum Marketability Discounts 2nd Edition,” Business Valuation Review, June
2005 pp. 58-64.
19 Ronald M. Seaman, “Minimum Marketability Discounts—3rd Edition,” September 2007, available at
http://www.dlom-info.com/ .
20 Ronald M. Seaman, “Minimum Marketability Discounts—4th Edition, A Study of Discount for Lack of
Marketability Based on LEAPS Put Options in November 2008,” March 2009, available at
http://www.dlom-info.com/ .
D. Summary of DLOM Studies/Methods
Securities-Based Approaches
DLOM Job Aid page 31
b. The underlying securities are marketable
c. The LEAPS can be sold at any time during the holding period
d. There is a known liquidity event for LEAPS e.g. the option has an
expiration date generally between 1.5 and 2.0 years.
One year median discounts ranged from 8.3% for the safest company to 17% for
the riskiest company. Two year median discounts ranged from 9.3% for the
safest company to 31% for the riskiest company. A one year or two year implied
discount would be used as a proxy depending on the length of time it would take
to market the subject interest (e.g. for a controlling interest a one-year discount
would generally be used as a proxy since it is easier to market a controlling
interest in a privately held concern than it is to market a minority interest). 21
One area in which there has been criticism of using the LEAPS data as a starting
point for the DLOM is that it only considers the cost of purchasing a put option,
which protects an investor from a downward price movement. Therefore only the
cost to purchase a put option is considered if using LEAPS data to develop a
DLOM. If an investor can purchase a put (Protective Put) to protect against a
downward movement in the stock the investor can also sell a call option
(Covered Call) and receive a premium to offset the cost of the put. As a result the
overall cost is reduced since the investor is receiving a premium for selling the
call. Purchasing a put option and selling a call on the underlying stock is called a
“collar” options strategy. 22
At issue here is whether an investor in a privately held company, if they had the
ability to hedge, would only purchase a put to protect against a price decline or
purchase a put and sell a call locking in the current price and foregoing unlimited
future profit potential23
Strengths
• There are more than twice the number of LEAPS transactions in the
LEAPS study than are considered in the restricted stock studies thereby
providing a more valid statistical sample
• LEAPS can be found that are valuation date specific
• Data can be segmented by industry and a search can be conducted for
comparable public companies
21 For additional reading refer to BVR’s 2008 Guide to Discounts for Lack of Marketability –The Use of
Theoretical Models to Estimate the Discount for Lack of Marketability, by Travis R. Lance.
22 For additional information on the collar options strategy refer to
http://www.optionseducation.org/strategy/collar.jsp
23 See http://www.dlom-info.com/q-and-a.html for response to collar options strategy by
Seeman
D. Summary of DLOM Studies/Methods
Securities-Based Approaches
DLOM Job Aid page 32
Weaknesses
• An appraiser would still have to perform a qualitative analysis in order to
arrive at a conclusion for the DLOM by adjusting the LEAPS based
discount for private company considerations
• An owner of a privately held company does not have the ability to hedge
the investment in an options market and as such the observed discount is
a proxy and other qualitative factors must be considered to arrive at a final
conclusion
Important Parameters for this Approach:
• Based on market data for the price and Value Line Investment Survey
reports to assess the safety factor
Prevalence in Professional Practice:
Not seen very often, particularly for closely held companies.
What the Courts say about this Approach (include cite):
This approach has not been vetted in any meaningful way by the courts.
(b) The Longstaff Study, Journal of Finance, December 199524
Background
Francis A. Longstaff authored a study that relies on stock option pricing theory to
estimate the DLOM for a privately held company. The Longstaff study is based
on the price of a “look back” option25. Using option-pricing theory the model
relies on the restriction period and the volatility or standard deviation of a
security’s return. Essentially Longstaff assumed that an investor with perfect
timing ability would have the ability to identify a point in time in which the security
24Longstaff, Francis A., “How Much Can Marketability Affect Security Values?”, The Journal of Finance,
Vol. L, No. 5 (1995), pp.1767-1774.
25A look back option is a path dependent option that is settled based upon the maximum or minimum
underlier value achieved during the entire life of the option. Essentially, at expiration, the holder can "look
back" over the life of the option and exercise at a value based upon the optimal underlier value achieved
during that period. Look backs can be structured as puts or calls and come in two basic forms: A fixed
strike and a floating strike.
D. Summary of DLOM Studies/Methods
Securities-Based Approaches
DLOM Job Aid page 33
price reaches its maximum value. If an investor is locked up for a certain period
of time the investor gives up the opportunity to sell the security at its maximum
price. The marketability discount in Longstaff’s model is the present value
difference between what the investor could sell the security for after the
marketability restrictions have lapsed and the maximum price the security could
have sold for during the restriction period.
One of Longstaff’s observations is that the discount for lack of marketability can
be economically significant even with a very short restriction period as can be
seen in the sample output below.
Sample Outputs from Longstaff Model
Volatility of Underlying Stock
Term 10% 20% 30%
1 Day 0.40% 0.80% 1.30%
30 Days 2.30% 4.70% 7.10%
180 Days 5.80% 11.80% 18.10%
1 Year 8.20% 17.00% 26.30%
5 Years 19.10% 41.0% 65.80%
It should be noted that the above table is for illustrative purposes only and the
data points above were referenced in the author’s study. Volatilities in excess of
30% would most likely be used as a proxy. Therefore, the model may produce
results which are not realistic as indicated in the table below.
Longstaff Model Discounts as a function of Time and Volatility
Volatility
Term 10% 20% 30% 40% 50% 60% 70%
1 Day 0.40% 0.80% 1.30% 1.70% 2.10% 2.50% 3.00%
30 Days 2.30% 4.70% 7.00% 9.50% 12.00% 14.50% 17.00%
180
days 5.70% 11.70% 18.00% 24.50% 31.20% 38.30% 45.70%
1 Year 8.20% 17.00% 26.30% 36.10% 46.60% 57.60% 69.20%
2 Years 11.80% 24.60% 38.60% 53.70% 70.10% 87.70% 106.70%
5 Years 19.10% 41.00% 65.80% 93.70% 125.00% 159.90% 198.50%
Summary
The Longstaff approach assumes perfect market timing and, therefore, derives
an upper bound for the lack of marketability discount since an investor is looking
backward in time to make his buy/sell decisions instead of making these
decisions based on present evidence and anticipated future stock price
movements. Volatilities in excess of 30% would most likely be used as a proxy
D. Summary of DLOM Studies/Methods
Securities-Based Approaches
DLOM Job Aid page 34
for privately held stock for which there is no public market. Therefore, the model
may produce results which are not realistic as the upper bound in circumstances
of this kind could well reach 100%.
Strengths
• The model can be easily implemented in Excel and provides a benchmark
maximum estimate on the discount for lack of marketability.
Weaknesses
• The Longstaff model assumes that the investor has perfect market timing
and that the investor has trading restrictions that prevent the security from
being sold at an optimal time. Absent these restrictions, the investor would
know the exact best time to exercise the option and sell the underlying
stock and would do so.
• The Longstaff model produces very high marketability discounts with
relatively low volatility of 30%. Most small cap companies have volatilities
in excess of 50%. The model produces an estimate of an “upper
boundary” for DLOM.
• As mentioned previously the model should be used as a proxy for a
maximum estimate and should not be used blindly to determine a discount
for lack of marketability
Important Parameters for this Approach:
• Time to expiration
• Volatility
Prevalence in Professional Practice:
The model is not seen often for estimating DLOM for a privately held company. It
is more useful for estimating the discount on a large block of restricted stock of a
publicly traded company.
What the Courts say about this Approach:
This approach has not been vetted in any meaningful way by the courts.
D. Summary of DLOM Studies/Methods
Securities-Based Approaches
DLOM Job Aid page 35
(c) The Chaffee Study
Background
In 1993 David B.H. Chaffee authored a study, which related the cost to purchase
a European put option to the measurement of the Discount for Lack of
Marketability.
Summary
In 1993 David Chaffee III published an article on his theory that the Black
Scholes Option Pricing Model could be used to determine the DLOM. He found
that the European Option26 exercisable only at expiration was an appropriate
model for the SEC Rule 144 Holding Period of restricted shares. 27
Chaffee relied on the Black Scholes Option Pricing Model for a put option to
determine the cost or price of the put option. The cost of the put option divided by
the market price equals the Discount for Lack of Marketability (“DLOM”).
Chaffee determined his proxy of a Discount for Lack of Marketability based on
volatilities in excess of 60% based on analysis of small Over the Counter (“OTC”)
public companies.
The appropriate DLOM for a stock with a two-year holding period and a volatility
between 60% to 90% according to Chaffee was between 28% and 41% which he
cited as similar to the restricted stock studies.
Chaffee increased the holding period to 4 years, which showed a range of DLOM
from 32% to 49%. Increasing the holding period to greater than four years did not
materially change the DLOM.
According to Chaffee the use of the Black Scholes Option Pricing model for
European options produced a minimum DLOM since a European put option
pricing formula does not take into account early exercise.
Strengths
• The model can be easily implemented in Excel and is based on the
European put option Black Scholes Formula
26 European options can be exercised only at maturity. American options can be exercised early.
27 See James R. Hitchner, Financial Valuation, 2nd Edition John R. Wiley and Sons 2006.
D. Summary of DLOM Studies/Methods
Securities-Based Approaches
DLOM Job Aid page 36
Weaknesses:
• As with all the option pricing models mentioned in this section, the DLOM
should be used as a proxy only. Other qualitative factors must be
considered to determine a final DLOM.
• Chaffee considered his results as “downward” biased and as such his
findings are considered a minimum DLOM
• The owner of privately held company stock does not have the ability to
hedge their investment. The option models provide a proxy for
marketability and the model can't be used without consideration to other
factors.
Important Parameters for this Approach
• Stock price and exercise price are equal. The stock price and exercise
price is equal to the marketable value of the privately held stock at the
Valuation Date
• The rate is equal to the Weighted Average Cost of Capital
• Volatility is based on comparable publicly traded guideline companies
• The term is equal to the length of time the security is expected to remain
non-marketable
Prevalence in Professional Practice
Not seen very often, particularly in valuations of private companies.
What the Courts say about this Approach
This approach has not been vetted in any meaningful way by the courts.
(d) Bid-Ask Spread Method to Determine DLOM28
Background
The bid-ask spread is the difference between the price asked for the business by
the seller (“ask price”) and the price offered for the business by the buyer (“bid
price”). The illiquidity is measured as the percentage difference between the bid
and the ask price. In most markets, there is a dealer or market maker who sets
the bid-ask spread to cover its costs of holding inventory, processing orders and
28 Amihud, Yakov, and Mendelson, Haim. “Asset Pricing and the Bid-Ask Spread,” J. Financial Econ. v 17
(December 1986): 223–49.
D. Summary of DLOM Studies/Methods
Securities-Based Approaches
DLOM Job Aid page 37
trading with more informed investors. The spread has to be large enough for the
dealer to cover his costs and yield a reasonable profit. Amihud and Mendelson
tested market rates of return against yield spreads (difference between bid-ask
price) for various financial stocks for the period 1961-1980. Their regression was
significant. This signifies that the returns on the stocks were not only a function of
risk but also of illiquidity. Therefore, the riskier the stock, the larger the spread
and the higher the implied DLOM29.
Summary
This is a conceptually simple approach and utilizes actual market data. Market
makers are market savvy and could be inclined to over-estimate the implied
DLOM to build a spread that will bring them increased profits. The more traders
that there are in the marketplace the better the bid-ask spread should represent
the actual effects of lack of marketability.
Strengths
• There is a large sample of trading firms from which an illiquidity discount
can be computed
Weaknesses
• This approach provides an illiquidity discount only. Other factors such as
restrictions on marketability need to be considered to get to DLOM
• The bid-ask spreads of publicly traded stocks must be related to variables
that can be measured for a private business
• Considerable subjective judgment is still required on the part of the
valuator
Important Parameters for this Approach:
�� In order to apply this approach to a private company, a model could be
developed which could, for example, take into consideration such
parameters as revenues, a measure of size, and whether a firm was
profitable or not.
29 See Kasper Larry J, Business Valuations: Advanced Topics, Greenwood Publishing Group 1997 Chapter
5 Premium and Discounts
D. Summary of DLOM Studies/Methods
Securities-Based Approaches
DLOM Job Aid page 38
Prevalence in Professional Practice:
This approach is not seen very often for estimating DLOM for a privately held
company.
What the Courts say about this Approach
This approach has not been vetted in any meaningful way by the courts.
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 39
3. Analytical Approaches
Approach Overview
The analytical approach studies the discount for lack of marketability (DLOM)
through the consideration of various transactional data sets. The involved data
sets have been put together by the authors of the DLOM studies from various
sources and number from less than 100 to several hundred sale transactions
involving stock sales conducted outside the public market place. The sales
normally involve the stock issuer as seller and various institutional entities as
buyers thus by-passing the normal registration requirements of the U. S.
Securities and Exchange Commission (SEC) for stock to be sold to the general
public. These data sets generally compare the sale price for blocks of publicly
traded stocks sold through private placements as compared to the sale price of
the shares as traded on the primary market where such are listed. These data
sets are analyzed statistically and through regression analyses to both determine
the total amount of the discount and the breakdown of that discount across
various postulated causal factors. The types of data in question are similar to
those that form the basis of the better known “restricted stock studies” that are
the subject of another portion of this DLOM job aid.
The transactions that make up the dataset are screened in various ways to
eliminate outliers and to identify any specific factors relating to the private
placement that are not comparable to the factors that are attributable to
associated traded shares that also constitute minority interests. A typical private
placement block size might be 15% of the total outstanding common stock.
Where significant size blocks are involved in comparison to normal daily trading
volumes for the associated stock on the public marketplace, some aspect of
blockage discount as well as regular DLOM may be present in the transaction.
The valuation analyst needs to be alert to such a possibility.
There have been a number of different researchers starting in the late 1980’s that
have taken an analytical approach to estimating DLOM. Almost all of these
researchers come from the academic community and none started out his or her
research with tax concerns in mind. The research was undertaken for various
purposes but the fundamental underlying intent was to better understand the
characteristics of capital formation among public companies. Typical questions
posed for study are when should debt be issued instead of stock, when should
preferred equity be issued instead of common equity, when should common
equity be issued instead of debt or preferred equity and what mode of issuance
should be used.
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 40
Four such studies are reviewed below. The first two are early studies (Wruck –
1989 and Hertzel & Smith – 1993) that illustrate the methodology for an eventbased
analysis often used in corporate capital formation investigations. The third
study is the Bajaj et al analysis that has been referred to in a number of court
cases that have been tried since the year 2000 and the fourth study is a portion
of a body of work by Ashok Abbott that has drawn recent attention to the area of
discounts for lack of liquidity (DLOL). Lack of marketability (LOM) and lack of
liquidity (LOL) have often been treated in the literature as identical concepts.
However, these two areas have been distinguished by Pratt30 and Abbott31 as
follows. Per Pratt, marketability is the legal ability to sell an asset whereas
liquidity is the ability to sell an asset without delay and without loss of value. Per
Abbott, marketability denotes the right to sell an asset in an established and
efficient public capital market, within a reasonable time, with relatively low
transaction costs, and with minimal effect on that security’s public market price.
Liquidity, on the other hand, denotes the ability to convert an asset into cash
without diminishing its value.
In addition to these studies, Exhibit C – Analytical Approach Revisited provides a
summary of several additional studies that further expand the analysis of the
mechanics of corporate capital formation.
Terminology
The analytical studies are usually configured as “event studies” which involve the
“private placement” of “unregistered” or “registered” shares of stock or, in some
cases, both. These terms are explained below.
Event Study – a study that investigates the circumstances surrounding and the
results of a specific event such as a private placement of stock in bulk.
Private Placement – a transaction involving a seller which is usually the issuer of
a class of stock and a buyer which is usually a large investor such as an
institution or a stock fund outside of the normal market mechanism of a public
stock exchange. Evidence indicates that the per share price of a private
placement transaction is often set at a discount to the publicly traded price of the
same stock as quoted in the market.
Unregistered Share – a share of stock that has not been registered under the
Securities and Exchange Act of 1933 and thus which cannot be sold to just any
interested investor or traded on the public exchange. Such shares can be sold to
specific sophisticated investors such as those noted above.
30 Pratt, Shannon P., Business Valuation Discounts and Premiums, Wiley 2001, pg 10
31 Abbott, Ashok B., Presentation at Business Valuation Conference: Summit on Lack of Marketability,
University of San Diego School of Law, September 18, 2008, Slide 4
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 41
Registered Share – a share of stock that has been registered under the
Securities and Exchange Act of 1933 and that can be freely sold to any investor
desiring to buy.
In many cases, both registered and unregistered shares sell at a discount when
privately placed in bulk. If one assumes that a registered share is freely tradable
to anyone at any time then a marketability discount of zero would pertain to that
share. Thus, by comparing the total discount per share for the private placement
of unregistered shares to that of registered shares, analysts can obtain an
estimate of the discount for lack of marketability for those shares since all other
discount factors should be the same.
Some analysts dispute this approach on the grounds that even registered shares
do not necessarily have a lack of marketability discount of zero if such are
offered in bulk or are thinly traded in the marketplace. Under this logic the
difference between the price of unregistered shares and registered shares
offered in private placements would tend to under-estimate the discount for lack
of marketability. For example, if the difference in total discount is 10% but the
registered shares already have a 5% discount for DLOM built-in then the actual
DLOM for the unregistered shares is 15% rather than 10%. As the unregistered
shares serve as a surrogate for the shares of a non-publicly traded entity the
substance or lack thereof in the question raised above can be of some
importance (in the illustration this amounts to an increase in DLOM of 50%).
Primary Reviewed Studies
(a) Karen Hopper Wruck32
Background and Summary
Karen Wruck studied equity ownership concentration and its effects on firm
value. Her premise was that private placements act to increase ownership
concentration by bringing aboard more large shareholders and that such
increased concentration should manifest itself in an overall increase in firm value
thereby benefiting all shareholders. On the other hand, public offerings of equity
tend to dilute share value for the existing ownership base.
Wruck studied 128 private sales of equity involving 65 companies traded on the
New York Stock Exchange and 63 companies traded on the American Stock
Exchange between July 1979 and December 1985. She measured the share
price of the stock on the exchanges 1 day after the announcement of the private
placement and compared that price to the share price involved in the placement.
32 Wruck, Karen Hopper, “Equity Ownership Concentration and Firm Value: Evidence from Private Equity
Financings”, Journal of Financial Economics 23 (1989), 3-28.
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 42
She considered both placements of registered shares and placements of
unregistered shares and found a 17.6% average difference in discounts between
the two types of shares when privately placed. The median difference in
discounts was 10.4%.
Wruck concluded that private placements of all types sell at a discount to the
publicly traded shares but that unregistered shares required a higher discount for
placement than registered shares. It was postulated that the need for this higher
discount was a function of lack or marketability as well as the increased costs of
monitoring borne by investors that hold unregistered shares. She hypothesized
that private placements are generally bought by active investors that act to keep
management on its toes thereby positively affecting overall firm value.
Since monitoring costs are involved to some extent for private placement
investors, whether their shares are registered or unregistered, users of the Wruck
study have postulated that the 17.6% average discount difference is primarily
related to lack of marketability for the unregistered shares. However, since the
Wruck analysis did not control for the effects of other potential contributing
variables, it is quite possible that a meaningful portion of the average discount
difference could be caused by existing operational differences in data set firms
rather than to marketability.
Strengths
• The strength of the Wruck analysis is its clearly defined hypothesis and
the use of analytical tools to investigate that hypothesis. Both registered
and unregistered placements are considered with companies listed on two
different exchanges represented almost equally.
• The discount result reached is logically supported by the analysis
approach used.
• Further, by comparing registered and unregistered placement discounts,
the Wruck methodology presents a way of isolating the discount for lack of
marketability from certain other factors such as assessment and
monitoring costs that could also lead to discounts.
Weaknesses
• The weakness of the Wruck analysis relates to the data selection
approach that was utilized. The sample of firms chosen seems to have
been primarily based on data availability rather than logical selection
methodologies.
• The classification determination as to whether placed shares were
registered or unregistered was predicated on published reports in the Wall
Street Journal. Of the 128 firms in the sample, a determination was
available for only 73 of the placements and that determination was
subjective in nature.
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 43
• The measurement point was chosen as one day after the announcement
date which would seem to take advantage of any immediate bounce in
stock price thereby increasing measured discount amounts. This
weakness is somewhat mitigated by the methodology that compares
registered discounts to unregistered discounts instead of measuring
unregistered discounts in total as an indication of lack of marketability.
Thus, assuming that a market bounce might result from any private
placement as Wruck hypothesizes, the difference in discount existing
between the two types of placements might still be a valid measure of lack
of marketability effects.
Important Parameters of the Study
The primary parameters in the Wruck study are:
• the selection of the sample itself,
• the registration status of the placement, and
• the selection of a proper measurement point.
View of the Valuation Community
The Wruck study has been cited by a number of practitioners but is basically
utilized as background material to introduce the subject of investigating
marketability discounts analytically. Although the average and median discounts
of the study are offered as evidence that the results of the benchmark studies
may be much too high, the Wruck discounts themselves are not offered as actual
discount proposals.
View of the Courts
Since the numerical values of the Wruck discounts have not been advanced in
court as actual discount amounts, the courts have not specifically opined on the
Wruck study and its results.
(b). Hertzel and Smith33
Background and Summary
Hertzel & Smith (H & S) studied market discounts and shareholder gains involved
in the private placement of equity. They hypothesized that private equity
33 Hertzel, Michael and Richard Smith, “Market Discounts and Shareholder Gains for Placing Equity
Privately”, Journal of Finance, 48 (1993), 459-485.
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 44
placements are often undertaken by firms with limited tangible assets, by firms
engaged in the speculative development of new products and by firms in financial
distress. Due to the higher risk inherent in these types of firms, they tend to offer
private placements priced at higher than normal discounts. These higher than
normal discounts compensate investors for the higher information costs incurred
and the higher monitoring costs required to keep suitably informed of investment
status. Based on these premises, H & S believed that the discounts required to
sell equity privately existed for a number of reasons beyond the potential lack of
marketability of the purchased shares or the expectation that the buyers would
provide services as well as investment capital.
H & S used statistical analysis techniques to identify those factors that contribute
to the overall observed discount; including, but not limited to, the effects of lack of
marketability. H & S found an average discount differential between private
placements of unregistered shares as compared to private placements of
registered shares of 13.5%. They considered this to be a surrogate for DLOM.
However, they opined that this surrogate should not be accepted on face
because they believed that if the DLOM discount was really this high, then firms
would react by registering all of their shares prior to placement. H & S postulated
that portions of the discount were due to the higher required assessment and
monitoring costs required of private placement investors and the tendency of the
market to bid up the price of traded shares where private placement investors
had taken an interest and shown a willingness to invest.
H & S analyzed 106 private equity placements with about 75% of those being
firms traded over-the-counter. The time period of their study was January 1, 1980
through May 31, 1987. The measurement date used was 10 days after the
announcement of the placement was made. Of the placements analyzed, 45
involved registered shares, 18 involved unregistered shares and 43 had an
unknown registration status. H & S assumed that all of the placements where the
registration status could not be determined were, in fact, registered for study
purposes since this would lead to a conservative result with regard to the
discount differential.
A regression analysis was performed using 7 independent variables with the
registered versus unregistered variable used to estimate DLOM. The average
private placement discount overall was found to be 20.14% with about two-thirds
of that discount (13.5%) being related to concerns about lack of liquidity. The
remainder of the discount was due to such other factors as the size of the
placement, the degree of financial distress existing in the firm and the nature of
the placement buyers. In the context of their paper, H & S seem to be using the
terms marketability and liquidity interchangeably rather than with the type of
differentiation that was noted earlier per Pratt and Abbott. As stated above, H
& S considered this to be an upper bound for DLOL/DLOM due to the perceived
difference in assessment and monitoring costs between registered and
unregistered shares.
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 45
Strengths
The strength of the H & S study is that it is somewhat more complete in its
analysis than the Wruck study as seven variables potentially affecting
discounts are identified and analyzed using a regression model. Through
the multi-variate analysis, H & S were able to isolate what they believe to
be the specific effect of lack of marketability from the effects of the other
variables considered. This effect is measured at 13.5% based on the use
of a dummy variable relating to registration status.
• The H & S sample is primarily (75%) made up of smaller companies that
are traded over-the-counter whereas the Wruck sample was composed of
companies traded on major stock exchanges. These smaller companies
would seem to be more like the companies that are most often the
subject of valuation assignments where lack of marketability is a concern
than are the larger companies studied by Wruck.
Weaknesses
• The H & S study once again suffers from sample selection, registration
status determination and measurement point problems as was the case
with the Wruck study.
• H & S were able to determine the registration status of only 63 of their 106
sample companies and assumed that the 43 that could not be determined
would all be considered as registered. This is an obvious, very serious
problem with the methodology employed since it is the registration status
variable that is put forth as the measure of lack of marketability in the
study. H & S consider this approach to lead to a conservative result since
the assumption used would act to reduce the amount of discount
attributable to lack of marketability.
• H & S chose a measurement point at 10 days after the announcement
date which gives any bounce upon announcement some time to dissipate
prior to the measurement. This choice should also act to produce a more
conservative discount result; however, the choice of measurement point
remains arbitrary and totally subjective.
Important Parameters of the Study
The analysis parameters considered by H & S are:
• Fraction of total outstanding stock placed
• Financial distress of issuer34
• Book to market ratio of stock value
• Log of the proceeds of the offering35
34 The financial distress parameter is based on an analysis of such things as the company’s solvency,
liquidity, return on assets, debt-serving capacity, etc. to measure overall financial condition.
35 This is a measure of the size of the placement in dollar terms expressed on a logarithmic scale
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 46
• Registration status
• Investor is an individual
• Investor is a member of management
The other important variables in the approach are the sample selection
methodology and the choice of measurement point.
View of the Valuation Community
The H & S study, like the Wruck Study, has been cited by a number of
practitioners but is basically utilized as background material to introduce the
subject of investigating marketability discounts analytically. Although the average
and median discounts of the study are offered as evidence that the results of the
benchmark studies may be much too high, the H & S discounts themselves are
generally not offered as actual discount proposals.
View of the Courts
Since the numerical values of the H & S discounts have not been advanced in
court as the primary determiners of proposed discount amounts, the courts have
not specifically opined on the H & S study and its results.
(c). Bajaj, Denis, Ferris and Sarin36
Background and Summary
Bajaj et al set about to study the concept of firm value and marketability
discounts. They defined marketability as how quickly an asset can be converted
into cash, without the owner incurring substantial transaction costs or having to
give significant price concessions. They postulated that lack of marketability
increases opportunity costs for asset holders and that such holders are also
exposed to increased risks of loss. Both of these factors increase risk and lead to
the need for discounting to lure investors to buy.
Bajaj et al set out the following factors affecting marketability:
-Uncertainty of the assets value
-Lack of availability of information on the asset to an outsider
-Availability of close substitutes for the asset
-Duration of the restriction on trades of the asset
-Size of the block being sold
36 Bajaj, Mukesh, David J. Denis, Stephen P. Ferris and Atulya Sarin, “Firm Value and Marketability
Discounts”, Journal of Law and Economics (2002).
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 47
An analysis was made of private equity placements during the period January 1,
1990 through December 31, 1995 involving 88 transactions. The measurement
date used was 10 trading days after the announcement date. Accounting data
was drawn from Compustat. A cross-sectional analysis of discounts was made
using regression techniques.
Bajaj et al found that, on average, all private placements are made at discounts
whether the block placed consists of registered shares or non-registered shares.
For registered shares, the average discount was 14.04% and for unregistered
shares the average discount was 28.13%. The respective median discounts were
9.85% and 26.47%. Combining unregistered and registered share transactions
gave an overall average discount of 22.21% and a median discount of 20.67%.
As a first estimate of DLOM the average discounts were compared to get a
discount differential of 14.09%. This was predicated on the premise that no
DLOM should exist for registered shares since such could become immediately
freely traded. A regression analysis was then conducted to attempt to further sort
out the factors contributing to the overall discounts. This analysis used four
independent variables with the registered/unregistered status being one. The
coefficient for the registration variable turned out to be 7.23% indicating that
registered shares would require a lesser discount than unregistered shares by
that amount. This provided a more refined estimate of the specific effects of lack
of marketability in Bajaj’s view.
Bajaj et al also stratified their overall discount data to provide statistics for the
larger group of discounts, the middle group of discounts and the smallest group
of discounts. Averages of 43.33%, 20.36% and 2.21% were derived by group.
Discussion was provided of the various factors that might explain the range of
differences among these stratified groups. These included the fractional size of
the block to total shares outstanding, the business risk facing the firm, the degree
of financial distress of the firm and the total proceeds raised in the offering.
The Bajaj et al study has generated considerable response and criticism as it
was the first study offered as a basis for court testimony for tax purposes when
Dr. Bajaj began testifying before the Tax Court in cases such as the Estate of
Gross and McCord. Most notable among the parties criticizing the study were
Shannon Pratt, Mark Mitchell, Lance Hall and Chris Mercer. These critics found
problems with many facets of the study including sample selection, measurement
date, the combining of registered and unregistered share transactions, the choice
of regression variables, the failure to consider the holding period as an
explanatory factor, the failure to consider the Rule 144 affiliate provisions, the
failure to properly identify registration status, and lack of rigor in the regression
model employed.
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 48
Strengths
• The Bajaj study like the H & S study concentrated primarily (82%) on
companies traded over-the-counter. Although there is some debate
among critics, the Bajaj sample of 88 companies seems to be better
defined and the registration status of the component private placements
more confidently determined with about 58% being unregistered.
• As mentioned for H & S the use of primarily smaller companies seems to
be better suited to the measurement of the effects of lack of marketability
than companies traded on major exchanges.
• Bajaj considered five different parameters that were seen to affect
discounts, one of which was a variable based on registration status. This
approach, like the approach pursued by H & S, allowed a direct
measurement of what Bajaj considered to be the effects of lack of
marketability. His isolated discount amount of 7.23% is supported by his
model but seems to be too low to survive the application of a sanity check.
Weaknesses
The potential weaknesses of the Bajaj study have been spotlighted by a number
of its critics including Pratt, Hall, Mercer and Mitchell and Norwalk. These
weaknesses are concentrated in the areas of concern over sample choice, the
remaining presence of some uncertainty in actual registration status, the
relatively low coefficient of determination or R2 factor37 generated by the
regression model used and the choice of a measurement date of 10 days after
the announcement.
• Certain writers have pointed to data errors in the sample and the failure to
consider other transactions occurring within the analysis period that are
considered to be logical choices with required data available.
• There is some question among analysts as to what the 7.23% discount
amount attributable to lack of marketability by Bajaj really measures and
whether, even if it truly measures a pure marketability component of
discount, it is the proper level of discount to be considered in a
transactional analysis. Bajaj himself has been somewhat inconsistent in
how he applies the results of the study using the 7.23% in certain cases
and a larger discount that is said to include the effects of assessment and
monitoring costs in other cases.
• Another weakness of the Bajaj study in the view of his critics is it does not
explicitly consider the length of the required holding period for an
unregistered placement as a factor in the analysis. Not all unregistered
placements are subject to the same holding period limitations and,
accordingly, the analysis of registered versus unregistered placements
should not be treated as a binary variable as Bajaj has proposed.
37 The coefficient of determination is a measure of how well a regression model fits the data by indicating
how much of the total data variation is explained by the model. If all the data were to fall directly on the
model line then the coefficient would be 1.00. The lower the coefficient the less of the variability of the
data is explained by the model.
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 49
• Finally, critics argue that simply because some private placement shares
are registered does not automatically make them freely tradable such that
no DLOM should apply to them.
Important Parameters of the Study
Bajaj combines the five areas potentially affecting marketability related discounts
into four parameters for use in his model. These parameters are:
• the percent of shares placed out of the total outstanding shares,
• the Z-score38 which is a measure of a firm’s financial strength or lack
thereof based on an analysis of ratios focusing on solvency, liquidity,
return on assets, debt serving capacity, etc.,
• the registration status of the placement and
• the volatility of the stock as determined using actual data for the publicly
traded stock of the sample company.
Other important variables are the selection of the sample to be analyzed and the
choice of the measurement point.
View of the Valuation Community
Unlike Wruck and Hertzel & Smith, the Bajaj study has received intense attention
from the valuation community, much of it critical in nature. Critics such as Pratt,
Hall, Mercer and a number of other practitioners have cast much skepticism on
Bajaj’s sample selection, his model’s weaknesses including its rather low
explanatory value as measured by R2, the use of registration status as a binary
variable rather than one that considers the differential effects of required
restriction periods and the unreasonably low amount that is attributable to lack of
marketability as a discrete variable. The general thesis advanced by his critics for
Bajaj’s relative success in his court appearances is that he had poor and
unprepared opposition that could not and did not exploit all of the weaknesses in
his study and his testimony.
The critics advance a number of reasons why the Bajaj approach should not be
accepted by practitioners but, in each case, the criticism is accompanied by
support for the critics own preferred approach to DLOM. In the case of Pratt and
Hall, this is the use of the benchmark study approach while in the case of Mercer
it is the use of his QMDM approach. Hall believes that the data in the FMV
Opinions restricted stock study can be used to counteract the conclusions that
Bajaj has advanced.
38 See Edward I. Altman, Financial Ratios, Discriminant Analysis and the Prediction of Corporate
Bankruptcy, J. Fin 589, 589-605 (1968). The higher the Z-Score of a company, the stronger its financial
position.
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 50
View of the Courts
To date, only Bajaj and his colleague Dr. Shapiro have gone to Court with the
analytical approach as their main support for a DLOM discount selection. Bajaj
has testified in the Estate of Gross39, Litman and Diener v. USA40, McCord et ux
v. Commissioner41 and Richie C. Heck v. Commissioner42 among others. Shapiro
utilized the same approach in his testimony in Lappo v. Commissioner43.
In general, the Courts have given favorable treatment to Bajaj’s general
approach to DLOM citing the conceptual basis and the use of mathematical
techniques to separate out contributing factors. However, no Court has accepted
his 7.23% estimate as the proper DLOM at face value. In McCord, the Court
instead chose to look at all of the Bajaj data and to select a DLOM based on the
summary results from his middle strata of discount transactions arriving at a
number of 20%. A similar approach has been taken in other cases where the
20% discount has been accepted as a starting point and then adjusted up to 23%
or 25% based on factors that the Court thought were important. In Gross, Bajaj
did not propose a strict DLOM discount based on his study but instead argued for
25% which included a 20% original amount plus 5% to account for the S corp.
effects on marketability. This total discount was accepted by the Court.
(d). Ashok B. Abbott44
Background and Summary
Abbott studied empirical methods for estimating marketability and liquidity
discounts. He defines marketability as the ability to sell a block of securities in an
established and efficient public capital market, with relatively low transaction
costs, and with minimal effect on that security’s public market price. Liquidity is
then seen as the ability to convert a block of securities into cash. Per Abbott,
marketability refers to a right and liquidity is a measure of speed.
Abbott believes that neither the pre-IPO nor the Restricted Stock Studies give
very usable results for a number of reasons. Among these are changes in the
39 Estate of Gross, T.C. Memo 1999-254, 78 T.C.M. (CCH) 201, T.C.M. (RIA) 99254, 1999 Tax Ct. Memo
LEXIS 290
40 David S. and Malia A. Litman v. The United States, United States Court of Federal Claims, 2007 U.S.
Claims LEXIS 273, August 22, 2007
41 McCord v. Comr., 120 T.C. 358 (2003)
42 Heck v. Comr., T.C. Memo 2002-34
43 Clarisa W. Lappo v. Comr., T.C. Memo 2003-258, Tax Ct. Memo LEXIS 257, 86 T.C.M. (CCH) 333
44 Ashok B. Abbott, Various Dates, Empirical Measures of Marketability and Liquidity Discounts,
Discounts for Lack of Marketability: An Empirical Analysis and DLOM – Concepts and Models,
Presentations at Various ASA and NACVA Conferences and on the BVR Teleconference of April 26, 2006
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 51
Rule 144 holding period, the growth of the derivatives market, the reduction in
required trading costs due to discount brokerages, the new transparency rules
established by the SEC and FASB, and their use of averages.
Per Abbott, recent law changes and market developments have made public
markets more liquid but this change does not extend to private markets which
could lead to an understatement of discounts appropriate to these markets.
Hence, he believes that a more scientific and statistically supportable approach
to marketability and liquidity is now required. He then analyzes a number of
studies and discount indications that exist. This review provides the following lack
of liquidity indicators.
�� In 1996, for shares traded on the NYSE, the most liquid stocks when
compared to the least liquid stocks indicated a discount for lack of
liquidity range of 35.5%
�� In an IPO study for the period 1993 to 2003, the average trimmed mean45 for
DLOL is 6.05% based on some 7,824 IPOs
�� In a 2004 IPO study the range for DLOL was from 4.3% to 9.9%
depending upon market capitalization
• Small cap stocks had greater holding periods during the period from 1993 to
2004 in the range of 30 to 130 months as compared to 10 to 21 months for
large cap stocks; the overall average range was from 25 to 69 months
• Large cap stocks have been as much as 9 times more liquid than small cap
stocks for trades during 2001
Abbott mentions that Longstaff46 has postulated a DLOL of 3% to 42% based on
his option study where 3% is for a 5% block size for a large cap stock and 42% is
for a 25% block size for a small cap stock. These discounts are upper-bounds
since Longstaff assumes perfect market timing in making his analyses.
Finally, Abbott concludes that for smaller block sizes a proper DLOL is limited to
less than 25% with the DLOL for a 5% block limited to about 15%.
Strengths
Abbott recognizes the differences between public and private markets and the
importance of block size as considerations in the discount for lack of
marketability. He further recognizes the effect of relatively new innovations in
45 The trimmed mean is the average obtained from a subset of the data after some of the largest and the
smallest values have been removed. It is thought to be a better measure of the central tendency of the
concentrated core of the data than is the overall mean.
46 Francis A. Longstaff, How Much Can Marketability Affect Security Value?, J. Fin,, 1767, December
1995
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 52
security markets as factors that act to reduce the discount required by investors
in non-liquid stocks. Further, he recognizes the importance of overall company
capitalization on the holding periods required to sell stocks. Abbott cautions as to
the risks involved in using public stock-based discounts for stocks that are not
publicly traded on any recognized exchanges. His strengths are mostly
conceptual rather than of a nature that would necessarily lead to a reliable
numerical estimate for either DLOL or DLOM.
Weaknesses
Abbott’s results have been mostly presented in academic and valuation society
environments and have not been properly vetted by either practitioners or the
courts. It is doubtful that his work could serve as a primary approach to
marketability quantification as of the present time.
Important Parameters of the Study
Variables indicated by Abbott as potentially significant factors in liquidity and
marketability include
• block size,
• overall market capitalization,
• availability of hedging opportunities,
• anticipated holding period of market participants and
• the general need for liquidity in the economy in general.
View of Valuation Community
To date, the valuation community has shown an interest in Abbott’s work and his
concepts. He has been invited to speak at numerous valuation conferences and
to participate in a number of panel discussions such as the BVR
Teleconferences. There has been no use of the results that he has generated as
a basis for discounts that would properly serve as a foundation for an overall
valuation.
View of the Courts
The Abbott analyses and findings have had no vetting in the courts.
Conclusion
Overall, many judges seem to be using the work of Bajaj and the other analytical
studies as ammunition to hold all practitioners accountable for unsupported
reliance on the benchmark studies. Even though an acceptable bottom line
number has not come out of these studies per se, they have raised several
questions and have tended to show that the benchmark studies can sometimes
lead to unreasonably high results. Among the questions that they have brought to
D. Summary of DLOM Studies/Methods
Analytical Approaches
DLOM Job Aid page 53
the surface is the existence of investors with long investing horizons for which
marketability is not a particular concern and the development of the derivative
markets which have allowed the creation of synthetic liquidity that did not exist at
the times when the benchmark studies were constructed.
As a result of the weaknesses cited relating to sample selection, sample point
classification and measurement point concerns, it is unlikely that these
approaches can be used to derive a numerical result that will go forth
unchallenged. Instead, the raw data collected and the many component factors
proposed can be used to make subjective judgments about discount magnitudes
that would seem more satisfactory than using the gross averages generated by
the benchmark studies, either with or without unsupportable adjustments for
changing facts and circumstances. For example, consideration of volatility and
expected holding period as opposed to restriction period would seem to be
factors that provide meaningful insight to the DLOM and DLOL question. Also the
availability of hedging strategies can act to increase effective liquidity where
those strategies exist. These strategies replicate the existing value parameters of
a non-liquid security by combining the value parameters of other securities that
are publicly traded and, therefore, more liquid.
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 54
4. Other Approaches
(a) QMDM (Christopher Mercer)
Background and Summary
The complete reference for this approach to the Discount for Lack of
Marketability (“DLOM”) is the “Quantitative Marketability Discount Model” (see
Mercer’s book: Quantifying Marketability Discounts, by Z. Christopher Mercer,
ASA, CFA, Peabody Publishing, LP, 1997). The model calculates a matrix of
discounts for lack of marketability, based upon a range of variables. Variables
include rate of appreciation in assets, holding period until liquidation, and
required rate of return to the hypothetical investor. The appraiser estimates which
variables from the matrix are most appropriate for the subject interest. The
intersection of those variables within the calculation matrix yields the DLOM.
Given the variable inputs, discounts from this method can vary significantly. For
example, a “base case” illustration on page 225 of Mercer’s book presents a
matrix of possible discounts ranging from 5% to 100%. Within the matrix, three
discounts are proposed for purposes of discussion (31% [low], 58% [medium],
and 71% [high]).
Areas of Focus
In discussing this approach with taxpayer or taxpayer’s appraiser, the following
areas of focus should be explored:
• On what basis has the Taxpayer’s appraiser estimated the expected rate
of appreciation (i.e. growth) on the underlying investment assets?
• On what basis has the Taxpayer’s appraiser estimated the holding period
before the hypothetical buyer would receive the cash flow return on their
investment?
• On what basis has the Taxpayer’s appraiser estimated the required rate of
return to the hypothetical buyer?
• How does the required rate of return compare to alternative investments
that were available to the hypothetical buyer on the valuation date?
Strengths
• As its name states, the QMDM provides a quantitative basis for reaching
an opinion of the DLOM.
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 55
• Instead of arbitrarily selecting “35%” after a vague discussion of valuation
theory and restricted stock studies, the QMDM allows the appraiser to
estimate specific factors (e.g. rate of appreciation, holding period, and
required rate of return), to conclude a specific DLOM from the calculation
matrix.
Weaknesses
• While it avoids arbitrary selection of a DLOM, estimation of factors for the
calculation matrix can be just as arbitrary and subjective.
• The matrix increases the number of things the appraiser needs to have an
“opinion” about, potentially leaving the appraiser over-extended on their
clairvoyance about a multitude of events expected to occur many years
into the future.
• Alternatively, if the appraiser simply relies upon management (i.e. the
“client”) projections for parameter estimation, the appraiser’s opinion of the
DLOM might lack credibility and independence.
Important Parameters for this Approach
1) Base value of the marketable minority interest (the base value would be
the pro rata of the subject interest, after the discount for lack of control, but
before the discount for lack of marketability);
2) Expected appreciation on base value over the holding period;
3) Expected dividend yield over the holding period;
4) Expected growth rate in dividends over the holding period;
5) Assumed length of the holding period in years; and
6) Required rate of return to hypothetical investor over the holding period
Variations of the QMDM can incorporate additional factors, such as interim cash
flows, compensation to officers (including over-compensation), taxes, etc.
However, the model can become very complicated with the introduction of
additional variables.
Prevalence in professional practice:
This approach has seen minimal use by outside valuation professionals as the
primary basis for the DLOM. More recently, QMDM has been presented as
additional support (“sanity check”) for a DLOM estimated using methods other
than the QMDM.
From the perspective of originator of QMDM method: At the September 18, 2008
DLOM Summit in San Diego, Chris Mercer, the originator of QMDM, argued in
favor of this approach, stating that his firm still uses the QMDM (although he
mentioned that E&G tax valuations were not a significant portion of his firm’s
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 56
case work). He further stated that, despite some Court rulings involving the
QMDM approach, he (and his firm) has not been rebutted in Court for using the
QMDM.
View of the Courts
Prior to the QMDM, the Courts had criticized appraisers for a lack of quantitative
basis for their DLOM determination (e.g. arbitrarily selecting a 35% DLOM). The
QMDM appeared to be an answer, but Weinberg v. CIR (T.C. Memo. 2000-51)
and Janda v. CIR (T.C. Memo. 2001-24) suggest otherwise. In each of these
cases, the QMDM was criticized:
Weinberg v. CIR: “We disagree with the discount computed by Dr. Kursh
on the basis of the QMDM model because slight variations in the
assumptions used in the model produce dramatic differences in the
results.”
Janda v. CIR: “We have grave doubts about the reliability of the QMDM
model to produce reasonable discounts...”
(b) NICE (William Frazier)
Background and Summary
According to Howard, Frazier, Barker, Elliot, Inc. (www.hfbe.com), a Texasbased
valuation firm, firm principal William Frazier authored an article, "Nonmarketable
Investment Company Evaluation (NICE)", that appeared in the
November/December 2006 issue of Valuation Strategies (Vol 10, No 2, published
by Warren, Gorman & Lamont, RIA Group, Boston MA).
NICE is a valuation system under the income approach designed to determine
the fair market value of equity interests in closely held investment entities. NICE
uses investment returns to calculate value.
According to the article in Valuation Strategies (see above for citation reference):
[NICE] is a valuation system under the income approach to value. It is designed
specifically to determine the fair market value of equity interests in closely held
investment entities, such as family limited partnerships, S corporations, and
limited liability companies. NICE does not use [lack of control and lack of
marketability] discounts in its operation. Instead, lack of control and lack of
marketability are viewed as investment risks embodied in the required rate of
return for the subject interest.
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 57
The key issue is that incremental rates of return for lack of control and/or lack of
marketability need to be estimated. Such estimates can begin to appear
subjective, depending on the availability of adequate information.
Given the variable inputs, discounts from this method can vary. For example, a
“scenario” illustration on page 46 of the respective issue of Valuation Strategies
shows a discount range from 37% to 47.5%, with an indicated discount of
42.25%.
The NICE method specifically states that it should not be used when the holding
period is either known or can be reasonably estimated. According to the article,
the method assumes a “very long-term and illiquid investment”...“[T]he liquidation
date can be a very distant event, with a practical range of no less than ten years.”
Thus, the NICE method would tend to lead to an elevated estimate of total
discounts for an interest that did not meet these assumed conditions.
Areas of Focus
In discussing this approach with the taxpayer or taxpayer’s appraiser the
following areas of focus should be explored:
• On what basis has the Taxpayer’s appraiser estimated the additional rate
of return to compensate for lack of control and/or lack of marketability?
• Do the incremental rates of return reflect arbitrary selection of 1%, 2%,
3%, etc.?
• How does the required rate of return compare to alternative investments
that were available to the hypothetical buyer on the valuation date with
comparable degrees of total risk?
Strengths
• The NICE method avoids subjective estimation of discounts for lack of
control and lack of marketability. On that basis, the method appears to be
a more traditional, and straight-forward, “income approach” to valuation.
• NICE is also presented as a better alternative to the QMDM, on the basis
that the QMDM does not specifically address the additional required rate
of return for lack of control and/or lack of marketability, while the NICE
method does.
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 58
Weaknesses
• The method assumes the hypothetical buyer can demand (and receive) a
higher required rate of return for lack of control and lack of marketability.
• The basis (or capability) for the hypothetical buyer to receive the higher
rate of return can become a matter of subjective estimation.
• For example, the method claims to avoid subjectivity, but the illustration
within the article estimates (somewhat subjectively) a precise 2.00%
increase in required rate of return for lack of marketability. This
incremental return is illustrated on the basis of above-average
performance of certain mutual funds. However, the article admits that
mutual funds generally cannot maintain above-average performance
indefinitely.
• The method assumes a holding period well-in-excess of 10 years
(upwards of 50 years in some examples). However, it could be argued that
“predicting” a liquidation date 50-years into the future is just as speculative
as subjectively estimating a DLOM.
Important Parameters for this Approach
1) Baseline rates of return for market interest rates and stock market returns
(baseline reflects comparable investments that do not have additional
risks from lack of marketability); and
2) Incremental returns for lack of control and lack of marketability, which are
estimated on the basis of various “spreads” of different types of
investments.
Prevalence in Professional Practice:
The NICE or Frazier method has not been seen in valuation reports we have
reviewed. However, valuation reports have used rate-of-return methods to value
closely held investment interests (or as “sanity checks”), but the terms NICE or
Frazier were not cited.
William Frazier continues to conduct seminars on his “NICE” method. For
example, he presented on NICE at the AICPA/ASA conference in Las Vegas in
November 2008.
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 59
What the Courts say about this model
No Court references were found for the NICE or Frazier method. If presented to a
Court it is likely that the Court will criticize this method as relying upon
subjectively-estimated incremental rates of return for lack of control and lack of
marketability unless some definitive market evidence were provided in support of
these rates.
(c) NERA (David Tabak)
Background and Summary
NERA (National Economic Research Associates) is a consulting firm. Dr. David
Tabak, a Senior Vice President with NERA, published an in-house working paper
entitled: “A CAPM-Based Approach to Calculating Illiquidity Discounts”. The
working paper is dated November 11, 2002, and is posted for free on NERA’s
website (www.nera.com).
According to the NERA website (www.nera.com):
In this working paper, Dr. Tabak provides a review and analysis of existing
studies and theories on calculating appropriate illiquidity discounts for
restricted stock. Dr. Tabak discusses how existing studies have limited
applicability in calculating an appropriate discount because they generally
present only median or average results.
As an alternative, Dr. Tabak offers a theoretical model based on the
CAPM, or capital asset pricing model, that allows for a quantification of the
illiquidity discount based on objective criteria specific to the asset under
consideration. This equity risk premium-based model is the first approach
to apply the CAPM to the process of calculating illiquidity discounts, and
offers a number of benefits over using simple average discounts or any of
the other methodologies discussed in this paper.
The result is a framework for measuring illiquidity discounts that vary over
time and depend on the length of the restriction and the riskiness of the
illiquid asset. Perhaps most importantly, Dr. Tabak's new model is less
subjective than the analysis often used in practice today.
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 60
Given the variable inputs, discounts from this method can vary. For example,
page 16 of the working paper presents a table of “Implied Illiquidity Discounts”
(based on different equity risk premiums). The table indicates a full dataset range
of discounts from 15.4% to 82.9%, with mid-point average discounts ranging from
37.8% to 44.8%.
Areas of Focus
In discussing this approach with taxpayer or taxpayer’s appraiser, the following
areas of focus should be explored:
• For reference: The higher the equity risk premium (or the greater the
expected volatility of returns relative to the overall market [i.e. “Beta”]), the
lower the estimated value (and vice-versa). (Briefly defined: Beta is a
factor indicating the relative risk of a specific investment, as compared to
overall risk attributable to the aggregate market of investments.)
• How was the additional equity risk premium (or Beta) for lack of control
and/or lack of marketability determined?
• How was the time period until liquidation of the initial investment
determined?
• How does the equity risk premium (or Beta) compare to alternative
investments that were available to the hypothetical buyer on the valuation
date? (NOTE: While some methods compare overall rates of return [e.g.
risk-free rate plus the equity risk premium], the NERA method is focused
upon the equity risk premium portion of the return.)
Strengths
According to the article,
• the method provides a quantitative basis (using the capital asset pricing
model) to incorporate lack of marketability as an additional “risk” that
increases the equity risk premium (and lowers the “price”);
• “The calculation of an illiquidity discount is objective (or at least relatively
so) because it can be calculated based on volatility (actual for a security,
from a peer group for a company) and the equity risk premium.”
Weaknesses
• The method requires that a number of variables be either measured from
market activity, or estimated from market comparables. Estimates based
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 61
upon selected market comparables can introduce subjectivity into the
valuation analysis.
• Additional estimates with respect to holding period can introduce further
subjectivity into the valuation analysis.
• The model is theoretical in nature and there is no sound way to calibrate
its results against the market. Tabak has run a number of analyses
against S & P 500 stocks for various years and has used the old
benchmark study averages to provide a sanity check on his results.
Important Parameters for this Approach
According to the working paper, the model requires data (or estimates) of:
1) risk-free rate of return;
2) expected return to a market portfolio;
3) expected return to the subject asset;
4) covariance of the subject asset with respect to the market portfolio;
5) standard deviation of rates of returns; and
6) period of time that the asset is restricted from sale.
Of particular significance to the use of this method, the working paper (see above
for citation reference) states:
To begin, assume that these quantities are all measurable...[T]his theory
will still require a somewhat subjective analysis if one or more of these
quantities, typically T, the time of the restriction, must be estimated based
on qualitative data.
This suggests (from Dr. Tabak himself) that there are inherent weaknesses in the
method.
Prevalence in Professional Practice:
We have not seen the NERA or Tabak methods, per se. However, some
appraisals have used CAPM-based methods to estimate a risk-adjusted rate of
return for non-marketable securities (or as “sanity checks”).
What the Courts say about this model:
No Court references were found for the NERA or Tabak method. It is deemed
likely that the Courts might criticize this method as being overly-complicated,
and/or relying upon subjectively-estimated variables.
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 62
(d) Partnership Profiles (Partnership Spectrum)
Background and Summary
Partnership Profiles (aka “Partnership Spectrum” or “Direct Investments
Spectrum”) is a quarterly publication (moving to an online database
[www.partnershipprofiles.com or www.dispectrum.com]) that summarizes data on
re-sales of minority interests in Real Estate Limited Partnerships (“RELP’s”).
Partnership Profiles reportedly tracks more than 300 different RELP’s. Data for
each re-sale includes a pro rata net asset value attributable to each RELP
interest being sold. On that basis, a “discount” from pro rata net asset value can
be inferred from each re-sale.
Partnership Profiles is primarily used as the basis for lack of control discounts on
minority limited partnership interests. However, the RELP re-sale market is so
small (i.e. “thinly-traded”) that Partnership Profiles data arguably reflect some
additional consideration for lack of marketability. With respect to lack of
marketability, Direct Investments Spectrum has stated:
Although it is not possible to precisely quantify the amount of
discount attributable to marketability versus lack of control
considerations, it is the opinion of Direct Investments Spectrum,
along with many appraisers, that most of the overall discount is due
to lack of control issues.47
NOTE: Real Estate Investment Trusts (aka “REIT’s”) are similar to RELP’s, and
are also commonly-cited as the basis for lack of control discounts on minority
interests. However, REIT’s are freely-traded in an active market, and therefore,
discounts observed from REIT’s are generally assumed to exclude any
consideration for lack of marketability.
Areas of Focus
In discussing this approach with taxpayer’s or taxpayer’s appraiser, the following
areas of focus should be explored:
• Are the Partnership Profiles comparables similar to the subject interest in
terms of: a) the type of real estate; b) relative debt ratios; and c) cash
distributions yield?
• Has Taxpayer’s appraiser been able to verify if the baseline net asset
values in Partnership Profiles data were established using actual
47 May/June 2004 issue of Direct Investments Spectrum, at www.dispectrum.com.
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 63
“appraisals”, versus management estimates of the values of underlying
real estate investments?
• Assuming that Taxpayer’s appraiser used Partnership Profiles to estimate
the discount for lack of control, and then used another method (e.g.
restricted stock studies) to estimate the DLOM, did Taxpayer’s appraiser
give any consideration to “lack of marketability” considerations that
already exist within Partnership Profiles data (i.e. to avoid double-counting
lack of marketability factors)?
• In the case of a Charitable Contribution appraisal, does it appear that
Taxpayer’s appraiser is trying to minimize the discount (and maximize
value) by using Partnership Profiles for a single, combined discount for
lack of control and lack of marketability?
Strengths
• Appraisers who wish to avoid “over-discounting” might rely on Partnership
Profiles data to provide a single “combined discount” for lack of control
and lack of marketability.
• Partnership Profiles data include descriptive factors of the types of RELP
investments, debt ratios, and whether or not the RELP has been making
regular cash distributions to limited partners. These factors provide
specific bases to identify comparables within the data.
Weaknesses
• It has been argued that RELP’s referenced in Partnership Profiles are not
representative or not comparable to subject interests being valued in
appraisal reports (i.e. RELP’s are not directly comparable to family limited
partnerships).
• The data have also been criticized as being inconsistent with the fair
market value standard. One reason is that Partnership Profiles data
reportedly reflect remnant RELP’s formed in the 1970’s under different tax
laws. Those RELP’s no longer provide the same tax benefits after tax law
changes in 1986. On that basis, Partnership Profiles might reflect out-offavor
investments, being sold under distressed conditions at high
discounts to net asset value.
• The pool of RELP’s is also reportedly shrinking, creating a potential
problem of statistical significance in the quantity of reported sales for each
type of RELP.
• Another criticism is that the pro rata net asset values attributed to RELP
re-sales might have been arbitrarily reported (i.e. management estimates),
and do not reflect thorough appraisals of underlying investment assets
within the RELP’s.
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 64
• Method is logically limited to entities that have substantial amounts of real
property assets in their portfolios.
Important Parameters for this Approach
1) Types of underlying investments (e.g. real estate, vacant land, etc.);
2) Relative debt ratio; and
3) Dividend yield on net asset value.
Prevalence in Professional Practice
Partnership Profiles data are primarily used to estimate lack of control discounts
on minority limited partnership interests. In most cases, the appraiser would use
Partnership Profiles to estimate the lack of control discount, and then use
another method (such as restricted stock studies) to estimate a separate DLOM.
However, because of the nature of the data, some appraisers use Partnership
Profiles to estimate a single combined discount for lack of control and lack of
marketability.
In cases of charitable contributions (e.g. charitable remainder trusts), the
appraiser might cite Partnership Profiles as the source for a single, combined
discount for lack of control and lack of marketability (e.g. if an appraiser were
seeking to avoid over-discounting).
What the Courts say about this Approach:
In Estate of W.W. Jones II v. CIR (116 T.C. No. 11 filed March 6, 2001), the
taxpayer’s expert acknowledged that: “[A] large discount for lack of marketability
is already built into the secondary market discount [from Partnership Profiles
data].” The Court agreed and reduced the taxpayer’s [separately-determined]
lack of marketability discount from 20% to 8%.
In Estate of Kelly v. CIR (T.C. Memo 2005-235), the Court stated: “We are also
not persuaded by ATI's analyses of PPI's studies regarding minority discounts as
ATI admits that these discounts contain some element of discount for lack of
marketability, and therefore these studies result in an overstatement of the
minority discount.”
In Lappo v. CIR (T.C. Memo 2003-258), the Court stated: “[M]r. Oliver’s reliance
on the published RELP market prices seems questionable.” The record in the
Lappo case further noted that RELP’s had very low trading volume, and that the
underlying net asset values: "[R]epresent either estimates by general partners,
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 65
appraised values determined by independent appraisers retained on behalf of the
partnerships, or some combination of the two."
(e) Public vs. Private P/E Ratios in Acquisitions (MergerStat)
Background and Summary
A dataset published in annual editions of Mergerstat Review sorts transactions
into categories of “public” versus “private” companies being acquired [see
Mergerstat Review, FactSet Mergerstat, LLC, 2007 (and earlier) edition(s), Table
1-12, page 20].
The table compares the “Median P/E” offered for public versus private
companies, over a number of years. In general, Median P/Es offered in each
year were higher for public companies (those whose shares were publicly traded
at time of offer) than for private companies (those whose shares were NOT
publicly traded at time of offer).
Based upon a premise that all data involved similar control conditions (all of the
companies were being acquired), it would be reasonable to infer that the
observed “premium” paid for public versus private companies reflected public
company sellers’ ability to liquidate their shares elsewhere—since a public
market existed for those shares.
On that basis, public company sellers negotiated higher relative purchase prices
because their shares were marketable, and could be sold elsewhere if
necessary. However, private company sellers could not easily sell their shares
elsewhere. Thus, they negotiated lower relative purchase prices because their
shares lacked marketability. Observation of lower relative purchase prices for
shares of private companies versus public ones implies a discount for lack of
marketability (“DLOM”).
While there is some variation of medians from year to year, the data indicate
fairly-consistent median DLOM’s by comparing public versus private acquisition
Median P/Es in the range of 15% to 20%. The median has not followed any
single trend in prior years. A review of the MergerStat data will indicate how the
median has trended in the years leading up to any specific valuation date.
As a last consideration, these data reflect “control” conditions (all of the
companies were being acquired). It could be argued that these data might be
inappropriate for evaluating lack of marketability on “non-controlling” interests.
Therefore, reliance upon these data for analyzing lack of marketability on a
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 66
minority interest implies a condition that factors of “control” and “marketability”
are effectively separable.
Areas of Focus
In discussing this approach with taxpayer’s or taxpayer’s appraisers, the
following area of focus should be explored:
• Assuming that Taxpayer’s appraiser has referenced this method in relation
to other methods (such as restricted stock studies), on what basis did the
Taxpayer’s appraiser weigh the significance of a DLOM from this method
in relation to a DLOM from another method?
Strengths
• Source data are objective, market-based transactions, and provide a
simple illustration of the “discount” that sellers of closely-held companies
had to accept (in arm’s-length, market transactions) because they lacked
an alternative to sell their shares in a public market.
Weaknesses
• DLOM’s inferred from these data reflect median values for each year, and
exclude any notation of upper- or lower-bound figures in each year’s
dataset. Summary median figures can obscure significant variance in
underlying data.
• Variance in underlying data could reflect consideration of factors other
than exclusively marketability versus lack of marketability.
• While it is possible to locate and analyze individual transactions in each
year’s dataset, a thorough analysis of variance (or comparability factors) in
each year’s dataset could be time consuming (some years included
hundreds of transactions).
• Method is dependent upon specific companies acquired by public
companies in a given year, and might not be reflective of DLOM levels in
private transactions.
• The transactions summarized by MergerStat are control transactions,
rather than minority interest transactions. This presents the question: “Is it
reasonable to assume that the same P/E percentage comparison would
apply to smaller traded interests?”
D. Summary of DLOM Studies/Methods
Other Approaches
DLOM Job Aid page 67
Important parameters for this model
1) Since the data are summarized in the single table from MergerStat
Review, there is no need to have anything other than a copy of the
MergerStat Review covering the year of the valuation date.
2) The simplicity of this method prevents a more-thorough analysis of
comparability factors. However, this method can provide additional
support for an overall analysis of the DLOM that incorporates one or more
additional methods of estimating the DLOM in a given appraisal.
Prevalence in professional practice
The use of Mergerstat for DLOM has been seen a few times, but generally only
as additional support for an overall DLOM analysis that used additional methods
of estimating the DLOM. One possible explanation for its infrequency of use is
that MergerStat Review is so commonly cited as the source of data for lack of
control discounts. Another citation of MergerStat Review in the DLOM area of the
valuation analysis might be confusing to the reader.
What the Courts say about this model
No Court references were found regarding the use of MergerStat specific to
estimating the discount for lack of marketability (there are Court rulings where
MergerStat was used for the discount for lack of control). It is likely that the
Courts will criticize this approach as being over-simplified and/or lacking
comparability factors to support an opinion of the DLOM for a given subject
interest (in cases where these data were used as the sole method for estimating
the DLOM).
E. Evaluation and Recommendations
DLOM Job Aid page 68
E. Evaluation and Recommendations
1. Approaching Marketability Discount as a Reviewer
In considering the discount for lack of marketability as a reviewer, you will be
presented with an approach and be concerned with judging its reasonableness,
its reliability, its adherence to the prevailing facts and circumstances of the
valuation problem at hand, its general acceptance within the valuation community
and the treatment that the approach has received at the hands of the Courts.
Hopefully, the taxpayer and/or the taxpayer’s appraiser will have offered
arguments for the approach or approaches chosen and for the numerical result
decided upon. These arguments will need to be considered in detail and judged
upon their merits. If the taxpayer or the appraiser has not offered any real
analysis but rather simply presented a numerical result without substantial backup
that does not automatically make the result achieved wrong or unsustainable.
You will need to analyze the result in the light of the prevailing facts and
circumstances to determine whether it is reasonable or unreasonable.
If the result is considered unreasonable as a result of your review, you will likely
be called upon by the client to produce an alternative independent estimate of
DLOM based on your own analysis of the valuation problem. Your estimate
should be constructed so as to not exhibit the same weaknesses found in the
appraisal being reviewed. If the taxpayer or appraiser has used a valid approach
or approaches but reached an unreasonable result you may be able to simply
discuss what makes that result unreasonable and why you believe that your
analysis yields a more reasonable result. If the taxpayer or appraiser has not
used a valid approach in your view then you will have to start from scratch in
preparing your opinion.
2. Approach Marketability Discount as a Valuator
If you are approaching the question of DLOM fresh, either as a reviewer
confronted with an unreasonable taxpayer position based on invalid approaches
or as a valuator charged with making your own valuation discount decisions, it is
often helpful to start with a basic question as relates to DLOM. That question is:
“Under the prevailing facts and circumstances and considering the nature of the
interest to be valued why is the DLOM not zero?” By enumerating the factors that
would lead to a conclusion that some DLOM at all is appropriate you will be
building a framework as to how substantial a discount for lack of marketability
might be reasonable. This process will give you a reality check on DLOM
amounts that you might ultimately derive using some of the approaches
discussed in this job aid.
E. Evaluation and Recommendations
DLOM Job Aid page 69
For example, if you have a very small minority interest in a non-publicly traded
entity which has little or no history of interest sales and where shareholders are
bound by a very restrictive shareholder’s agreement, you could reasonably
believe at the outset that a DLOM is appropriate and that it could be substantial.
On the other hand, if you have a somewhat larger interest in a non-publicly
traded entity that has a relatively large and active shareholder base with no
restrictive shareholder agreement and where the potential seller holds a put right
back to the corporation at fair market value then very little DLOM might be
reasonable.
A common mistake among valuators considering DLOM (and discounts for
minority interests) is to concentrate almost exclusively on the viewpoint of the
hypothetical buyer who will be pushing at all times for larger discounts while
ignoring the viewpoint of the hypothetical seller. In proposing a DLOM amount
the valuator needs to ask whether this is an amount that a hypothetical seller
could accept under the prevailing facts and circumstances and whether there is a
reasonable chance that an arms-length negotiation between buyer and seller
could arrive at such a discount amount. A fair market value determination
requires the consummation of a hypothetical sale. If the analysis relies too
heavily on the needs of the buyer it is likely that no such sale would occur and
that this underlying premise of fair market value would be violated.
3. Dealing with Marketability Discount in a Report Review
Under Certain Specific Situations – Typical Report Language for
Getting Started
Report reviewers frequently see the use of DLOM studies inappropriately. What
follows is sample report language to use when these situations are encountered:
a) Use of Pre-IPO studies to support DLOM
b) Use of simple average or median from Restricted Stock Studies
c) Use of analytical study results without getting behind the data
d) Use of study results not supported by market data
e) Reliance solely on court decisions
a) Use of Pre-IPO studies to support DLOM
The pre-IPO studies cited (Emory, Willamette or Valuation Advisors) examine the
difference between pre-IPO stock transactions and their IPO price. When
companies register for an IPO, they are required to disclose all transactions
within three years prior to the offering. The pre-IPO studies observe transactions
in privately-held companies that eventually completed an IPO. The private
transaction price was compared to the public offering price, and the percentage
discount from the public offering price is considered a proxy for the discount for
lack of marketability.
E. Evaluation and Recommendations
DLOM Job Aid page 70
These studies are overstate DLOM and are unreliable for assessing the size of a
discount for lack of marketability for many reasons:
• Because study data includes only successful IPO’s, it artificially inflates
the discount by ignoring unsuccessful IPO’s
• The discount reflects more than lack of marketability—it includes risk that
an IPO may not occur
• Almost always involve related-party transactions with employees or
service providers who are compensated by a bargain price
• Pre-IPO transactions tend to be under priced as IPO’s frequently involve
high growth companies which are rapidly evolving (difference in pre & post
company)
• Not contemporaneous – too much time gap exists between pre-IPO
transaction and public offering
• There are indications that the Willamette Management Associates Studies
1999 and 2000 data may be skewed due to the dot.com "bubble"
Add if appropriate:
A business with the reputation, size and long history of profitability, such as
_____ would likely have the option of becoming publicly traded with total
floatation and registration costs significantly lower than the claimed ____%
discount. Such an event would minimize any discount for marketability.
b) Use of simple average or median from Restricted Stock
Studies
Restricted stock studies are a common source of market data on lack of
marketability. One of the original studies, the SEC Institutional Investor Study
(“SEC Study”), compared the market prices paid for stock of publicly-traded
companies with the prices paid for “restricted” shares of stock in those same
companies.
The restricted shares were generally sold in private placements, or similar
transactions, under conditions which prevented them from being re-sold for some
period of time (generally two years for the SEC Study).48 Observed price
differences between sales of restricted stocks and their immediately salable
equivalents (in those same companies) imply a discount for lack of marketability.
SEC Study
Table 1 (Table 1 Analysis of SEC Institutional Investors Restricted Stock Study)
presents detailed data from the SEC Study. According to the source reference,
48 The restriction period has generally decreased from two years to one year for similar
transactions occurring after the year 1997.
E. Evaluation and Recommendations
DLOM Job Aid page 71
these data were published in the year 1971, and reflect 398 transactions over the
years 1966 – 1969.
In regards to Table 1, the following observations are often noted:
1) The data indicate that illiquid shares generally sold for less than liquid
shares, suggesting an average discount for lack of marketability of 26%;
2) The range of variance was significant, however, with groupings ranging
from a negative discount of -15% (thus, a premium for lack of marketability),
to high-end groupings upwards of an 80% implied discount for lack of
marketability; and,
3) Greatest weighting of transactions occurred within the “15%” and “25%”
implied discount groupings. This suggests a most-common discount for lack
of marketability of 20%.49
Data in Table 1 are presented in regards to the issue of lack of marketability.
However, significant variance in implied discounts for lack of marketability
throughout the dataset suggests that factors, other than exclusively marketability,
contributed to observed price differences between restricted and unrestricted
shares of stock.
Management Planning Study
Table 2 (Table 2 Analysis of MPI Restricted Stock Study) presents detailed data
from the Management Planning Study, which also analyzed discounts on sales of
restricted stock. According to the source reference, these data are more recent
than the SEC Study, and reflect 49 transactions over the years 1980 through
1995.
In regards to Table 2, the following observations are noted:
1) Figures in the “Average Discounts” column suggest that discounts for lack
of marketability decrease, as company size (in annual revenues) increases;
2) However, figures in the “Range of Discounts” columns indicate significant
variance within each grouping, with even the smallest companies (under $10
million in annual revenues) reflecting implied discounts for lack of
marketability ranging from a low of 2.8% to a high of 57.6% (see note [2] of
Table 2); and,
3) While figures in the “Average Discounts” column decrease as company
size increases, low-end figures within the “Range of Discounts” columns for
49 (15% + 25%) 2 = 20%, see note [4] of Table 1.
E. Evaluation and Recommendations
DLOM Job Aid page 72
each grouping do not follow this trend. Instead, the lowest discounts observed
within the entire range (2.8% and 0.0%) occurred within the smallest and
largest company groupings, respectively.
Data in Table 2 are presented in regards to the issue of lack of marketability.
However, significant variance in implied discounts for lack of marketability
throughout the dataset (including lack of trend for lowest discounts within each
grouping) suggests that factors, other than exclusively marketability, contributed
to observed price differences between restricted and unrestricted shares of
stock.
Other factors
Restricted stock studies have been criticized as being inconsistent with the Fair
Market Value standard. Restricted stock sales reportedly reflect transactions
among a select group of individuals, with particular motivations for buying/selling
under specific conditions. For example, some criticisms argue that discounts on
restricted stock and/or private placements represent “compensation” to specific
investors who provide guidance and assistance to the company’s management.
This suggests that other factors might have affected observed discounts in prices
from “marketable” shares of those same stocks.
Other criticisms argue that “blockage” or other “price-pressure” effects might
contribute to observed discounts. As one example, suppose a publicly-traded
company needed to raise additional capital, but management believed that issuing
new public shares would depress the market price (assume a market price of
$20/share). A large private placement of restricted shares might then occur at a
below-market price (assume a restricted price of $15/share). This presents the
question: Is it appropriate to infer a 25% discount for lack of marketability by
comparing the $15 restricted price to the $20 market price ($20 – 25% = $15)?
All else equal, the market price in this example would have decreased below
$20/share if new public shares had been issued. On that basis, the value of the
company’s comparative “liquid” shares is perhaps less than $20/share. And
therefore, in this example, comparing the $15 restricted price to the $20 market
price might overstate the implied discount for lack of marketability.
This example also illustrates that restricted stock studies data could reflect
transactions of varied buyer/seller motivations. All else equal, the buyer in this
example might demand a below-market price to offset risks of investing in a
company that was having difficulty raising additional capital. While the seller (the
company) might demand restrictions on the new (below-market) shares to protect
existing shareholders from a potential drop in stock price.
E. Evaluation and Recommendations
DLOM Job Aid page 73
Observers of this example transaction might then ask themselves...
Were the shares priced below-market because they were restricted?...
Or were the shares restricted because they were priced below-market?
This example illustrates the importance of understanding that observed
“discounts” from the market prices of assumed comparative “liquid” shares might
include consideration of factors other than exclusively marketability.
On excluding other factors
In regards to excluding other factors, the Bajaj Study 50 explored separation of
lack of marketability from other factors believed to affect observed price
differences between sales of restricted and unrestricted shares of stock.
The following citation from the Bajaj Study suggests a 7.23% discount for “lack of
marketability”:
“Therefore, controlling for all other factors influencing private placement
discounts, an issuer would have to concede an additional discount of
7.23% simply to compensate the buyer for lack of marketability.”
This statement supports a premise that market data commonly relied upon for
estimating discounts for lack of marketability include consideration of other
factors.
Summary
An appropriate discount for lack of marketability should not overstate the effects
of marketability upon the otherwise determinable pro rata value. The appraiser
should use judgment when applying discounts derived from summary median or
average data sources to a specific company or subject interest.
c) Use of analytical study results without getting behind data
Business valuators will often refer to one or more of the analytical studies and
quote certain of the statistics from the studies. For example, a statement may be
made that Wruck found a discount for lack of marketability of 17.6%, Hertzel &
Smith found a discount of 13.5% for lack of liquidity or that Bajaj et al determined
that the discount for lack of marketability should be 7.23%. These quotations are
then used to build a discount for lack of marketability pertinent to the valuator’s
50Bajaj, Denis, Ferris, and Sarin, "Firm Value and Marketability Discounts,"
Vol. 27, No. 1, Journal of Corporation Law, pp. 89-115, Fall 2001 (“Bajaj Study”).
E. Evaluation and Recommendations
DLOM Job Aid page 74
assignment or to justify a discount already determined by some other method.
Sometimes, one of these figures is simply adopted as representing the
appropriate discount for lack of marketability in a given assignment.
It should be remembered that these figures are the result of statistical analysis of
a specific data set as chosen by the researcher. The data set in question
contains those transactions chosen for one reason or another by the selector and
is pertinent to a given time period. Wruck pulled her data from 1979 – 1985,
Hertzel & Smith studied 1980 – mid-1987 while Bajaj utilized 1990 – 1995. In
each case, the sample size was small (128 transactions for Wruck, 106 for
Hertzel & Smith and 88 for Bajaj). Further, the selection methodology was not
well documented and, in each case, relied upon certain assumptions as to
registration status and appropriate measurement date. Finally, these studies
were all conducted for academic purposes rather than tax purposes investigating
various facets of capital formation and shareholder behavior. Although Bajaj
eventually extended his study for tax use in his Tax Court testimony it was not
originally intended for that purpose.
A valuator should not use the results from any of the analytical studies without
getting behind the data that was used in the various analyses. With respect to
Bajaj this is what the Tax Court attempted to do in McCord. Rather than
accepting the 7.23% discount presented to it in the direct testimony, the Court
looked at the data itself and instead determined a discount of 20% for use based
on the average discount attributable to Bajaj’s middle group of individual
transaction results. The Court justified its approach by noting that the
transactions in this middle group most closely represented the transaction with
which it was confronted in the Mc Cord case. In so doing the judge distinguish
the present valuation problem from the postulated circumstances attendant to
both the highest and the lowest discount groups from the Bajaj study. Whether
one accepts the Court’s logic in McCord or not this is the kind of analysis that
needs to be undertaken if one or more of the analytical studies is to be used in
framing an opinion on the proper level of marketability discount for a given
situation.
d) Use of study results not supported by market data
It is not uncommon for a valuator to propose a theoretical model as the basis for
the determination of a discount for lack of marketability. Having put in chosen
parameter values, the model then cranks out a percentage loss in value or a
reduced value that can be used to calculate a percentage discount for
shortcomings in liquidity or marketability. Although the model may seem
conceptually sound in the abstract, there is no attempt to validate the model
using actual current market data. For this reason, there is no way for the reviewer
to perform a reality check on the model results. Examples of this approach may
involve the application of the Quantitative Marketability Discount Model, one of
E. Evaluation and Recommendations
DLOM Job Aid page 75
the models based on option theory or one of the analytical approaches based on
a limited data set.
The discount for lack of marketability must be firmly based on current market
evidence. This point was brought out clearly in the recent summit on DLOM held
in San Diego and organized by Judge David Laro and Mel Abraham. No matter
how conceptually sound a model may appear to be, unless it can be
demonstrated that it produces results that can be verified with market evidence, it
remains a theoretical construct that assumes a negotiation pattern between
willing buyers and sellers rather than being based on the results of such a
pattern. A valuator must remember that a discount for lack of marketability or for
anything else is but a step towards arriving at fair market value. Thus, without a
verifiable basis in the market, the valuator is asking the audience to take his
result on faith based on what sounds reasonable rather than on what has been
empirically demonstrated.
e) Reliance solely on court decisions
Sometimes a valuator will base a decision as to the choice of marketability
discount on previous court decisions. For example, the valuator will review the
results of several cases such as McCord, Lappo and Peracchio and then base
the choice of discount on the discounts accepted by the court in the reviewed
cases. For example, the range of court discounts might have been from 20% to
25% so the valuator chooses 22.5% with the rationale that his valuation subject
is similar to the subjects under consideration in the cases cited. Judges are
sometimes found to adopt this approach as well. The judge will look at McCord
with its 20% discount and add a factor of say 3% based on his analysis of the
special factors of his case to arrive at a chosen DLOM level of 23%.
It must be remembered that judges are not valuators and are not constrained to
the environment in which professional valuators operate. A judge can adopt any
approach that is considered useful and can arrive at any result that seems
reasonable in his or her view based on all the considerations of the case which
often go well beyond the discount for lack of marketability. In addition, a judge
will often select one discount over another simply based on the ability or lack
thereof that the two sides of the dispute display in arguing their respective cases.
The court is a trier of fact and need not, if that is its choice, go beyond what is
presented to it. If one side argues persuasively while the other side disappoints
the court for one reason or another a discount may emerge without any real
justification for why it has been chosen. In fact, the discount selection may not be
based on any clear valuation logic at all.
The courts are an excellent source of information when legal precedent is in
question but can be a very questionable source when valuation guidance is
desired. If the decisions from various court deliberations are to be utilized in the
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