Viewpoint on Value
September/October 2014
Questions IRS wants
answered about
marketability discounts
Recycle paper and
plastic, not appraisal reports
How do private and
public companies differ?
Methodologies on trial
Keys to surviving a Daubert challenge
E-mail: Mac@LeaskBV.Com
Questions IRS wants answered
about marketability discounts
he Discount for Lack of Marketability Job Aid for
a particular interest can vary significantly from the
IRS Valuation Professionals helps IRS field agents
median. Empirical studies provide a useful starting
T
better understand the theory underlying this
point. From there, valuators weigh various factors
complicated discount. But the relevance of the job aid
that may warrant a higher or lower DLOM than the
extends beyond discounts applied in a federal tax con-
median range.
text. Anyone who relies on an appraisal that includes
a discount for lack of marketability (DLOM) may
The job aid summarizes questions valuators address
benefit from reviewing this 116-page publication.
when selecting a DLOM for a subject interest:
What are the company’s prospects for selling?
The basics
The more likely it is for the business to sell in the
The job aid defines marketability as “the ability to
near future, the lower its DLOM.
quickly convert property to cash at minimal cost…
with a high degree of certainty of realizing the antici-
Could the company realistically file for a public
pated amount of proceeds.”
offering? Large businesses with lower registration
costs tend to warrant a DLOM below empirical stud-
A marketability discount is taken to reflect the lesser
ies medians.
price that’s expected from a private business interest
that can’t be quickly sold and converted to cash. It’s
Who owns the rest of the company’s stock?
appropriate when the subject interest is nonmarket-
Valuators consider the relationships of the other
able, but the prior steps in the valuation process
shareholders — including related parties, institu-
result in a marketable value.
tional investors and controlling owners. A business
owned by bickering family members or a stingy,
The job aid recognizes that the process of quantify-
autocratic controlling shareholder may warrant an
ing a DLOM is “factually intensive” and “heavily
above-median DLOM, for example.
dependent upon the experience and capability
of the valuator.” In other
What’s the relative size of the
words, professional judg-
ownership interest?
ment guides a valuator’s
Smaller blocks of stock are
approach to quantifying a
generally less desirable, unless
DLOM.
they possess swing vote rights.
These rights occur when a
DLOM
small owner has the power
questionnaire
to side with another
Generally, empirical
owner to sway business
research — such as
decisions. Conversely,
restricted stock and
large blocks of stock
pre-initial public offer-
may possess elements of
ing studies — suggests
control. But they also may
a range of median
“flood” the market, which
discounts from 30% to
may warrant a higher dis-
60%. But, depending
count (or a separate “block-
on the facts at hand,
age” discount).
the “right” discount for
2
Is the interest subject to transfer restrictions? If
positive financial results, low leverage, predictable
so, what’s the length and severity of the restric-
earnings and professional management teams are
tions? The right of first refusal to shareholders or
more salable than their weaker counterparts.
the company, for example, may extend an investor’s
expected holding period — making it harder to sell
What’s the company’s dividend-paying history
the subject interest quickly.
(and ability)? Companies that distribute cash to
shareholders provide a return on investment other
than liquidating their interests. Both real and poten-
A marketability discount
tial dividends make an investment more attractive
and, therefore, warrant a lower DLOM.
is taken to reflect the lesser
price that’s expected from a
Are there outside influences in play? External
factors that impact a DLOM include the industry’s
private business interest that
outlook, state laws and general economic conditions.
Many of these factors were outlined by the Tax Court
can’t be quickly sold and
in the landmark Mandelbaum v. Commissioner case.
converted to cash.
Bottom line
Do investors have access to reliable financial
The job aid urges IRS agents to judge each DLOM
information about the subject company? A lack
based on its reasonableness and adherence to the
of reliable, transparent information could make an
company’s circumstances. Above all, a valuator’s
investment less attractive in the marketplace and,
methodology must be generally accepted within the
therefore, warrant a higher DLOM.
valuation community — and it must consider the per-
spectives of both buyers and sellers. Appraisal reports
How strong is the company’s financial perfor-
that provide detailed written support for discounts
mance and management? Healthy companies with
help the IRS make these critical determinations. l
Common DLOM approaches
In total, the Discount for Lack of Marketability Job Aid for IRS Valuation Professionals published by the IRS
(see main article) describes 23 different DLOM approaches. Two of the most common studies cited are:
1. Restricted stock studies. The Securities and Exchange
Commission restricted stock rules before 1997 required investors
to hold such stock for at least two years (and after 1997 to the
present for at least one year). The differences between prices at
which restricted stocks are issued relative to freely traded stocks
of the same company are considered a proxy for a DLOM. These
studies typically show medians around 35%.
2. Pre-initial public offering (pre-IPO) studies. These studies
compare sales of the same company’s stock before and after its
IPO. Initial measurement points range from several days before the IPO to several years before the IPO.
The median discounts reported in pre-IPO studies tend to range between 30% and 60%. So, a DLOM
based on pre-IPO studies will generally tend to be higher than one based on restricted stock studies.
Some valuators turn to bid-ask spreads, option pricing models and various analytical methods when
quantifying a DLOM. The job aid covers these newer methods in detail, as well.
3
Recycle paper and
plastic, not appraisal reports
t may seem economical and time-
effective to reuse an old business
I
appraisal for a new purpose. But recy-
cling an appraisal without your valua-
tor’s approval could prove costly over
the long run for a few simple reasons.
Value evolves over time
Think of value as a moving target.
Internal and external factors — such as
employee turnover, equipment condi-
tion, competition levels and govern-
ment regulations — affect a company’s
value over time. It’s also relevant to
consider how active the industry’s cur-
rent merger and acquisition market is.
To illustrate, suppose Al bought 5%
of ABC Co. for $10 per share in 2004,
company’s income stream also depend on the size of
based on a formal appraisal. Today, Bob wants a
the block and the valuation purpose.
piece of the action, and ABC’s controlling owner
offers to sell him shares based on the 2004 appraisal.
Continuing with the previous example, suppose
Is it fair to use a 10-year-old appraisal?
Bob wants to buy 75% of ABC from the controlling
shareholder. But Al bought only a minority inter-
The answer depends, in part, on how internal and
est in 2004. Valuing a large block of stock requires
external factors have affected the company’s value
different adjustments and analyses than valuing
over time. The 2004 appraisal may overstate ABC’s
a minority interest in a private firm with limited
current value, for example, if the company has lost
marketability.
25% of its market share because of increased compe-
tition and several key employees have left to work
for competitors.
An appraisal is valid only
Value has many definitions
for the dates and purposes
Value also depends on how you define it. Different
listed in the report.
standards — such as investment value, fair value or fair
market value — may apply. Or the basis of value —
such as controlling or minority, nonmarketable —
may differ.
Value is case-sensitive
An appraisal is valid only for the purposes listed in the
Discounts for lack of control and marketability can
report. Valuators face different considerations depend-
have a significant impact on value. But valuation
ing on why a business is being appraised. Shareholder
discounts don’t always apply and may differ depend-
disputes, mergers and acquisitions, and tax purposes are
ing on the size of the block. Adjustments to the
just a few common reasons for an appraisal.
4
It’s important to disclose all intended uses of a valu-
Suppose the divorce occurred in a jurisdiction that
ation report. In some cases, recycling may work out.
excludes all goodwill, or just the personal goodwill
But often the appraiser will need to update — or
component, from the marital estate. If so, the valua-
even redo — the appraisal, depending on how much
tor might need to value all or part of ABC’s goodwill
the two assignments differ.
to determine the interest that’s includable in the
marital estate.
Continuing with our previous example, suppose
ABC’s controlling owner is currently getting divorced.
One size doesn’t fit all
Should she (or her spouse) rely exclusively on the
An appraisal provides a snapshot of a company’s value
2004 appraisal when divvying up the marital estate?
on a specific date and for a specific purpose. Never
Although the valuator might mention the previous
assume an old appraisal still fits today — particularly
appraisal in his or her report, there are many reasons
when in a high-stakes litigation setting. l
it’s not valid — especially in a divorce context.
How do private and
public companies differ?
rivate company appraisals are often derived
basis. But it may be less relevant when valuing a
from public stock data, because it’s more rele-
minority interest in the subject company.
P
vant and plentiful. But private and public com-
panies can markedly differ in terms of risk, expected
While private deal data is hard to find, public data
return and liquidity. Appraisals that fail to account
is plentiful. Public companies are required to report
for these differences could be making “apples-to-
transaction details to the Securities and Exchange
oranges” comparisons.
Commission (SEC). Their current public stock prices
and market capitalizations are also readily available.
Searching for relevant data
So, valuators often turn to public stock data when
valuing private companies.
Private companies tend to keep the details of their
ownership transfers close to the cuff. But there are
some exceptions. For a fee, some private firms and
business brokers disclose deal terms to
proprietary databases. In turn, valu-
ators may use these databases to
value private companies.
Unfortunately, private trans-
action databases may lack
an adequate sample of com-
parables or may not provide enough
detail about each transaction to offer
meaningful comparisons. There’s also
the merger and acquisition method,
which generates value on a controlling
5
For instance, the guideline public company method
Financial reporting. Investors want insight into the
derives value from pricing multiples based on compa-
financial performance of their investments. The SEC
rable public companies’ stock prices relative to funda-
requires public companies to issue audited financial
mental financial variables (such as price-to-earnings
statements on a quarterly basis. In contrast, private
or price-to-cash-flow).
companies are less likely to provide similar levels of
assurance and often provide only year end reports.
The income approach also relies on public stock
data. A subject company’s rate of return is typically
Smaller private firms
based on public stock market returns. Rates of return
are used to discount the subject company’s expected
tend to be riskier — and
income stream to its net present value. Riskier invest-
ments typically warrant higher rates of return, which
generally warrant higher
generates a lower value.
rates of return or lower
Understanding what’s different
pricing multiples — than
Here are some key differences between private and
larger public companies.
public companies — though there may be exceptions
to these generalizations:
Internal controls. Investors and the SEC expect
Size. A company must be fairly large to justify public
public companies to implement strong internal con-
registration costs and ongoing regulatory compliance
trol systems that include whistleblower hotlines,
costs. So, public companies tend to be larger than
corporate codes of conduct and internal audit func-
their private counterparts.
tions. At small private companies, it may not even be
feasible to effectively segregate duties, mandate vaca-
Diversification. Similarly, private companies tend
tions or rotate jobs, for example.
to have fewer lines of business and operate within
a smaller geographic radius. They’re more likely to
Factoring in differences
rely on key customers or provide niche products
Most of these differences boil down to risk. Smaller
and solutions.
private firms tend to be riskier than larger public com-
panies. Therefore, they generally warrant higher rates
Management quality. Public companies tend to be
of return or lower pricing multiples. Those are two
professionally managed, because they have greater
ways valuators account for the differences between pri-
access to financial resources that enable them to pay
vate and public companies in their analyses.
salaries that top managers expect. Small private firms
tend to be run by entrepreneurs and their families.
Another key difference relates to marketability. A
They also may have less access to debt and equity
minority interest in a public company — such as
capital than large public corporations.
shares of Disney or Microsoft — sells faster and at a
more certain price than a minority interest in a small
private business. Valuators reflect this difference by
taking discounts for lack of marketability, which are
often 30% or greater, depending on the nature of the
business interest.
Getting it right
Private and public companies differ in many ways,
so comparisons between the two types of entities
aren’t perfect. Experienced valuators understand
how to adjust for these differences, taking care not
to double-count the effects when quantifying their
discount rates, pricing multiples and marketability
discounts. l
6
Methodologies on trial
Keys to surviving a Daubert challenge
aluators often serve as expert witnesses if the
parties to a lawsuit can’t agree on the value of
V
a private business interest or economic losses
that have been incurred. Before valuators take the
stand, they should be prepared to defend their valu-
ation methodologies from what’s commonly referred
to as a Daubert challenge.
Techniques and theories
The accuracy of an expert’s conclusion isn’t the
primary focus of a Daubert challenge — that’s left
to the court during trial. Instead, judges consider
four factors related to the expert’s methodology in
isn’t enough to prove an expert is qualified to value a
accordance with the landmark Daubert v. Merrell Dow
business or calculate economic damages.
Pharmaceuticals, Inc. decision:
Instead, hire a valuator who has earned business
1. Testing. A technique or theory that stands up
valuation credentials from one of the following
under technical scrutiny is generally perceived to be
organizations:
relevant and reliable. Laypeople should be able to
understand your appraiser’s methodology, and other
experts should be able to replicate his or her work.
American Institute of Certified Public
Accountants (AICPA),
2. Peer review. Reliable methods have been pub-
American Society of Appraisers (ASA),
lished in trade journals to give other practitioners the
opportunity to reveal potential flaws and weaknesses.
Canadian Institute of Chartered Business
Novel techniques are less likely to pass muster.
Valuators (CICBV),
3. Error rate. No method is perfect. Valuators
Institute of Business Appraisers (IBA), or
admit the shortcomings of their techniques, using
more than one method whenever possible and recon-
National Association of Certified Valuation
ciling differences between valuation methodologies.
Analysts (NACVA).
Valuators also must adhere to professional standards.
Also check whether the expert is current on his or
4. Acceptability. Reliable methods are generally
her professional dues and continuing professional
accepted by the valuation community as appropriate for
education requirements. Failure to stay atop of these
the case at hand. All valuation techniques won’t apply in
requirements can be an embarrassing revelation dur-
every case — relevance to the case in question is key.
ing a Daubert challenge.
Qualifications
High stakes
Courts also want to know that an expert is truly quali-
So-called “experts” who fail Daubert challenges never
fied to value a business in the subject company’s indus-
make it to trial. Instead, their reports and testimony are
try. Today, business valuation is a separate, established
excluded from evidence. Always review the techniques,
discipline within an accounting or a consulting prac-
theories and qualifications of both sides’ valuators to
tice. A CPA license or an economics degree generally
gauge the admissibility of their reports and testimony. l
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other
professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In
addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2014 VVso14
7
John M. Leask II CPA, LLC.
PRSRT STANDARD
US POSTAGE
Business Valuation Services
PAID
PERMIT NO. 57
FAIRFIELD, CT
765 Post Road, Fairfield, Connecticut 06824
John M. Leask II (Mac), CPA/ABV, CVA, values 25 to 50 businesses annually. Often, Mac’s valuations,
oral or written, are compiled in conjunction with the purchase or sale of a business, to assist shareholders
prepare buy/sell agreements, or to set values when shareholders purchase the interest of a retiring share-
holder. Here are examples:
Professional
• Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses
Business
by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to
Valuation
closing and/or helps structure and secure financing. Services have included, but are not limited to,
verifying liabilities and assets, reviewing sales and expense records, and identifying critical issues
Services
relating to future success, and helping management plan future operations.
• Family Limited Liability Partnerships, Companies & Closely Held Businesses. Mac regularly values
various sized business interests for estate and gift tax purposes. He provides assistance to estate and trust
experts during audits of reports prepared by other valuators.
Mac also helps business owners and their CPAs and/or lawyers in the following ways:
• Planning — prior to buying or selling the business
CVA
• Prepare valuation reports in conjunction with filing estate and gift tax returns
• Plan buy/sell agreements and suggest financing arrangements
• Expert witness in divorce & shareholder disputes
John M. Leask II CPA, LLC.
• Support charitable contributions
Business Valuation Services
• Document value prior to sale of charitable entities
• Assist during IRS audits involving other valuators’ reports
• Succession planning
• Prepare valuation reports in conjunction with pre-nuptial agreements
• Understanding firm operations & improving firm profitability
More information about the firm’s valuation services (including case studies) may be found at www.LeaskBV.com.
To schedule an individual consultation or to discuss any other points of interest, Mac may be reached at 203 – 255 – 3805.
The fax is 203 – 380 – 1289, and e-mail is Mac@LeaskBV.Com.
If you have a business valuation problem, Mac is always available to discuss your options — at no charge.
Newsletters
2018
Avoid common pitfalls whe...
March/April 2018
2017
Tax issues play a central...
November/December 2017
How to factor taxes into ...
September/October 2017
Let’s make a deal Custo...
July/August 2017
Finding hidden assets and...
May/June 2017
Discounted cash flow vs. ...
March/April 2017
3 reasons why selling pri...
January/February 2017
2016
Valuation looks to the fu...
November/December 2016
Deal of a lifetime Market...
September/October 2016
Spotlight on marketabilit...
July/August 2016
Tried-and-true guidance f...
May/June 2016
Why companies need to put...
March/April 2016
Retire at your own risk
January/February 2016
2015
Year end gifts: Valuing a...
November/December 2015
How much does human capit...
September/October 2015
How does industry risk im...
July/August 2015
Casting a spotlight on th...
May/June 2015
Factoring taxes into divo...
March/April 2015
Think of valuation first ...
January/February 2015
2014
M&A deal skyrocket: Ways ...
November/December 2014
Questions IRS wants answe...
September/October 2014
Holding companies with bu...
July/August 2014
Facts and figures you nee...
May/June 2014
Strategic investments , H...
March/April 2014
Coming to terms with the ...
January/February 2014
2013
Cross-examining a valuato...
November/December 2013
7 questions to gauge mark...
September/October 2013
Too good to be true?
July/August 2013
A house divided , Shareho...
May/June 2013
S corporation conversions...
March/April 2013
Viewpoint on Value
January/February 2013
2012
Liquidation value may be ...
November/December 2012
Devil in the details Crea...
September/October 2012
Winning the DLOM debate U...
July/August 2012
When selling isn’t an o...
May/June 2012
Who, what, why and when? ...
March/April 2012
Accept no shortcuts when ...
January/February 2012
2011
Transaction databases: Ha...
November/December 2011
A valuator’s insight in...
September/October 2011
Purchase price allocation...
July/August 2011
Risk assessment The added...
January/February 2011