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Empirical Support for Illiquidity Discount Levels. 

Is it time for a new road map?


The business valuation community should commend academics and analysts such as Pratt, Bajaj, Lerch, Hall, Schilt, Mercer, Hitchner, Grabowski, Miles and others too many to name for their direct or indirect contribution to the discussions and debates involving Discounts for Lack of Marketability (DLOM). Like many valuators, I have struggled for almost fifteen years and hundreds of engagements to not only understand, but isolate the impairments specific to illiquidity when attempting to reflect the cash equivalent value proxy for closely held businesses and business interests. After all, after valuing the business or business interest, it is typically the area of greatest adjustment.

In this article, I hope to elicit responses from the vocal as well as the more timid souls contending with empirically supporting the level of DLOM. First, we'll revisit valuation fundamentals concerning issues such as expected investor returns and market volatility encompassed within the fair market value standard. Then we'll examine how isolating these factors influencing risk and illiquidity are interrelated, but must be isolated to avoid overlap. We then explore existing merits of Benchmark Analyses of IPO and Restricted Stock studies as well as the QMDM theory before embarking on examining possible alternatives involving transactions of 100% interests in closely-held businesses in our next article.

THE FAIR MARKET VALUE (FMV) STANDARD REVISITED

All valuation analysts understand FMV is frequently defined as:

"The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts." Treas. Reg. Sec. 25.2512-1, 20.2031-1(b) and Rev. Rul. 59-60, 1959-1 C.B. 237.

The definition incorporates the following assumptions:

1. The prospective purchaser is prudent and profit seeking, without synergistic benefit;
2. The business will continue as a going concern and not be liquidated;
3. The business would be sold for cash or cash equivalent; and
4. The business would be held on the market for a reasonable period of time.

What I am challenged by is what appears to be a minimization of addressing items one through four above. In the absence of doing such, how can we be justified in our base value and subsequent adjustment(s) conclusions.


1. The prospective purchaser is prudent and profit seeking, without synergistic benefit;

First, who is this investor (buyer or seller)? As I understand it, under the FMV standard, the investor is a notional individual from a pool who is after the highest likely return that could be obtained after consideration of alternative investments (risks). I must ask, does this include sophisticated investors, a valuation analyst applying fiscally responsible fundamentals or the individual who is likely to buy a "typical" closely held business or shares in a publicly traded company or mutual fund? I am befuddled by the often-time complex, statistical applications to "prove" the "correct" investor model; which, nevertheless, requires assumptions (often tainted with analytical bias). Would the "typical" investor be applying these arithmetic gyrations and would an analyst receive the time for the "sound bites" an expert is typically afforded in litigation to defend his or her theory and conclusion? I would submit, they would not. This is why documentation in a report is so critical.

Further, analysts crave some proxy of reasonable return; however, the market can be fickle on a daily basis with the market fluctuating considerably on current news, which often can be meaningless in the longer term. While this volatility may be industry specific, it may often have less to do with performance and more to do with investor psychology. Fundamental expected return is supposed to be the most statistically likely result a rational, informed investor can anticipate for an investment over time based upon historical performance.

Are monthly, quarterly or even annual betas an appropriate measure of industry risk; especially, when they deviate between reporting sources? How else do we explain the quoted stock analysts often differing on their buy-hold-sell recommendations on the same company and/or industry or when stocks with a history of operating losses are selling at outrageous share prices? Are these transactions reflecting the investor psychology we are retained to approximate in a closely held company; especially, when it appears many act upon the greed of quarterly versus long-term results? Shouldn't there be a distinction between indexing and value investing?

There are likely some "problems" with existing and accepted financial theory when considering the proxy of market returns derived from the publicly traded theory. Dun & Bradstreet and Small Business Administration data suggest about 90% of businesses have annual revenues below $10 million. I operate under the assumption this is the typical business or business interest being transacted by most notional investors despite many of these transactions including the purchase of a job!

Just how large is this pool of buyers for closely held business interests and what is the volume of actual transactions during what period of time? The fair market value standard assumes the existence of a notional market, which "precludes" the requirement for an actual buyer pool to exist. By virtue of requiring a notional market, the "pool" may be small or non-existent suggesting a very high discount. This is likely very much the case as suggested by Hertzell and Smith.

In the case of Central Trust vs. U.S., 305 F. 2d 393 (Ct. Cl. 1962), the Court stated the following principle relating to marketability discounts:

"it seems clear…, that an unlisted closely held stock of a corporation…, in which trading is infrequent and which, therefore lacks marketability, is less attractive than a similar stock which is listed on an exchange and has ready access to the investing public."

This statement implies the pool of potential buyers is considerably smaller based upon the limited awareness of closely held investment opportunities as well as its lack of ready transferability. What it may not address is there may also be an entrepreneurial risk taker who differs from a "typical" investor. Or is this reflecting a collective investor (often irrational) judgment that may over- or under-react to the information available, such as when investors continue to sell off shares of a historically stable company despite it may be nearing or at the bottom of its slide? Clearly, most venture capitalists, despite their historic poor returns also expect a return that comes with a certain level of control over the investment of a closely held business not commonly offered in ownership of small blocks of publicly traded shares.

Wisdom would suggest that as the size of this pool and frequency of transactions declines and the duration of a listing lengthens past an optimal period, the bid-ask price is likely to be adjusted downward in order to attract a purchaser. As this period lengthens, the size of adjustments is likely to increase; however, total return (growth and yield) must also be considered. This is something I believe Mercer's model attempts to convey.

Clearly, most marketable securities are actively traded on a daily basis; however, it would be worthwhile to determine the number of trades and by whom. The trades tend to be motivated by two principles: (1) A deteriorating performance, which creates a greater immediacy for selling or (2) Identification of a better alternative, where urgency for a trade is not as great. It should be apparent these are time driven decisions and become even more relevant when considering the sale of a closely held business interest and the period before a cash equivalent proxy occurs.

Are the preponderance of these "trades" representing investor sentiment made by institutional investors, brokers managing investments or the "typical" investor holding a few hundred shares in a number of public companies? The buyer and seller have differing ideas when to hold or sell stock based upon unique investment criteria in an otherwise imperfect market; otherwise, few transactions would take place. This can be readily demonstrated by examining the portfolios of a 35 year-old who may seek higher returns in growth stocks versus a 55-year old that wishes to preserve principal and receive relatively stable income from dividends of more mature companies.

What is interesting, market reactions appear to be more based upon expanding P/E multiples and lower overall borrowing costs and not earnings growth during the 20-year bull market.

This may be based upon the perception that equities are not as risky as they once were due to companies presumably being more stable; however, with the likely increase of interest rates investors will have to rely more upon earnings growth. Such performance has been somewhat lackluster and would suggest a possible downward adjustment of P/E ratios. During this period, more companies have transitioned from equipment intensive to intellectual capital with some studies suggesting that only 40% of market capitalization is due to net assets.

The oft-used basis for determining risk/reward/return is the application of the build-up method using data commonly derived from Ibbotson Associates' Stocks Bonds Bills and Inflation (SBBI). Prevailing wisdom is the median of the cost of capital represented from varying risk levels of transfers in minority interests in publicly traded securities comprises the core of these returns with further consideration given to size. Most analysts recognize there is a degree of volatility that is presumed to increase as the level of risk/return increases and the size decreases. Hitchner brings up a fine point that Grabowski's size studies reflect a period since the NASDAQ was established, which is briefer than the market performance from 1926 examined by Ibbotson. This is relevant to the extent that size is a significant component of the overall rate. Size apparently also was a common variable in the several of the benchmark analyses.

Further, by relying on this proxy for risk we must accept several potential flaws in the logic. In essence, we are implying a form of index examined for a long-term holding period (70+ years). Is this consistent with the holding period of a closely held business? By virtue of including risk among listed, publicly traded companies in this method, does the company specific risk also take into account the investment is in only one enterprise, a closely held one at that! And should there be an adjustment that reflects the costs associated with obtaining this proxy of return. If one held this indexed "portfolio," then a management expense of anywhere from 0.25% to 2.0% would decrease this return and the likely higher costs associated with buying and selling the closely held entity would need to be considered.

What I find interesting is there are just as many mutual fund managers who are as likely to achieve a return that falls above or below the holy grail of this proxy for return, which has historically had a long-term return of roughly 17% for the smallest (tenth decile "b") public companies, which incorporates size adjustments. Therefore, we traditionally accept this median as a proxy for return with further considerations for a "Company Specific Risk". Thereafter, subsequent adjustments to this base value, as may be appropriate, are made. If the entity is a closely held holding company, such as an LLC with real property then the historical returns of LPs and REITS are often applied.

I have some reservations with post 1970's Ibbotson results. Deregulation has changed the ballgame as has the increasing degree to which intellectual capital, (technology and outsourcing), overshadows tangible assets of many of the "S&P" and smaller sized companies used to determine equity risk premia. These unique issues are likely to have a sustained impact on overall market returns (FASB 141 and 142 seem to suggest this concern). These issues are for another article.

Also, I am struck by the degree to which the "size" component of the risk premia for the analyst opined proxies of aggregate market returns often represents about one-third to one-half of the overall total return.

Finally, the cyclical nature of the market does influence the duration, frequency and amount of capital investors are willing to place in marketable securities and other holdings at given period of times. The Ibbotson model appears to suggest the hypothetical investor return would be based solely on public equities. These returns presuppose the "investor" is not diversified in other investments to reflect a more accurate proxy of return Studies conducted by Raymond Miles and Toby Tatum of closely held business transactions tend to suggest that returns have been relatively stable despite overall market fluctuations/volatility.

Lance Hall's FMV Restricted Stock Studies examines about 430 transactions and during a recent industry conference I had understood him to have expressed his belief a key element of value differentiation between restricted and actively traded stock is one of volatility.

Tom West indicates in his annual Business Reference Guide that many of the business listings do not sell with two-thirds of those reporting between $3 million and $30 million in annual revenues not selling; although actively listed! This would tend to suggest that only examining transactions of businesses that are bought and sold may skew the proxy of investor activity as well as potentially overstate value.

The main points are what are the source(s) relied upon as the proxies of return; purported to represent whom; and during what time period(s)? If the stock market is bullish with returns reaching 20%, 30% or more, wouldn't this influence a venture capitalist's or private investor's expected rate for a "typical" closely held business?

2. The business will continue as a going concern and not be liquidated.

This appears a relatively straightforward component of the FMV standard; however, there are several areas that seemingly are generalized and require consideration.

Value in liquidation generally suggests a value in exchange on a piecemeal basis with normal market exposure. So do we assume that as of the date of value normal market exposure refers to the listing period of the entity or the assets held? Does the interest holder have the ability to influence liquidation if the time is "optimal" and what factors make this sale optimal? What is the aggregate period of time to wind up affairs, such as identification, selection and consultation with advisors (brokers, attorney, accountant, etc.) to preparing assets for sale to negotiation, contract and closing? Does this period have time-value considerations supporting the illiquidity adjustment?

Arguably, in many asset holding companies, an adjusted market value of underlying assets is determined; however, does this assume a controlling ownership interest for a liquidation event to occur? If the interest being valued is non-controlling, shouldn't greater or sole weight be applied to the income approach? And what if there is no income for distribution?

Would not consideration of the assets' appreciation be germane in reflecting a proxy of annual cash returns and determining the level of illiquidity adjustment? Why is the growth and appreciation relationship oversimplified with most sustainable proxies of growth hovering around 3% to 6%. Common wisdom suggests that anything greater would suggest an eventual saturated market share. Are vertical and horizontal integration and new product releases not an option for growth above these levels? Would the shareholders or the board of Pfizer rely solely on Viagra' sales to level off or would they expect new products to be introduced to the revenue pipeline?

Certainly, a going concern may suggest a longer time horizon before a sale. In fact, the time horizon or holding period would be an essential element to consider in conjunction with the level of growth, likelihood to make and the size of historic distributions or the capacity to do so.

Mac Taub indicated the DLOM is the presumption that the longer time passed, the greater the likelihood a seller would lower their price. During this period, there is increased risk that market conditions could adversely change between the time the business interest(s) is put up for sale and if and when it is actually sold.

I believe Mercer's QMDM model highlights the degree of subjectivity of estimating the holding period duration as well as the level of growth and returns during the selected period. The model may be less equipped for nominally income producing entities. It certainly makes a decent attempt to capture the above factors in the absence of any better application of prevailing theories. It recognizes the resulting rate of return is what aids in determining whether the level of any illiquidity adjustment is reasonable.

If the liquidation event is likely to occur, then would it not be reasonable to also consider the tax implications of embedded gains either directly or implicitly in the DLOM? After all, wouldn't one of two entities with identical assets of the same value, but with one having a higher tax liability have fewer buyers due to a lower amount of net proceeds? Does this not infer a greater degree of downward adjustment of the base value when considering marketability? Where is this addressed in existing benchmark studies?

3. The business would be sold for cash or cash equivalent.

The fundamental rationale for discounts for lack of marketability, even for a 100% ownership interest in a closely held business includes unknown time of a sale in terms of cash. This might seem straightforward, but seems to be overlooked when the levels of discounts are opined.

I suspect this is Dr. Bajaj's point he attempts to leverage when convincing those willing to accept that there's essentially a 6% DLOM when comparing trades in restricted stock of public securities to closely held company ownership interests. More thoughts on this hot debate shortly.

Since a DLOM will decrease the "base" value, it increases the expected rate of return over what it would be less the discount. The DLOM includes considerations, such as, the likelihood ("duration and risk") of receiving the asking price; seller financing deferring sales proceeds; as well as costs associated with preparing the business for sale and consummating its closing. This discount reflects the ability and time to liquidate and to receive sales proceeds in terms of cash. Pratt states it is often necessary to agree to a cash equivalent value for a controlling interest in closely held businesses, whether or not the business will actually be sold.

Marketability may be defined as a measure of the ability of a security to be bought and sold and to be converted into cash quickly and at minimal cost. Therefore, if an active marketplace for a security exists, it has good marketability. Marketability is similar to liquidity, except liquidity implies the value of the security is preserved, whereas marketability simply indicates that the security can be bought and sold easily.

The Encyclopedia of Banking and Finance defines marketability as the existence of a buying and selling interest and is indicated by the average daily volume of current transactions and the size of the bid-ask spread (offer-selling price). The smaller the size of the spread ("mark up"), the more active the market is likely to be for the security.

Marketability, then relates to the certainty of liquidity of an investment relative to a comparable and actively traded alternative, such as public securities, usually in terms of cash. On the other hand, inactive securities that rarely trade or for which buyers have to be located and terms negotiated are characterized by large spreads between bid and asked prices. In other words, investors want the choice to change their mind and exit an investment quickly, usually in 3 to 7 days. This is not the case, with a closely held business. These spreads have been argued by Dr. Chipalkatti to be a proxy for discounts for lack of marketability. Values derived from methods that apply aspects of securities of publicly traded companies result in what is termed a "publicly traded equivalent value".

Clearly, most private sales of closely held businesses cannot be readily converted into cash. Because a buyer must be induced to purchase something that may not be readily resalable, a price reduction, referred to as a "discount" is normally demanded by the buyer and agreed to by the seller. As they are not publicly traded and no ready secondary market exists for most closely held businesses, the inability to readily sell increases the owner's exposure to shifting market conditions and increases risk of ownership. The investor will commonly require a higher return in comparison to a similar, but publicly traded, interest. This tends to lead to paying a lower price.

Such outcomes represent the value of a marketable, minority interest. The values are marketable since they are readily traded on an open exchange or over-the-counter; however, some may be thinly traded. These values represent minority interests since they reflect the amount a single (or relatively few) share(s) would trade. That is, they do not represent a controlling block of stock. There are a myriad of issues concerning the isolation of the lack of control versus the illiquidity impairments in these transactions.

I concur with Michael Maher's position. He states in his restricted stock study the illiquidity "… discount would not contain elements of a discount for a minority interest because it is measured against the current fair market value of securities actively traded (other minority interests). Consequently, appraisers should also consider a discount for a minority interest in those closely held corporations where a discount is applicable".

In essence, impairment of marketability results in illiquidity (the increased length of time to convert property into cash for transactional, precautionary or speculative motives), in order to increase an investor's expected rate of return. As a result, the market-clearing price of a non-marketable security is discounted relative to the price of its marketable counterpart. The discount for lack of marketability is a price reduction inducement to purchase, which is stated as a percentage of a "freely traded" or marketable value.

Without ready market access, an investor's ability to control the timing of potential gains, to avoid losses and to minimize the opportunity cost associated with alternative investments is severely impaired. For two investment instruments identical in all other respects, the market will accord a considerable premium to the one, which can be liquidated into cash quickly; especially, without risk of loss in value.

Both economic and legal opinions are the underpinnings of the principle for reasonable estimates of discounts for lack of marketability (DLOM), which recognizes there is no ready market for a closely held corporation and that there may be a very small pool of potential willing buyers. The stated value is typically assumed to be cash equivalent; however, the market reality is most private transactions are, in part, seller financed and at rates and terms that are clearly at other than market!

Pratt dedicates an entire chapter to the issue of cash versus terms issue in his text Valuing Small Business and Professional Practices. In most scenarios, obtaining a debt financing from other than the seller would be improbable; yet, seller's loan rate and terms seldom reflect the degree of risk. Conversely, should one consider the price concession a seller is willing to make for an all cash buyer to be synonymous with cash equivalency?

Ian Campbell states notional market valuations are expressed on a cash equivalent basis and assumes an unequivocal transfer of risks and rights associated with an ownership interest in order to avoid interpretations of non-cash terms and conditions. In 1991, the U.S. Ninth Circuit Court in Finkelman v. Commissioner (TCM 1989-72) indicated the original purchase price must be adjusted if a seller-financed transaction differs from market terms; therefore, a conversion to a fair market value is appropriate.

The point is that cash equivalency and liquidity are hand and glove issues, which are occasionally overshadowed by empiricism of the discounts themselves and frequently fail to relate to the investor's motivation, return and holding periods.

4. The business would be held on the market for a reasonable period of time.

Lewis Solomon states the holding period is one of the primary factors affecting the degree of the discount ("downward value adjustment") for lack of marketability discount. This duration is the time an investor must "hold" an interest before the benefit of the investment is realized. Therefore, the longer the time before the investment can produce "cash", the greater the perceived probability internal or external factors might cause this return to be less than if the investor could immediately cause the investment to be converted to cash.

It seems evident that if a return, whether a distributed yield and/or value appreciation is occurring, the level of adjustment should take the amount and frequency into consideration. However, all things being equal if two investments had a return equal to the likely median proxy (current or long-term???) available in the market; however, one investment could be readily converted into cash and the other could not, would it be reasonable that a key consideration influencing the level of discount would be the holding period until this event occurred as well as the volatility of both the interest(s) held and the overall market? How valuable is an economic benefit to an investor if it cannot be received until it is achieved only when the interests are sold?

Marko Budgyk recognized that duration may be a key element of company-specific risk. He demonstrated a longer duration required a higher required yield, which is evidenced in the government bond market with yields of five-year bonds exceeding that of one-year bills. This is because the short-term obligation is quickly paid and less sensitive to market shifts which increase risk.

One may measure the level of risk associated with a holding period by examining certain fixed income securities. Since the cash flows to fixed-income securities are typically known, the process of valuation is primarily that of risk assessment and the measurement of uncertainty. Issue specific risk is one consideration. A key aspect of this risk is duration (or holding period). A longer duration is usually associated with a higher yield expectation. This is readily evident when comparing required yields of treasuries bills, bonds and notes between one week and thirty years. This is evidence of the securities' susceptibility to interest rate changes.

The difference between the holding periods of short-term securities and long-term provide insight to how investors measure risk with long term securities causing investors to be exposed to greater risks despite their marketability, which would not be sold at par value unless it is held till maturity. Therefore, to compensate for the risk, the investor expects a higher rate of return, which translates into a discount. This has been more profound in more recent years.

The average over the past five years suggests at least a (2.028%/5.438%) 63% discount for the longer holding period with this figure increasing in 2003 due to the continued market volatility.

 

1999

2000 

2001 

2002 

2003

30 Yr. Bond

6.82%

5.58%

  5.75% 

4.84% 

4.20%

3 Month Bill

4.68%

5.89%

3.83%

1.65%

1.00%

 

2.14%

-0.31%

1.92%

  3.19%

 3.20%

Bankrate.com Money Markets and CDs accounts are federally insured up to $100,000 per person. MMA yields are based upon method of compounding and a rate stated for the lowest required opening deposit to earn interest and allow third party transfers monthly. CD yields are fixed rates only.

A relatively short holding period can have a dramatic influence on the degree of DLOM based upon the holding period even in relatively risk free investments. As evidenced in recent yields, the daily rates reported for savings yields of federally insured institutions by Bank Rate Monitor indicate the following national indexes:

 

Money 
Market

3 Mo.
CD

6 Mo.
CD

1 Yr.
CD

2.5 Yr.
CD

5 Yr.
CD

Rate

0.45%

0.80%

0.91%

1.14%

1.81%

 3.10%

The only difference between each CD above is the yield associated with the required holding period of the investment. Therefore, the implied discount for a CD held 3 months (1 - (3mo. 0.80/6 mo. 0.91%)) is 12.1%; however, it increases to 20.2% for 6 months (1 - (0.91/1.14). Therefore, we may infer that a marketability discount of 20% due in part to the longer six month holding period is more than reasonably supported.

So in a notional example, where the actual yield (and/or growth) on a non-controlling basis of the investment is 8.4%, and whereas stable industry yields of 9.5% are regularly achieved and commonly sought by investors of similar types of investments, some sort of adjustment would be appropriate.

 

 


Value

Annual
Return

Percent 
Change

Noncontrolling,

Marketable Value

$22,210

 8.4% (e)

 

 

10% LOM Adjustment

$19,989

9.3%

9.7%

 

15% LOM Adjustment

$18,879

9.8%

 14.3%

 

20% LOM Adjustment

 $17,768 

10.5%

20.0%

     
It may be inferred a marketability discount due to the long holding period of between 10% and 15% is reasonably supported based upon the annual return being sought in the above example.

Pratt discusses the use of restricted stock studies and the subsequent reduction of applicable discounts for lack of marketability due to the change in Securities Exchange Commission mandated holding periods from two to one year, effective April 29, 1997. This is because of the guaranteed liquidity in a shorter time versus the longer period that represents additional market uncertainty.

The point seems to be missed as shorter holding periods are not guaranteed for most closely held businesses; therefore, the evidence of the greater discounts in the two year holding periods tends to suggest that the impairments are due to the time-risk relationships. Nevertheless, the issue of holding period appears central to the supportability for the DLOM. It is very possible a closer examination of what constitutes an optimal holding period may be necessary in future studies. The difference between the optimal value and the present value at which a business is actually sold represents the discount for lack of marketability.

USE OF BENCHMARK ANALYSES STUDIES

There is a considerable amount of examination of both restricted stock and Pre-IPO studies. Their merits have been explored. Therefore, only a brief summary of these studies will be discussed; however, the conclusions might be worthy of further consideration.

Restricted Stock Studies - Most of these studies cover the time period from 1966 through 2000 and found marketability discounts ranging from 0% to 90% with medians averaging between 35% to 45%; however, discounts appear to have been declining due to the bullish market of the late 1990's making the perceived holding periods, now only a year, less risky. This approach analyzes the differences in prices of publicly-traded securities and those of restricted stocks of the same companies, where little information may be readily available.

In order to raise additional capital companies typically use these private transactions. Since the Security Exchange Commission (SEC) Rule 144 "lettered" stock is identical to the traded stock counterpart in all respects except marketability, the difference in price highlights the marketability discount. These purchasers have a reasonable assurance that after the holding period, they would be able to sell in the public market; whereas, the willing buyer of closely held stock has no ready exit strategy and is likely entitled to a greater DLOM.

The restrictions on the securities in these studies were generally in the nature of Rule 144 stock that limits transfer for two years after issuance, after which time the stock becomes liquid. After 1996, this restriction was decreased to one year.

Dr. Kania noted that DLOMs on closely held stock may have been declining; however, the magnitude of the discount is based upon company-specific, causal factors: net sales, earnings and size of stock block. Lower sales and earnings as well as larger blocks generally trade at higher discounts. .

Restricted stock investors generally expect the stock to be registered and sold in as short a time period as one year. Highly trained and qualified institutional investors execute these transactions. Ordinarily, a closely held business is an illiquid interest with little prospect of being publicly traded in the future. As such, a discount that is higher than the studies' averages is appropriate.

Dennis Dolan, a restricted securities trader who spoke at the 1998 American Society of Appraisers' (ASA) National Conference, indicated the size of the discount for lack of marketability (DLOM) is directly related to rate of return demanded by investors with an incremental higher rate of return of 10% (1,000 basis points) for restricted stocks.

According to Jay Abrams letter stocks (restricted from sale until a certain date) reflect the lowest DLOM and that control interests in a private firm are less marketable than letter stocks because of the high transaction costs associated with their sale. This is compounded by no guarantee a sale will occur or that it will be timely. Therefore, a discount should be that of letter stocks plus transactional costs and uncertainty of sale, as appears to be the case in the Estate of Stratton v. Commissioner 45 TCM (1982), where the Court permitted a 25% discount associated with the cost(s) of a stock sale through a private placement.

Pre-IPO Studies - These studies found discounts ranging from 0% to 94% and averaging 35% to 45%. A second empirical approach to supporting DLOM is to analyze the relationship between the prices of companies whose shares were initially offered to the public (IPO) and the prices at which their shares traded within a five-month period immediately preceding the public offering. This suggests that the longer time frame before an IPO results in higher discounts, which is a reflection of the uncertainty of the holding period and the associated external and internal risks that may result. These studies are said to corroborate the restricted stock studies and add another layer of discount as an indeterminate period can be assigned to its "restriction" prior to its becoming public.

I have to agree in spirit with Dr. Bajaj, as there is some selection bias, as these studies examine promising companies that have a good potential of going public with insufficient analyses of those who don't and what becomes of their pricing well after becoming public. Also, there is some question of price inflation by "market makers" (underwriters) just following IPO issuance to support price. Dr. Paulsen indicates that the underwriters are often overly-optimistic on earnings projections, which produces misleading results from which DLOM studies may be premised. Lerch has argued the discounts are inflated due to underwriters' new (post) issue hype creating demand in excess of supply, with support withdrawn after the stock is seasoned.

Differences in earnings growth based on the additional equity capital may further contribute to whether the price ("pre" vs. "post") differential is solely reflecting liquidity. Additionally, those involved with interest transactions prior to an IPO are likely to be individuals who may be associated with the offering, such as legal and financial advisors, versus a larger pool of investors.

USE OF THE QUANTIFYING MARKETABILITY DISCOUNTS METHOD

Z. Christopher Mercer introduced and published this method in late 1997. It applies the concepts of holding period, returns, underlying asset growth and expected distributions during the holding period to a model, which produces a marketability discount. The methodology's model is readily applied to virtually any set of facts.

Mercer indicates on page 312 of QMDM, that as compared with public companies, most closely held businesses do not have ready access to additional equity or debt capital. The valuation of shares of stock in closely held corporations warrants a discount for lack of marketability. Many factors affect the liquidity of an investment to include: Time frame; Industry; Number of shareholders; Size of the block of stock being valued; Restrictions on its sale by agreement or law; The absence of registration; and, The anticipated dividend flow attributable to the investment.

The QMDM model has been rejected by some as slight variations in assumptions used in the model can produce dramatic differences in results. This was also Judge Vasquez' findings in Janda v. Commissioner TCM 2001-24 (February 2, 2001). Mercer opines that when attempting to quantify these factors that influence liquidity into an appropriate discount for lack of marketability, it is necessary to consider the following factors:

1. The holding period. Without an active market, an investor must hold for an uncertain length of time until a liquidity event occurs. In general, longer holding periods without liquidity imply higher discounts for lack of marketability. An investor should reasonably characterize exit timing along a probability distribution. Although subjective, the relative probabilities of exit dates are reasonably related to historical ownership policies (insiders, outsiders, family, investors, etc.) affected by (i) Buy/sell or other shareholder agreements; (ii) Management/ownership succession (age, health, competence, emerging liquidity needs); (iii) Business plans and likely exit strategies of the controlling owner(s); and, (iv) Emerging attractiveness for equity offering or acquisition.

2. Required holding-period-return. To overcome the unattractiveness of illiquidity, an investor in illiquid securities expects a premium return in excess of that provided by liquid alternatives. Investment features that impair marketability will exact higher expected rates of return, which imply higher discounts for lack of marketability.

Unattractive features of an illiquid security could include the following: (i) Absence, inadequacy or inability to pay dividends; (ii) Subjective uncertainties related to the duration of the expected holding period and to achieving a favorable exit-date valuation; (iii) Restrictive shareholder agreements; and, (iv) Various other features that increase uncertainty of cash flows.

3. Growth in underlying value during the holding period. If an investment is appreciating, that growth will provide a portion of the realized return during the holding period. Growth and marketability discounts are negatively correlated. As expected capital appreciation increases, discounts for lack of marketability decrease. Growth potential should be evaluated in the context of management's business plan, historical growth, and external factors such as emerging industry conditions and market valuations.

4. Expected cash flow distributions during the holding period. Holding period returns are also provided by interim cash flows (in addition to capital appreciation).

OBSERVATIONS FROM THESE THEORIES

The companies in these studies are often those with significantly greater revenue size and are either currently publicly traded or have a strong promise of being a successful public company. They exhibit characteristics not often found in smaller, closely held companies.

The degree of profitability appears to be more important in the studies than the ability to grow, which may have more to do with company specific risk than illiquidity. Moroney appears to have examined growth directly, which may suggest revenue growth was assumed by the other studies.

There are several notable shortcomings with most of these studies/theories. There appears to be the relative few transactions relied upon. Further, there is a degree of study subjectivity with no stated means to objectively quantify the levels(s) of discount for lack of marketability for a specific situation.

The Trout and SEC Overall Averages Studies clearly indicate that there are likely to be numerous variables that are not readily identifiable. Mercer appears to come closest to developing a model incorporating his variables with his QMDM theory by addressing factors of growth, holding period, return and actual distributions.

Lack of Information

If there is an absence of information to opine on the company specific risks in these studies, this also creates the likely existence of a discount. The lack of such information on smaller, closely held companies certainly should also contribute to the existence of even a higher discount. This appears to be the concerns expressed in the Trout, Silber, CFAI and Hertzel studies.

Revenue Size

Revenue size is the most prevalent factor addressed by 11 of the studies, with the larger the revenues, the lower the average DLOM. This adjustment can often overlap with other company specific risk considerations.

This is further evidenced by which exchange the study companies were listed. Commonly, larger companies that are better capitalized are listed on the New York Stock Exchange (NYSE), which has more stringent requirements. This is compared to Over The Counter (OTC) or the NASDAQ exchanges, which have lower SEC requirements.

Five studies identified the exchange listed as a contributor to the degree of discount, which may overlap with Company Revenue Size. This was a point in the Trout, Moroney, FMV, CFAI and SEC Studies.

Gary Trugman also points out there may be a size discount, if not already considered in developing a discount/capitalization (risk) rate. He refers to Raymond Miles' September 1992 article in the Business Valuation Review, "Price/Earnings Ratios and Company Size Data for Small Businesses", which found a considerable difference between the P/E mean of businesses with lower annual sales and those reporting between $500,000 - $1 million.

Tatum conducted various analyses using the BIZCOMPS database and identified that "all-cash" transactions indicate an inferred 21.2% average discount from those with 70% or greater seller financing. He further identifies that there is a size affect for closely held transactions with businesses with annual sales above $500,000 .

The above studies identify that ownership in smaller companies tends to be more risky. Therefore, "relatively" smaller enterprises, in addition to being more risky due to size are known to have far less liquidity due to fewer likely buyers. This begs the question, if the DLOM should be greater as a time frame for a sale is less identifiable and the pool of potential buyers is reduced for even smaller, closely held businesses?

Dividends/Distributions

The "typical" investor is more willing to accept risk if (s)he believes a dividend history exists and that it reflects a proxy of the future. The amount of dividends ("rate of return") tends to reflect the degree of company profitability. All things being equal, the company with a history of paying higher dividends will have a lower DLOM. About one-half of the above studies emphasize this factor, which may be argued as an indicator of "stability".

A company experiencing growth in the absence of increased earnings, may be argued to be a greater risk than a smaller company with a moderate rate of growth. This was the message shared by Dolan who is well versed in restricted securities trading.

In most respects, the effective rate of return should be the foremost consideration when determining the degree of DLOM applied.

An investor with alternative investment options would require adequate compensation for the increased risk of a lack of marketability. Clearly, dividend/ distribution history and size are key factors of almost all restricted stock studies other than Gelman, Trout, Maher, Willamette and CFAI.

Size of Block

The Williamette, Silber and FMV studies address size of block with Williamette stating no size influence, Silber stating a higher discount and FMV a lower one.

Holding Period

Certainly, holding period is a key factor in quantifying the DLOM; however, it appears only recognized explicitly in the Moroney, Willamette, CFAI, Emory and Pearson studies. Mercer also builds this factor into his model.

INFLUENCE A 100% CONTROLLING INTEREST HAS ON MARKETABILITY

These studies suggest the need for a "base" enterprise value of a business to be isolated from risks associated with dividends ("profitability" and "returns"), holding period and size; yet, these studies do not appear to examine the degree of control, which typically takes into consideration the existence of agreements, restrictions and contracts.

Again, there may be a presumption of control by the investors acquiring the interests. The Maher study strongly suggests the influences of [partial] interest size and the associated loss of control would be minimized by examining 100% ownership interests in business enterprises. Examining these types of transactions should provide some insight to the buyers' and sellers' motivations, which can be achieved with a greater degree of certainty based upon empirical data and the larger number of transactions observed.

Since closely held business interest holders, even those owning 100%, are unable to realize immediate cash proceeds, they may seek to sell the overall business enterprise, company assets or interest(s) within an uncertain time horizon (offset to some degree by cash flows until sale consummated); costs to prepare for and execute the offering for sale (appraisals, auditing, legal costs, administrative, transactional and brokerage costs); and risks concerning eventual sale (internal/external factors). These factors are then combined with noncash and deferred transaction proceeds. Sales price adjustments reflect risk, time and costs attendant to achieving a sale.

These issues were upheld in Estate of Woodbury G. Andrews (79 TC 938 - 1982), which examined the private placement market and flotation costs and allowed a combined discount of 65%. The IRS Valuation Training Text for Appeals Officers (1998) specifically references the Court decision in Andrews quoting: "… even controlling shares in a nonpublic corporation suffer from lack of marketability because of the absence of a ready private placement market and the fact that flotation costs would have to be incurred if the corporation were to publicly offer stock."

In Estate of Bennett v. Commissioner (65 TCM 1816 - 1992), Judge Parker recognized a 24.8% discount for lack of marketability, although Mr. Bennett held 100% of Fairlawn Development Inc. as there was an absence of a public market for the closely held business' shares. No sales of its stock had ever taken place. It had never been listed on any exchange or been on the OTC market. The corporation owned non-liquid assets - real estate, which could not be immediately and inexpensively sold on the day the shareholder would decide to liquidate (date of the decedent).

The Court relied on the rationale used in the Estate of Dougherty 59 TCM 698-1990, where Judge Hamblen allowed a 10% discount for management costs and a 25% discount for lack of marketability. This was despite valuing a 100% interest in a company's stock holding a diverse asset portfolio.

In the Estate of Morkill (November 26, 1997), the Court allowed a 30% discount for a 100% GP Interest that held 80% marketable securities and a residential interest. This decision appears consistent with a 91% GP interest in private company stock holding real property (farm) in the Estate of Anderson (June 11, 1999), where the Court allowed a 33.33% discount as well as Judge Shield's decision in Simpson v. Commissioner TCM (P-H) 94,207 (USTC, May 11, 1994).

CONCLUSION

Unquestionably, there are many factors of business risk/return influencing the base value of a business enterprise. Avoiding overlap and isolating these risks with those factors involving the ability to achieve a cash equivalent price appears to be an continuing challenge. Existing proxies of risk and investor sentiment are by no means absolute and should be questioned. Further, there is little evidence existing illiquidity studies adequately support the level of adjustment supported only that some discount for lack of marketability is appropriate.

Many of the existing studies have few transactions and do not appear to be reflective of the larger universe of smaller closely held businesses that may never be successfully sold. Some may argue the size of the companies in the studies may significantly overlap factors to be associated with illiquidity/marketability/cash equivalency.

It appears studies isolating holding period and examining cash equivalent transactions of business interests involving "typical" investors may provide a more objective and profoundly accurate reflection of their risk tolerance psychology.

A vetted and larger sample size may provide more quantifiable results. The next article will examine a possible alternatives focusing upon all cash purchases of 100% ownership interests in smaller, closely held transactions to determine whether such data samples may provide evidence of the level of discount due to length of holding period.

Carl L. Sheeler, PhD, CBA, AVA is the managing partner of the nationwide business valuation and litigation support firm, Allison Appraisals & Assessments, Inc.  Since 1954, the company has provided 1,000’s of business valuations and reviews as well as economic loss reports for purposes ranging from Estate Planning/Gifting/Taxes, Commercial Damages, Condemnation, Dissenting Shareholder/Disassociation Actions to Marital Dissolutions.  Mr. Sheeler has been involved in litigation support with national entities including Exxon, Ernest & Young, Bank of America, Amtrak and American Honda as well as a myriad of municipalities and insurers.  He has successfully prepared reports allowing for value adjustments as great as 65% of the entity value for estate related purposes. Designated an expert witness, he has provided testimony in deposition as well as in Federal and State Courts on over one hundred occasions.  He has authored a plethora of articles and presented on the above topics for legal and finance journals.  He is an instructor for one of the national business valuation associations.

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