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CHAPTER EIGHT
ALTERNATIVE DISCOUNT COMPUTATION METHODOLOGIES Chapter Objectives 1.
Identify the various alternative models available to quantify the discount for lack of marketability. Determine the differences and critiques of the alternative models.
2.
I. INTRODUCTION As challenges to the use of the Benchmark Method have grown, it has driven many within the profession to look for new and better ways to address the determination of discounts for lack of marketability. While certain of these methods are fundamental to a closer and more analytical approach using the empirical studies, i.e., the Comparative Analysis of Restricted Stock Approach (CARS), other models or methods present a new and innovative format on which to base discount for lack of marketability determinations. At the very least, practitioners need to be familiar with these methods and understand how to determine their applicability to the subject company under valuation. The methods addressed in this chapter include the following:
The FMV Method The Quantitative Marketability Discount Model The Vianello Forensic Consulting Methodology Dr. Ashok Abbott’s Model
It is apparent that the first three methods or models listed are gaining ground in day-to-day application. Dr. Abbott’s study does not directly address marketability discounts, and though discussed herein, is not likely to gain ground in practical application in its current form. However, it is an important and recent development with which all business valuators should have some familiarity. The frustration of most practitioners is the lack of “specific” authoritative guidance in developing the proper level of discount. Unfortunately, such guidance is nonexistent. As with all aspects of business valuation, the determination of a proper discount for lack of marketability is fact-specific and unique.
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As stated in the U.S. Tax Court case, Estate of LeFrak, T.C. Memo 1993-526 (November 16, 1993), …we must remind the parties that the amount of discount must be decided on the basis of the record of the instance case, and not on what a court found reasonable in another case involving different evidence. Given the lack of a method that will answer the question in every case, it becomes an analytical problem for the valuator, in which available empirical data must be combined with an intimate understanding of all common methodologies and, perhaps most important, well reasoned judgment. Incorporation of these three elements, along with well thought-out and complete workpaper documentation and report writing, will provide the valuator with the optimum chance of success in the event of a user challenge.
II. FMV METHOD FMV Opinions, Inc. FMV Restricted Stock Study serves as the basis for the FMV Method. In the study, over 700 restricted stock transactions were examined and analyzed. As a result of this analysis, it was determined that the discount varied based on a variety of underlying financial characteristics of the company. It is noted in this study that the discount is positively correlated with: 1. 2. 3. 4.
The subject market-to-book ratio (market value divided by book value); The subject entity’s unrestricted stock price volatility; The subject block size relative to the trading volume of the stock; The block size, described as a percent of the total ownership;
Conversely, it was noted in the study that the discount is negatively correlated with: 1. 2. 3. 4. 5. 6. 7. 8. 9.
The market value of the subject entity; The revenues of the subject entity; The earnings and net profit margin of the subject entity; The dividend payout ratio of the subject entity; The total assets of the subject entity; The book value of shareholders’ equity of the subject entity; The subject entity’s stock price per share; The trading volume of the subject entity’s stock; and The size of the block sold (dollar value).
FMV observed that under the dribble-out provisions of Rule 144, some blocks of stock that constitute larger portions of issued and outstanding shares resulted in liquidation time frames greater than the actual Rule 144 restriction period. By way of example, a 30% block may be subject to a one-year (or now six months) restriction under Rule 144 before it can be sold in the public exchanges. The limitation under the dribble-out rule is that quarterly sales can be no more than 1% of the total issued and outstanding shares or, if greater, 1% of the average monthly trading volume. Thus, the dribble-out rule may limit any sales after the restriction period lapses to 1% of total shares outstanding per quarter. Under this rule, then, total liquidation on a 30% block could take 7.5 years after the Rule 144 restriction period lapses. The resultant conclusion, although intuitive, is that larger blocks of stock are less marketable even when compared to smaller blocks of the same company. 2 – Chapter Eight
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While large stocks that are restricted are less marketable than smaller blocks, such is not generally the case with privately held equity interests. A 30% private company equity interest is likely to be just as illiquid as a 5% interest in the same entity. The FMV study concludes that private company equity interests are more illiquid and less marketable than even the large block restricted stocks and, as such, the large block restricted stock data should be the floor when determining privately held ownership interest discounts. FMV Opinions has determined through analysis and demonstrated that a public company’s stock price volatility is a key determinant of the discount for lack of marketability. Because private company volatility is not as easily measured, FMV Opinions has made an empirical connection between discounts for lack of marketability and overall stock market volatility. This information makes it possible for the business valuator to incorporate volatility as a consideration when determining discounts for lack of marketability for minority, nonmarketable equity ownership interest in privately-held companies. Keep in mind that while stock market volatility is currently at a low to moderate level, periods of intense volatility, such as 2008 through 2010, when investors fled the stock markets to highly-liquid, low-volatility investments, can significantly affect the marketability of any particular equity interest. To address this issue, FMV Opinions now presents a “VIX” variable for each transaction occurring after June 1990. This variable represents the level of expected future volatility in equity markets around the time of the transaction. With this brief overview, the FMV method requires that the valuator:
First, develop an analysis of the small block restricted stock data to derive an “as if” restricted stock discount for the private company interest. This discount is labeled the Restricted Stock Equivalent Discount (RSED) by FMV Opinions, Inc. Where the business valuator establishes greater transaction volatility than the market, a factor is calculated to account for this excess volatility and applied to the RSED as an adjustment, generally increasing, but possibly decreasing the RSED, should the transaction volatility be less than the market.
This concept for determining the discount for lack of marketability can be illustrated as follows:
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After the ARSED is determined, develop an analysis of comparative small and large block restricted stocks. This analysis should focus on identifying comparable or guideline final characteristics that eliminate as much “non block size” determinants as possible. Stated another way, excepting block size, the sample of small and large block restricted stocks would produce similar discount levels.
The difference in the discounts of the similar small and large block restricted stocks represent what the FMV Method refers to as the “private company discount increment” or “Large Block Discount Increment” (LBI). An illustration of the final discount for lack of marketability is as follows:
The FMV study notes that a direct comparison between the large block data and the private company equity interest is not performed because of the lack of sufficient large block restricted stock transactions in the study capable of making such comparisons meaningful. According to Lance S. Hall, of FMV Opinions, Inc., “the key advantage to using the three-step FMV method is that it recognizes that liquidity is a continuum and that, all things being equal, the private company equity interest should always have a discount greater than a similarly situated large block restricted stock interest, regardless of the size of the private company equity interest block.” FMV Opinions introduced the FMV DLOM Calculator in fall of 2010. This web-based, interactive tool enables business valuators to drill through the FMV Opinions database and takes valuators stepby-step through the recommended calculation methodologies.
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III. Z. CHRISTOPHER MERCER’S QUANTITATIVE MARKETABILITY DISCOUNTS MODEL (QMDM) Mercer’s QMDM is a shareholder-level discounted cash flow model designed to aid the valuation practitioner determine and explain a reasonable and transparent basis for the discount for lack of marketability. Mercer’s model focuses on a rate of return analysis in determining a discount for lack of marketability. It is based on the time value of money that an illiquid investment sacrifices. The model attempts to recognize the impact on value of minority shares of not benefiting from all the cash flow of a closely held business. A. DEVELOPMENT OF THE QMDM After introducing the model in 1994, Mercer followed up with a book explaining his methodology and a second updated edition titled, Business Valuation—An Integrated Theory, authored by Mercer and Travis W. Harms in 2007. The treatise is published by John Wiley & Sons, Inc. An accompanying text, QMDM Companion, Version 4.0, Explanatory Text to Accompany the Quantitative Marketability Discount Model, includes an Excel spreadsheet model to help guide the practitioner in applying the model. The tool is available at www.mercercapital.com. An additional treatise, Quantifying Marketability Discounts, by Z. Christopher Mercer was presented in 1997 to assist appraisers in developing, quantifying, and defending marketability discounts based on the facts and circumstances of each case. The valuation model to estimate marketability discounts presented in the book reflects the fair market value of a subject business interest at the nonmarketable minority interest level. The QMDM attempts to address two major issues regarding quantifying discounts for lack of marketability as he stated in his book: 1. 2.
The fact is that the two largest adjustments in most business valuation reports often receive only limited support and documentation. The real issue of absence of tools necessary to facilitate a well thought-out and defensible discount.
The QMDM addresses the incremental return represented by a marketability discount that is above the enterprise-level discount rate. This incremental return applicable to a nonmarketable security is necessary to induce investors to make the purchase rather than making an investment in a similar freely traded security. The quantitative methodologies developed in Mercer’s book focus on the factors that influence the concept of the incremental return. B.
BASIC FRAMEWORK FOR THE QMDM Mercer focuses on five categories of “the fundamental elements of value” used by investors in making their investment decisions: 1.
Capital Appreciation Quantifying a discount for lack of marketability requires consideration of the anticipated growth in the value of the investment.
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Dividend Yield The appraiser must consider the expected dividend yield based on the marketable minority interest value (dividends are the expected interim cash flow to the holder of the investment).
3.
Term of Investment The QMDM provides a means for the appraiser to make an assessment of the expected holding period of the investment.
4.
Prospects for Liquidity Since there is no ready market for investments in privately held securities, investors are concerned with the prospects for liquidity while holding the investment.
5.
Investor’s Required Holding Period Return The QMDM develops a means of assessing the required holding period rate of return for a hypothetical investor. The base for estimating is the equity discount rate used in the appraisal at the marketable minority discount level. Additional specific risks, which relate to investors in illiquid interests of the enterprise, are added. The required holding period return utilized in the QMDM is usually expressed in terms of an approximate range. Mercer explains: Since the expected cash flows generated by the business are the source of the nonmarketable minority investor’s cash flows, the risks faced by the nonmarketable minority investor encompass the risk of the business generating those cash flows, as well as incremental risks arising from the illiquidity of the investment. Therefore, the embodiment of risk for valuation purposes, the relevant discount rate, must for nonmarketable minority investors be greater than or equal to, but cannot be less than, the discount rate applicable to the valuation of the business.
C. UTILIZING THE QMDM In developing a valuation utilizing the QMDM, the model assumes that normalization adjustments, including those related to nonrecurring items and discretionary owner compensation and/or benefits have been made when arriving at the capitalizable benefit stream. There have been some challenges to this assumption under the model, as owner compensation adjustments are generally an element of control and not considered in a valuation of a minority interest.
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Using the five elements discussed previously, the discount can be calculated using the following equation:
An example to illustrate the calculation using Mercer’s equation follows: Assumptions: Discount rate .................................................................................... 25% Enterprise Level Anticipated growth ........................................................................................................ 5% Capitalization rate ............................................................................. 20% Enterprise Level Net earnings multiple (1/cr) ........................................................................ 5 P/E Multiple After-tax earnings power ............................................................................ $0.40 per Share Freely tradable value .................................................................................. $2.00 per Share Growth rate of value ...................................................................................................... 5% Interim cash flows (earnings retained to grow business) .............................................. 0% Probable holding period.........................................................................................10 Years Required holding period rate of return .......................................................... 20% per Year Based on the above assumptions, the subject interest would be valued at $0.53 per share. This value is calculated by growing the freely tradable value ($2) at 5% for 10 years, and discounting this terminal value back to the present by the 20% required holding period rate of return. As a result, the implied marketability discount based upon the assumptions contained herein is calculated using the equation as follows:
MD = 1 -
$0.53 $2.00
%
= (1 – 0.265)% = 73.5%
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Utilizing the above assumptions, the marketability discount calculated under this example is 73.5%. According to Mercer, the discount calculated is the “net impact of the factors that differentiate the postulated nonmarketable minority interest from a freely tradable interest.” The following example was presented by Mercer at the “Summit on Discounts for Lack of Marketability” in September 2008.
D. COURT CHALLENGES OF THE QMDM As previously stated in this chapter, the QMDM is another means of quantifying the marketability discount. Since the model’s introduction, it has been presented to the U.S. Tax Court dating back to Thompson in 1996. The merits of the model have been hotly debated, and it has received significant criticism by appraisers and in the courts. Three recent court cases specifically cited the QMDM:
Estate of Weinberg v. Commissioner, T.C. Memo 2000-51 Janda v. Commissioner, T.C. Memo 2001-24 Estate of Temple v. United States, Civil Action No. 9:03-CV-165
In Weinberg, the IRS expert adopted the QMDM and argued a 15% discount for lack of marketability. The Court criticized the expert’s use of the model, writing “…slight variations in the assumptions used in the model produce dramatic differences in the results.” The Court ultimately determined that a 20% discount for lack of marketability was appropriate in the case. 8 – Chapter Eight
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In Janda, the Petitioner’s expert utilized the QMDM and determined a 65.77% marketability discount. The Court rejected the application of the QMDM and further stated, “We have grave doubts about the reliability of the QMDM model to produce reasonable discounts, given the generated discount of over 65%.” In Temple, the taxpayer’s expert used QMDM, producing a discount for lack of marketability of 45%. The expert’s inputs included a 10-15 year holding period and 3% expected appreciation. The Court stated that it “found no holding period requirement in the controlling document; however, under the [QMDM], the longer the holding period, the higher the discount,” and, the holding period assumptions were “enough, in the absence of a holding period requirement… to concern the Court with the reliability of that aspect of [expert’s] calculations.” It is important and fair to note that the model has been submitted to the U.S. Tax Court dating to the mid-1990s by Mr. Mercer in the following cases without any comment by the Court:
B.W. Thompson, 72 T.C. Memo 1036, Dec. 51, 605 (M) T.C. Memo 1996-468 Estate of S.H. Marmaduke, 78 T.C. Memo 593, Dec. 53, 584 (M) T.C. Memo 1999-342 Estate of H.M. Noble, 89 T.C. Memo 649, Dec 55, 903 (M) T.C. Memo, 2005-02 In addition, the model was favorably viewed in Juan Armstrong v. LaSalle Bank National Association, No. 05-3417 (7 Cir. May 4, 2006)
There has been some controversy in the courts surrounding discounts for lack of marketability as judges look for a more scientific approach to quantifying these discounts. The QMDM is a shareholder-level discounted cash flow model that quantifies marketability discounts using a rate of return analysis based on specific factors utilized in making investment decisions. There have been some criticisms of the QMDM since its introduction by Mercer in 1994. Some appraisers feel that the model also measures a minority discount as the base or benefit stream by making normalization adjustments for items of control such as owner compensation. Another criticism of the QMDM is in the estimation of an expected growth rate in the value of the investment. This estimation is seen by some to be a force of the discount by choosing arbitrary assumptions to derive a growth rate. The model has been challenged by the U.S. Tax Court in several cases, but apparently accepted in others. The creator of the QMDM suggests that disagreeing with the inputs into the model do not invalidate its applicability. Mercer takes the position that in each critical case (Weinberg, Janda and Temple), the Court has disagreed with the underlying assumptions in the model and that the “integrity and validity of the valuation method is not impugned” This section is presented to provide appraisers with a familiarity of the additional tools used in valuing privately held businesses. Each valuation engagement should be performed on a caseby-case basis, assessing the specific elements of the subject interest.
IV. VFC LONGSTAFF DLOM METHODOLOGY Mark Vianello of Vianello Forensic Consulting, LLC (VFC) prefers a method of determining the discount for lack of marketability structured primarily around a formula developed in 1995 by Francis A. Longstaff in an article titled, “How Much Can Marketability Affect Security Values,” published in the Journal of Finance, Volume L, No. 5, December 1995. The method is predicated upon certain key assumptions set forth by Vianello: © 2003–2014 Robert J. Grossman and National Association of Certified Valuators and Analysts 2014.v1
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In comparing well run, publicly traded companies to well run privately held companies, the only real difference is liquidity or the lack of liquidity. Investment returns should be considered “public company returns” not minority, marketable returns. For the well run public company, it is assumed that all of the positive perquisites of control have been removed, thus allowing the opportunity to raise additional capital in the public marketplace for fractional ownership interests.
2.
Consideration of these key assumptions requires the valuator to view traditional levels of value in an alternative fashion: PUBLICLY TRADED VALUE Difference reflects the economic risk of lack of marketability NONMARKETABLE CONTROL VALUE Difference reflects the economic risk of lack of control NONMARKETABLE MINORITY VALUE
In the Vianello model, strategic value has no place in the discount for lack of marketability determination. He argues that although strategic opportunity suggests a benefit to being in control, it does not suggest that control is more valuable than liquidity. A. OTHER KEY THOUGHTS IN CONSIDERING THE VFC METHODOLOGY: 1. 2.
3.
Risk adjusted rates of return are fungible. There is a transaction cost to becoming and continuing as a public company that can only be justified through the greater access to capital of the public markets and the jump in value that pre-IPO owners receive after the Company goes public. If control were worth more than liquidity, it would serve as further disincentive to going public and ultimately, there would be no public companies.
As a result of these considerations, Vianello provides an expanded alternative view of traditional levels of value (see illustration on next page). In structuring this model, Vianello articulates that it is not the value of liquidity, per se, that discounts for lack of marketability seek to quantify, but rather, the risk associated with the lack of liquidity. If liquidity is the ability to convert an asset to cash quickly and capture gains or avoid losses, then the discount for lack of marketability, being the result of illiquidity, represents the economic risk associated with failing to realize gains or failing to avoid losses on an investment during the period the investors is trying to sell it.
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ALTERNATIVE VIEW OF THE LEVELS OF BUSINESS VALUE Controlling Interests in Private Companies
Public Companies
Minority Interests in Private Companies
INCREASING MARKETING PERIODS
Well Run DLOM
Well Run NO CONTROL
MGMT QUALITY
Strategic Value Opportunities
Well Run
MGMT QUALITY MGMT QUALITY
Poorly Run DLOM
Poorly Run
NO CONTROL
Poorly Run
B.
LONGSTAFF MODEL The Longstaff Model presents a simple analytical upper bound on the value of marketability using “look back” option pricing theory. In addition, the Longstaff Model: 1. 2.
Demonstrates that discounts for lack of marketability can be large even if the illiquidity timeframe is brief Provides insight into the relationship of the marketability discount and the length of time of illiquidity
Longstaff notes: The intuition behind these results can best be conveyed by considering a hypothetical investor with perfect market timing ability who is restricted from selling a security for T periods. If the marketability restriction were to be relaxed, the investor could then sell when the price of the security reached its maximum. Thus, if the marketability restriction were relaxed, the incremental cash flow to the investor would essentially be the same as if he swapped the time-T value of the security for the maximum price attained by the security. The present value of this lookback or liquidity swap represents the value of marketability for this hypothetical investor, and provides an upper bound for any actual investor with imperfect market timing ability.
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Vianello provides an example of Longstaff’s assessment as follows: 1.
2.
Assume an investor receives a share of stock worth $100 at time zero, but which he cannot sell for T = 2 years when the stock is worth $154 (present value at T = 0, discounted at a risk free rate of 5% = $139). If at its peak value the stock were worth $194 (present value at T = 0, discounted at a risk free rate of 5% = $180), then the present value cost of the restriction to the investor at T = 0 would be $41, or 41% of his $100 investment.
For this sample path: a) b) c) d)
With restriction, present value of T = 2 at T = 0 is 154*exp(-2*.05) = $139 Without restriction, could have 194*exp(-1.5*.05) = $180 present value Cost of restriction is the difference in present values = $180 - $139 = $41 DLOM percentage = present value difference divided by investment = 41/100 = 41%
The mathematical formula for Longstaff’s assessment is:
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The VFC Longstaff DLOM Methodology calculates a proxy for the subject company’s stock price volatility using appropriately selected guideline companies, using the two steps detailed below: 1.
2.
Calculate the annualized average stock price volatility for each of the guideline companies for an historic period of time equal to the period of time the valuator believes will be required to market the interest. Average the calculated volatilities using a simple average.
The methodology yields a discount reflective of average knowledge and average volatility. Why price volatility? 1. 2. 3.
Price volatility of a publicly traded stock reflects the market’s perception of the risks of owning that stock. The cost of illiquidity is a reflection of the price volatility of the investment during the period of illiquidity. Investments with no volatility only have an illiquidity cost to the extent that they cannot be fully arbitraged.
V. DR. ASHOK ABBOTT—LAMBDA Dr. Abbott is currently a professor at West Virginia University, where he has taken an active role in the debate of marketability and liquidity issues. In his paper, “Role of Liquidity in Asset Pricing,” Dr. Abbott introduces a directly observable measure of liquidity. By using 795,118 firm/month observations during January 1993 through December 2003, from all listed securities from the NYSE, AMEX, and the NASDAQ, Dr. Abbott researched two measures of liquidity. The two measures included a standard bid-ask spread measure and a new statistical measure, Lamda. Dr. Abbott concludes that the Lambda measure of liquidity performs significantly better than spreadbased measures of liquidity. Given the results, observed liquidity can be a predictor of future returns, such that an increase (decrease) in liquidity is expected to be followed by lower (higher) returns, indicating higher (lower) prices. Another article written by Dr. Abbott, “Estimating the Holding Period for Listed Securities,” was published in the September/October 2004 volume of Valuation Strategies. This article sets forth an empirical method of estimating the expected holding period for a stock. Dr. Abbott notes that while the concepts of marketability and liquidity are closely aligned, they are quite separate and distinct and defines them as such: A. MARKETABILITY The capability and ease of transfer or salability of an asset, business, business ownership interest, or security. The costs associated with the cost of an IPO (including registration, distribution, and regulatory costs would be encompassed in marketability). B.
LIQUIDITY The ability to readily convert an asset, business, business ownership interest, or security into cash without significant loss of principal during the liquidation period (not the holding period).
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Additionally, he states that the presence of one does not automatically indicate that the other is also present. An estimated holding period for each firm/month combination was calculated using a standard constant decay method. The results of the empirical study concluded that the average holding period (half-life) for listed securities is much longer than the standard of instantaneous liquidity assumed in existing literature. The average holding period for individual stocks is significantly influenced by the size of the firm (market capitalization), market liquidity, stock returns excluding dividends, dividend distributions, and stock price per share. A shorter average holding period is associated with larger firm capitalization, higher stock prices, and higher investment returns. However a higher dividend yield will result in longer holding periods. As a result of his study, Dr. Abbott concluded that markets appear to be relatively illiquid, especially for smaller firms. Therefore benchmark discounts applied based upon restricted stock studies assuming holding periods of 24 months and less may result in a severe underestimation of the true discount. Dr. Abbott also set out to provide further empirical analysis in his paper Discount for Lack of Marketability: An Empirical Analysis. Dr. Abbott notes that there are two problems with applying discounts determined from the restricted stock and pre-IPO benchmark studies. First, discounts are applied without exploring causal relationships between the observed discount and the characteristics of the subject company. The second problem is the failure to distinguish between the returns attributable to changes in liquidity and the combined effects of market conditions and other confounding factors. In an effort to provide empirical evidence, Dr. Abbott developed a quantitative model utilizing the delisting of stocks from the NASDAQ market and the observed change in market value of the delisted securities that separates the discount between the loss of liquidity and the effect of market conditions by looking at the excess returns attributable to the loss of liquidity event. Delisted stocks from the NASDAQ market during 1982 through 2001 serve as the foundation for the study. Dr. Abbott determined that the discount for lack of marketability decreases as the firm becomes larger, more profitable and the volume of trades increases. He sets forth the following regression model: Discount for lack of marketability = alpha + b1Xmarket value + b2Xfirm performance relative to the market + b3Xannual turnover of the stock. By virtue of Dr. Abbott’s regression analysis, he claims that the model explains 35% of the observed variance in excess returns representing the discount for lack of marketability, and that the model results have a less than one-in-ten-thousand chance of being a result of random occurrences.
VI. MINIMUM MARKETABILITY DISCOUNTS—TROUT & SEAMAN Robert R. Trout wrote the first edition of “Minimum Marketability Discounts,” in which he provided a guideline for a minimum discount of 24% for lack of marketability. The study analyzed the discounts on a type of stock option known as long-term equity anticipation securities (LEAPS). LEAPS are publicly traded, long-term options (call and put options) to buy or sell an underlying publicly traded equity. The options allow the holder to protect the purchase value of the investment for 14 to 26 months at a known cost. Trout believes that these discounts provide a reasonable base for the discount for lack of marketability applicable to holding a privately held stock.
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The study was updated by Ronald M. Seaman, FASA, who incorporated the effects of time and risk on the discounts. Mr. Seaman’s update confirms that the insurance provided by the LEAPS correspond to the risk involved. According to Seaman, “…the cost of a LEAPS put option, expressed as a percentage of the price of the underlying stock, measures the cost of price protection against a loss of value of the stock.” The cost of the option is a proxy for much of the discount for lack of marketability of a closely-held stock, as it eliminates the risk of loss in value. The discount percentage is calculated by dividing the cost of the put option by the cost of a share of the stock. A few facts about LEAPS:
They are publicly traded, Specific to the valuation date, They are industry-specific, Many of the Mandelbaum factors are included in LEAPS by definition, and Can be used like publicly-traded guideline companies.
Mr. Seaman first conducted his study using 2006 LEAPS prices, but has since updated the study with prices measured in November 2008. The discount changes over the two-year time period are significant as a result of the economic impact of the recession. In some cases, the 2008 discounts were double or greater than the October 2006 discounts. For more information visit http://www.dlom-info.com.
VII. CHAPTER SUMMARY There are many competing ideas and methods relative to quantifying discounts for lack of marketability. It is of the utmost importance for the valuator to fully understand the model(s) employed in each valuation project in order to achieve the best defensible report. Given the attention recently afforded to the various models and databases available to assist practitioners in calculating discounts for lack of marketability, it is imperative for the valuation professional to have an understanding of these models.
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CHAPTER EIGHT
ALTERNATIVE DISCOUNT COMPUTATION METHODOLOGIES Chapter Objectives 1.
Identify the various alternative models available to quantify the discount for lack of marketability. Determine the differences and critiques of the alternative models.
2.
I. INTRODUCTION As challenges to the use of the Benchmark Method have grown, it has driven many within the profession to look for new and better ways to address the determination of discounts for lack of marketability. While certain of these methods are fundamental to a closer and more analytical approach using the empirical studies, i.e., the Comparative Analysis of Restricted Stock Approach (CARS), other models or methods present a new and innovative format on which to base discount for lack of marketability determinations. At the very least, practitioners need to be familiar with these methods and understand how to determine their applicability to the subject company under valuation. The methods addressed in this chapter include the following:
The FMV Method The Quantitative Marketability Discount Model The Vianello Forensic Consulting Methodology Dr. Ashok Abbott’s Model
It is apparent that the first three methods or models listed are gaining ground in day-to-day application. Dr. Abbott’s study does not directly address marketability discounts, and though discussed herein, is not likely to gain ground in practical application in its current form. However, it is an important and recent development with which all business valuators should have some familiarity. The frustration of most practitioners is the lack of “specific” authoritative guidance in developing the proper level of discount. Unfortunately, such guidance is nonexistent. As with all aspects of business valuation, the determination of a proper discount for lack of marketability is fact-specific and unique.
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Advanced Discounts and Premiums
As stated in the U.S. Tax Court case, Estate of LeFrak, T.C. Memo 1993-526 (November 16, 1993), …we must remind the parties that the amount of discount must be decided on the basis of the record of the instance case, and not on what a court found reasonable in another case involving different evidence. Given the lack of a method that will answer the question in every case, it becomes an analytical problem for the valuator, in which available empirical data must be combined with an intimate understanding of all common methodologies and, perhaps most important, well reasoned judgment. Incorporation of these three elements, along with well thought-out and complete workpaper documentation and report writing, will provide the valuator with the optimum chance of success in the event of a user challenge.
II. FMV METHOD FMV Opinions, Inc. FMV Restricted Stock Study serves as the basis for the FMV Method. In the study, over 700 restricted stock transactions were examined and analyzed. As a result of this analysis, it was determined that the discount varied based on a variety of underlying financial characteristics of the company. It is noted in this study that the discount is positively correlated with: 1. 2. 3. 4.
The subject market-to-book ratio (market value divided by book value); The subject entity’s unrestricted stock price volatility; The subject block size relative to the trading volume of the stock; The block size, described as a percent of the total ownership;
Conversely, it was noted in the study that the discount is negatively correlated with: 1. 2. 3. 4. 5. 6. 7. 8. 9.
The market value of the subject entity; The revenues of the subject entity; The earnings and net profit margin of the subject entity; The dividend payout ratio of the subject entity; The total assets of the subject entity; The book value of shareholders’ equity of the subject entity; The subject entity’s stock price per share; The trading volume of the subject entity’s stock; and The size of the block sold (dollar value).
FMV observed that under the dribble-out provisions of Rule 144, some blocks of stock that constitute larger portions of issued and outstanding shares resulted in liquidation time frames greater than the actual Rule 144 restriction period. By way of example, a 30% block may be subject to a one-year (or now six months) restriction under Rule 144 before it can be sold in the public exchanges. The limitation under the dribble-out rule is that quarterly sales can be no more than 1% of the total issued and outstanding shares or, if greater, 1% of the average monthly trading volume. Thus, the dribble-out rule may limit any sales after the restriction period lapses to 1% of total shares outstanding per quarter. Under this rule, then, total liquidation on a 30% block could take 7.5 years after the Rule 144 restriction period lapses. The resultant conclusion, although intuitive, is that larger blocks of stock are less marketable even when compared to smaller blocks of the same company. 2 – Chapter Eight
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While large stocks that are restricted are less marketable than smaller blocks, such is not generally the case with privately held equity interests. A 30% private company equity interest is likely to be just as illiquid as a 5% interest in the same entity. The FMV study concludes that private company equity interests are more illiquid and less marketable than even the large block restricted stocks and, as such, the large block restricted stock data should be the floor when determining privately held ownership interest discounts. FMV Opinions has determined through analysis and demonstrated that a public company’s stock price volatility is a key determinant of the discount for lack of marketability. Because private company volatility is not as easily measured, FMV Opinions has made an empirical connection between discounts for lack of marketability and overall stock market volatility. This information makes it possible for the business valuator to incorporate volatility as a consideration when determining discounts for lack of marketability for minority, nonmarketable equity ownership interest in privately-held companies. Keep in mind that while stock market volatility is currently at a low to moderate level, periods of intense volatility, such as 2008 through 2010, when investors fled the stock markets to highly-liquid, low-volatility investments, can significantly affect the marketability of any particular equity interest. To address this issue, FMV Opinions now presents a “VIX” variable for each transaction occurring after June 1990. This variable represents the level of expected future volatility in equity markets around the time of the transaction. With this brief overview, the FMV method requires that the valuator:
First, develop an analysis of the small block restricted stock data to derive an “as if” restricted stock discount for the private company interest. This discount is labeled the Restricted Stock Equivalent Discount (RSED) by FMV Opinions, Inc. Where the business valuator establishes greater transaction volatility than the market, a factor is calculated to account for this excess volatility and applied to the RSED as an adjustment, generally increasing, but possibly decreasing the RSED, should the transaction volatility be less than the market.
This concept for determining the discount for lack of marketability can be illustrated as follows:
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Advanced Discounts and Premiums
After the ARSED is determined, develop an analysis of comparative small and large block restricted stocks. This analysis should focus on identifying comparable or guideline final characteristics that eliminate as much “non block size” determinants as possible. Stated another way, excepting block size, the sample of small and large block restricted stocks would produce similar discount levels.
The difference in the discounts of the similar small and large block restricted stocks represent what the FMV Method refers to as the “private company discount increment” or “Large Block Discount Increment” (LBI). An illustration of the final discount for lack of marketability is as follows:
The FMV study notes that a direct comparison between the large block data and the private company equity interest is not performed because of the lack of sufficient large block restricted stock transactions in the study capable of making such comparisons meaningful. According to Lance S. Hall, of FMV Opinions, Inc., “the key advantage to using the three-step FMV method is that it recognizes that liquidity is a continuum and that, all things being equal, the private company equity interest should always have a discount greater than a similarly situated large block restricted stock interest, regardless of the size of the private company equity interest block.” FMV Opinions introduced the FMV DLOM Calculator in fall of 2010. This web-based, interactive tool enables business valuators to drill through the FMV Opinions database and takes valuators stepby-step through the recommended calculation methodologies.
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ALTERNATIVE DISCOUNT COMPUTATION METHODOLOGIES
III. Z. CHRISTOPHER MERCER’S QUANTITATIVE MARKETABILITY DISCOUNTS MODEL (QMDM) Mercer’s QMDM is a shareholder-level discounted cash flow model designed to aid the valuation practitioner determine and explain a reasonable and transparent basis for the discount for lack of marketability. Mercer’s model focuses on a rate of return analysis in determining a discount for lack of marketability. It is based on the time value of money that an illiquid investment sacrifices. The model attempts to recognize the impact on value of minority shares of not benefiting from all the cash flow of a closely held business. A. DEVELOPMENT OF THE QMDM After introducing the model in 1994, Mercer followed up with a book explaining his methodology and a second updated edition titled, Business Valuation—An Integrated Theory, authored by Mercer and Travis W. Harms in 2007. The treatise is published by John Wiley & Sons, Inc. An accompanying text, QMDM Companion, Version 4.0, Explanatory Text to Accompany the Quantitative Marketability Discount Model, includes an Excel spreadsheet model to help guide the practitioner in applying the model. The tool is available at www.mercercapital.com. An additional treatise, Quantifying Marketability Discounts, by Z. Christopher Mercer was presented in 1997 to assist appraisers in developing, quantifying, and defending marketability discounts based on the facts and circumstances of each case. The valuation model to estimate marketability discounts presented in the book reflects the fair market value of a subject business interest at the nonmarketable minority interest level. The QMDM attempts to address two major issues regarding quantifying discounts for lack of marketability as he stated in his book: 1. 2.
The fact is that the two largest adjustments in most business valuation reports often receive only limited support and documentation. The real issue of absence of tools necessary to facilitate a well thought-out and defensible discount.
The QMDM addresses the incremental return represented by a marketability discount that is above the enterprise-level discount rate. This incremental return applicable to a nonmarketable security is necessary to induce investors to make the purchase rather than making an investment in a similar freely traded security. The quantitative methodologies developed in Mercer’s book focus on the factors that influence the concept of the incremental return. B.
BASIC FRAMEWORK FOR THE QMDM Mercer focuses on five categories of “the fundamental elements of value” used by investors in making their investment decisions: 1.
Capital Appreciation Quantifying a discount for lack of marketability requires consideration of the anticipated growth in the value of the investment.
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Dividend Yield The appraiser must consider the expected dividend yield based on the marketable minority interest value (dividends are the expected interim cash flow to the holder of the investment).
3.
Term of Investment The QMDM provides a means for the appraiser to make an assessment of the expected holding period of the investment.
4.
Prospects for Liquidity Since there is no ready market for investments in privately held securities, investors are concerned with the prospects for liquidity while holding the investment.
5.
Investor’s Required Holding Period Return The QMDM develops a means of assessing the required holding period rate of return for a hypothetical investor. The base for estimating is the equity discount rate used in the appraisal at the marketable minority discount level. Additional specific risks, which relate to investors in illiquid interests of the enterprise, are added. The required holding period return utilized in the QMDM is usually expressed in terms of an approximate range. Mercer explains: Since the expected cash flows generated by the business are the source of the nonmarketable minority investor’s cash flows, the risks faced by the nonmarketable minority investor encompass the risk of the business generating those cash flows, as well as incremental risks arising from the illiquidity of the investment. Therefore, the embodiment of risk for valuation purposes, the relevant discount rate, must for nonmarketable minority investors be greater than or equal to, but cannot be less than, the discount rate applicable to the valuation of the business.
C. UTILIZING THE QMDM In developing a valuation utilizing the QMDM, the model assumes that normalization adjustments, including those related to nonrecurring items and discretionary owner compensation and/or benefits have been made when arriving at the capitalizable benefit stream. There have been some challenges to this assumption under the model, as owner compensation adjustments are generally an element of control and not considered in a valuation of a minority interest.
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Using the five elements discussed previously, the discount can be calculated using the following equation:
An example to illustrate the calculation using Mercer’s equation follows: Assumptions: Discount rate .................................................................................... 25% Enterprise Level Anticipated growth ........................................................................................................ 5% Capitalization rate ............................................................................. 20% Enterprise Level Net earnings multiple (1/cr) ........................................................................ 5 P/E Multiple After-tax earnings power ............................................................................ $0.40 per Share Freely tradable value .................................................................................. $2.00 per Share Growth rate of value ...................................................................................................... 5% Interim cash flows (earnings retained to grow business) .............................................. 0% Probable holding period.........................................................................................10 Years Required holding period rate of return .......................................................... 20% per Year Based on the above assumptions, the subject interest would be valued at $0.53 per share. This value is calculated by growing the freely tradable value ($2) at 5% for 10 years, and discounting this terminal value back to the present by the 20% required holding period rate of return. As a result, the implied marketability discount based upon the assumptions contained herein is calculated using the equation as follows:
MD = 1 -
$0.53 $2.00
%
= (1 – 0.265)% = 73.5%
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Utilizing the above assumptions, the marketability discount calculated under this example is 73.5%. According to Mercer, the discount calculated is the “net impact of the factors that differentiate the postulated nonmarketable minority interest from a freely tradable interest.” The following example was presented by Mercer at the “Summit on Discounts for Lack of Marketability” in September 2008.
D. COURT CHALLENGES OF THE QMDM As previously stated in this chapter, the QMDM is another means of quantifying the marketability discount. Since the model’s introduction, it has been presented to the U.S. Tax Court dating back to Thompson in 1996. The merits of the model have been hotly debated, and it has received significant criticism by appraisers and in the courts. Three recent court cases specifically cited the QMDM:
Estate of Weinberg v. Commissioner, T.C. Memo 2000-51 Janda v. Commissioner, T.C. Memo 2001-24 Estate of Temple v. United States, Civil Action No. 9:03-CV-165
In Weinberg, the IRS expert adopted the QMDM and argued a 15% discount for lack of marketability. The Court criticized the expert’s use of the model, writing “…slight variations in the assumptions used in the model produce dramatic differences in the results.” The Court ultimately determined that a 20% discount for lack of marketability was appropriate in the case. 8 – Chapter Eight
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In Janda, the Petitioner’s expert utilized the QMDM and determined a 65.77% marketability discount. The Court rejected the application of the QMDM and further stated, “We have grave doubts about the reliability of the QMDM model to produce reasonable discounts, given the generated discount of over 65%.” In Temple, the taxpayer’s expert used QMDM, producing a discount for lack of marketability of 45%. The expert’s inputs included a 10-15 year holding period and 3% expected appreciation. The Court stated that it “found no holding period requirement in the controlling document; however, under the [QMDM], the longer the holding period, the higher the discount,” and, the holding period assumptions were “enough, in the absence of a holding period requirement… to concern the Court with the reliability of that aspect of [expert’s] calculations.” It is important and fair to note that the model has been submitted to the U.S. Tax Court dating to the mid-1990s by Mr. Mercer in the following cases without any comment by the Court:
B.W. Thompson, 72 T.C. Memo 1036, Dec. 51, 605 (M) T.C. Memo 1996-468 Estate of S.H. Marmaduke, 78 T.C. Memo 593, Dec. 53, 584 (M) T.C. Memo 1999-342 Estate of H.M. Noble, 89 T.C. Memo 649, Dec 55, 903 (M) T.C. Memo, 2005-02 In addition, the model was favorably viewed in Juan Armstrong v. LaSalle Bank National Association, No. 05-3417 (7 Cir. May 4, 2006)
There has been some controversy in the courts surrounding discounts for lack of marketability as judges look for a more scientific approach to quantifying these discounts. The QMDM is a shareholder-level discounted cash flow model that quantifies marketability discounts using a rate of return analysis based on specific factors utilized in making investment decisions. There have been some criticisms of the QMDM since its introduction by Mercer in 1994. Some appraisers feel that the model also measures a minority discount as the base or benefit stream by making normalization adjustments for items of control such as owner compensation. Another criticism of the QMDM is in the estimation of an expected growth rate in the value of the investment. This estimation is seen by some to be a force of the discount by choosing arbitrary assumptions to derive a growth rate. The model has been challenged by the U.S. Tax Court in several cases, but apparently accepted in others. The creator of the QMDM suggests that disagreeing with the inputs into the model do not invalidate its applicability. Mercer takes the position that in each critical case (Weinberg, Janda and Temple), the Court has disagreed with the underlying assumptions in the model and that the “integrity and validity of the valuation method is not impugned” This section is presented to provide appraisers with a familiarity of the additional tools used in valuing privately held businesses. Each valuation engagement should be performed on a caseby-case basis, assessing the specific elements of the subject interest.
IV. VFC LONGSTAFF DLOM METHODOLOGY Mark Vianello of Vianello Forensic Consulting, LLC (VFC) prefers a method of determining the discount for lack of marketability structured primarily around a formula developed in 1995 by Francis A. Longstaff in an article titled, “How Much Can Marketability Affect Security Values,” published in the Journal of Finance, Volume L, No. 5, December 1995. The method is predicated upon certain key assumptions set forth by Vianello: © 2003–2014 Robert J. Grossman and National Association of Certified Valuators and Analysts 2014.v1
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Advanced Discounts and Premiums
In comparing well run, publicly traded companies to well run privately held companies, the only real difference is liquidity or the lack of liquidity. Investment returns should be considered “public company returns” not minority, marketable returns. For the well run public company, it is assumed that all of the positive perquisites of control have been removed, thus allowing the opportunity to raise additional capital in the public marketplace for fractional ownership interests.
2.
Consideration of these key assumptions requires the valuator to view traditional levels of value in an alternative fashion: PUBLICLY TRADED VALUE Difference reflects the economic risk of lack of marketability NONMARKETABLE CONTROL VALUE Difference reflects the economic risk of lack of control NONMARKETABLE MINORITY VALUE
In the Vianello model, strategic value has no place in the discount for lack of marketability determination. He argues that although strategic opportunity suggests a benefit to being in control, it does not suggest that control is more valuable than liquidity. A. OTHER KEY THOUGHTS IN CONSIDERING THE VFC METHODOLOGY: 1. 2.
3.
Risk adjusted rates of return are fungible. There is a transaction cost to becoming and continuing as a public company that can only be justified through the greater access to capital of the public markets and the jump in value that pre-IPO owners receive after the Company goes public. If control were worth more than liquidity, it would serve as further disincentive to going public and ultimately, there would be no public companies.
As a result of these considerations, Vianello provides an expanded alternative view of traditional levels of value (see illustration on next page). In structuring this model, Vianello articulates that it is not the value of liquidity, per se, that discounts for lack of marketability seek to quantify, but rather, the risk associated with the lack of liquidity. If liquidity is the ability to convert an asset to cash quickly and capture gains or avoid losses, then the discount for lack of marketability, being the result of illiquidity, represents the economic risk associated with failing to realize gains or failing to avoid losses on an investment during the period the investors is trying to sell it.
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ALTERNATIVE VIEW OF THE LEVELS OF BUSINESS VALUE Controlling Interests in Private Companies
Public Companies
Minority Interests in Private Companies
INCREASING MARKETING PERIODS
Well Run DLOM
Well Run NO CONTROL
MGMT QUALITY
Strategic Value Opportunities
Well Run
MGMT QUALITY MGMT QUALITY
Poorly Run DLOM
Poorly Run
NO CONTROL
Poorly Run
B.
LONGSTAFF MODEL The Longstaff Model presents a simple analytical upper bound on the value of marketability using “look back” option pricing theory. In addition, the Longstaff Model: 1. 2.
Demonstrates that discounts for lack of marketability can be large even if the illiquidity timeframe is brief Provides insight into the relationship of the marketability discount and the length of time of illiquidity
Longstaff notes: The intuition behind these results can best be conveyed by considering a hypothetical investor with perfect market timing ability who is restricted from selling a security for T periods. If the marketability restriction were to be relaxed, the investor could then sell when the price of the security reached its maximum. Thus, if the marketability restriction were relaxed, the incremental cash flow to the investor would essentially be the same as if he swapped the time-T value of the security for the maximum price attained by the security. The present value of this lookback or liquidity swap represents the value of marketability for this hypothetical investor, and provides an upper bound for any actual investor with imperfect market timing ability.
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Vianello provides an example of Longstaff’s assessment as follows: 1.
2.
Assume an investor receives a share of stock worth $100 at time zero, but which he cannot sell for T = 2 years when the stock is worth $154 (present value at T = 0, discounted at a risk free rate of 5% = $139). If at its peak value the stock were worth $194 (present value at T = 0, discounted at a risk free rate of 5% = $180), then the present value cost of the restriction to the investor at T = 0 would be $41, or 41% of his $100 investment.
For this sample path: a) b) c) d)
With restriction, present value of T = 2 at T = 0 is 154*exp(-2*.05) = $139 Without restriction, could have 194*exp(-1.5*.05) = $180 present value Cost of restriction is the difference in present values = $180 - $139 = $41 DLOM percentage = present value difference divided by investment = 41/100 = 41%
The mathematical formula for Longstaff’s assessment is:
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ALTERNATIVE DISCOUNT COMPUTATION METHODOLOGIES
The VFC Longstaff DLOM Methodology calculates a proxy for the subject company’s stock price volatility using appropriately selected guideline companies, using the two steps detailed below: 1.
2.
Calculate the annualized average stock price volatility for each of the guideline companies for an historic period of time equal to the period of time the valuator believes will be required to market the interest. Average the calculated volatilities using a simple average.
The methodology yields a discount reflective of average knowledge and average volatility. Why price volatility? 1. 2. 3.
Price volatility of a publicly traded stock reflects the market’s perception of the risks of owning that stock. The cost of illiquidity is a reflection of the price volatility of the investment during the period of illiquidity. Investments with no volatility only have an illiquidity cost to the extent that they cannot be fully arbitraged.
V. DR. ASHOK ABBOTT—LAMBDA Dr. Abbott is currently a professor at West Virginia University, where he has taken an active role in the debate of marketability and liquidity issues. In his paper, “Role of Liquidity in Asset Pricing,” Dr. Abbott introduces a directly observable measure of liquidity. By using 795,118 firm/month observations during January 1993 through December 2003, from all listed securities from the NYSE, AMEX, and the NASDAQ, Dr. Abbott researched two measures of liquidity. The two measures included a standard bid-ask spread measure and a new statistical measure, Lamda. Dr. Abbott concludes that the Lambda measure of liquidity performs significantly better than spreadbased measures of liquidity. Given the results, observed liquidity can be a predictor of future returns, such that an increase (decrease) in liquidity is expected to be followed by lower (higher) returns, indicating higher (lower) prices. Another article written by Dr. Abbott, “Estimating the Holding Period for Listed Securities,” was published in the September/October 2004 volume of Valuation Strategies. This article sets forth an empirical method of estimating the expected holding period for a stock. Dr. Abbott notes that while the concepts of marketability and liquidity are closely aligned, they are quite separate and distinct and defines them as such: A. MARKETABILITY The capability and ease of transfer or salability of an asset, business, business ownership interest, or security. The costs associated with the cost of an IPO (including registration, distribution, and regulatory costs would be encompassed in marketability). B.
LIQUIDITY The ability to readily convert an asset, business, business ownership interest, or security into cash without significant loss of principal during the liquidation period (not the holding period).
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Additionally, he states that the presence of one does not automatically indicate that the other is also present. An estimated holding period for each firm/month combination was calculated using a standard constant decay method. The results of the empirical study concluded that the average holding period (half-life) for listed securities is much longer than the standard of instantaneous liquidity assumed in existing literature. The average holding period for individual stocks is significantly influenced by the size of the firm (market capitalization), market liquidity, stock returns excluding dividends, dividend distributions, and stock price per share. A shorter average holding period is associated with larger firm capitalization, higher stock prices, and higher investment returns. However a higher dividend yield will result in longer holding periods. As a result of his study, Dr. Abbott concluded that markets appear to be relatively illiquid, especially for smaller firms. Therefore benchmark discounts applied based upon restricted stock studies assuming holding periods of 24 months and less may result in a severe underestimation of the true discount. Dr. Abbott also set out to provide further empirical analysis in his paper Discount for Lack of Marketability: An Empirical Analysis. Dr. Abbott notes that there are two problems with applying discounts determined from the restricted stock and pre-IPO benchmark studies. First, discounts are applied without exploring causal relationships between the observed discount and the characteristics of the subject company. The second problem is the failure to distinguish between the returns attributable to changes in liquidity and the combined effects of market conditions and other confounding factors. In an effort to provide empirical evidence, Dr. Abbott developed a quantitative model utilizing the delisting of stocks from the NASDAQ market and the observed change in market value of the delisted securities that separates the discount between the loss of liquidity and the effect of market conditions by looking at the excess returns attributable to the loss of liquidity event. Delisted stocks from the NASDAQ market during 1982 through 2001 serve as the foundation for the study. Dr. Abbott determined that the discount for lack of marketability decreases as the firm becomes larger, more profitable and the volume of trades increases. He sets forth the following regression model: Discount for lack of marketability = alpha + b1Xmarket value + b2Xfirm performance relative to the market + b3Xannual turnover of the stock. By virtue of Dr. Abbott’s regression analysis, he claims that the model explains 35% of the observed variance in excess returns representing the discount for lack of marketability, and that the model results have a less than one-in-ten-thousand chance of being a result of random occurrences.
VI. MINIMUM MARKETABILITY DISCOUNTS—TROUT & SEAMAN Robert R. Trout wrote the first edition of “Minimum Marketability Discounts,” in which he provided a guideline for a minimum discount of 24% for lack of marketability. The study analyzed the discounts on a type of stock option known as long-term equity anticipation securities (LEAPS). LEAPS are publicly traded, long-term options (call and put options) to buy or sell an underlying publicly traded equity. The options allow the holder to protect the purchase value of the investment for 14 to 26 months at a known cost. Trout believes that these discounts provide a reasonable base for the discount for lack of marketability applicable to holding a privately held stock.
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The study was updated by Ronald M. Seaman, FASA, who incorporated the effects of time and risk on the discounts. Mr. Seaman’s update confirms that the insurance provided by the LEAPS correspond to the risk involved. According to Seaman, “…the cost of a LEAPS put option, expressed as a percentage of the price of the underlying stock, measures the cost of price protection against a loss of value of the stock.” The cost of the option is a proxy for much of the discount for lack of marketability of a closely-held stock, as it eliminates the risk of loss in value. The discount percentage is calculated by dividing the cost of the put option by the cost of a share of the stock. A few facts about LEAPS:
They are publicly traded, Specific to the valuation date, They are industry-specific, Many of the Mandelbaum factors are included in LEAPS by definition, and Can be used like publicly-traded guideline companies.
Mr. Seaman first conducted his study using 2006 LEAPS prices, but has since updated the study with prices measured in November 2008. The discount changes over the two-year time period are significant as a result of the economic impact of the recession. In some cases, the 2008 discounts were double or greater than the October 2006 discounts. For more information visit http://www.dlom-info.com.
VII. CHAPTER SUMMARY There are many competing ideas and methods relative to quantifying discounts for lack of marketability. It is of the utmost importance for the valuator to fully understand the model(s) employed in each valuation project in order to achieve the best defensible report. Given the attention recently afforded to the various models and databases available to assist practitioners in calculating discounts for lack of marketability, it is imperative for the valuation professional to have an understanding of these models.
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