A recent case in the Court of Appeals of Indiana focused on a misunderstood valuation issue, the so-called “marketability discount applicable to a controlling interest” in a company.  See Srinivasulu Kakollu v. Sraina Sowmya Vadlamudi, Court of Appeals Case No. 21A-DC-96.

Let’s call this discount DLOM for brevity (“Discount for Lack of Marketability”).  To let the cat out of the bag early on, the trial court did not allow a marketability discount to the 100% value of four dental practices. The Court of Appeals also affirmed the trial court (“the Court”).

Background

The case highlights a “valuation duel” that came down to the single issue of whether or not a DLOM should be applied to the values of four dental practices.  The Husband hired an appraiser.  The Wife hired an appraiser.  The Court said of the experts: “Both are well qualified and knowledgeable individuals.  Both considered the same valuation approaches, Asset, Market, and Income.”

The Husband’s expert concluded that the fair market value of 100% of four dental practices in Indiana was $2,835,600.  The Wife’s expert concluded that the fair market value of the practices was $2,712,000.  Yes, the Husband’s expert had a conclusion that was $123 thousand, or 4.5% higher, than that of the Wife’s expert. So what happened?

Well, the Husband’s expert applied a 45% DLOM and the Wife’s expert (properly) did not.  After the 45% DLOM, the Husband’s expert’s conclusion was $1,559,600 lower than the conclusion of the Wife’s expert.

The primary rationale offered by Husband’s expert for the DLOM was that 65% of the revenues of the practice were attributable to Medicaid.  This fact was apparently not documented in the expert’s report because the Court found that this statistic was based on the unsupported statement of the Husband.  No market evidence or studies were mentioned in the decision to support the DLOM, so we cannot comment on that. Shouldn’t this important fact have been considered in the primary valuation?

Husband’s expert claimed to have valued some 50 dental practices and testified that there was a market for dental practices, since new dentists were coming out of dental school every year.  That testimony did not help the assertion of a 45% DLOM and the Court found that the Husband had no intent to sell anytime in the foreseeable future, and concluded that that weighed against the DLOM, as well.

The court held for the conclusion of Wife’s expert.  Husband appealed on three grounds, including the valuation.

The Court of Appeals held that the trial court had exercised its discretion regarding the valuation question, had listened to the experts and observed them in court, and explained its rationale for not allowing the 45% DLOM.  The Court of Appeals affirmed the lower court’s decision.

Analysis

The trial court got the right answer and seriously questioned the 45% DLOM.  However, the Court did not have the tools to properly analyze the issue.  In the following analysis, we assume the following regarding the two appraisals for purposes of illustration.  The appraisers used:

• The same discount rate
• The same long-term growth rate
• The same net income capitalization rate and multiple.

For purposes of this illustration, assume that the only difference in the two appraisals, excluding the DLOM, was the measure of earnings, which differed exactly enough to account for the difference in their conclusions.  The “valuations” are shown in the following figure.

This oversimplification will help show the DLOM applied by the Husband’s expert for what it is, an increase in the effective discount rate in the appraisal.

The discount rates are the same, 16% on row 6.  Growth, the capitalization rate and the multiples employed are the same.  Earnings differ only to provide the actual conclusions of the experts.

What is the valuation effect of assuming a 45% DLOM in Husband’s expert report?  Note the 9% on row 5 under the Husband’s column.  It says “Marketability discount risk premium” is 0%.  What does that mean?  It means that the economic and valuation effects of the DLOM actually reflect an increment to the discount rate in an amount necessary to achieve the same conclusions as with the 45% DLOM.  We see this in the next figure.

Note that the conclusion of the Husband’s expert is the same as in the first figure and that the DLOM is 0%.  The change occurs on row 5, where an incremental risk premium of 10.65% is necessary to achieve the Husband’s expert’s conclusion (row 14).  That raises the discount rate from 16.0% to 26.65% (row 6) and lowers the multiple from 7.69x to 4.23x (row 9).

Had Husband’s expert gone to court with a 26.65% discount rate, the judge might have been impressed.  Husband then would have had to explain why the discount rate was so high and alternatively, why the Wife’s expert’s discount rate of 16.0% was too low.  The discussion would have been quite different than the one that occurred in court, I’m sure.

In this short piece, we have disclosed the “marketability discount for controlling interests” for what it is – a disguised increase in the discount rate, or required return for the subject interest.

A Recent Survey

BVR recently posted a survey that had one question pertaining to the topic of this post : BVR Survey on Methods Used for Estimating a Discount for Lack of Marketability (DLOM) July 2021 (login required)

The survey was taken between June 30, and July 28, 2021, so it is hot off the press.  There were 202 responses.  Question #8 of the ten question survey was: “Would you apply a DLOM to a 100% interest in a private company?”  The responses to the three choices were:

• Yes 33% – 67 responses
• No 27% – 54 responses
• Maybe 40%  – 81 responses

The 67 appraisers who answered yes to the question should read this post.  They should also read Appendix 7-A of Business Valuation: An Integrated Theory Third Edition (by Mercer and Harms), which addresses the issue.

The 81 appraisers who might or might not use a DLOM for a controlling interest in a private business would benefit from the same readings.  They might move from the “maybe” response to the “no” response.

The 54 appraisers who do not apply DLOMs to controlling interests might find the same readings affirmative of the position they have reached.

Conclusion

The value of a business is a function of three things, expected cash flows, the expected growth of the cash flows, and the risks associated with achieving the cash flows.  When appraisers apply a DLOM to the value of a business they have just reached, we know that the neither the expected cash flow nor the growth in the cash flow are changed.  It is still the same business.  The reduction in value from the application of a DLOM therefore must be reflected in an increase in risk.  We see that clearly in the two figures above.

In a coming post, we will look at the economic and valuation rationales that explain why there is no such thing as a “marketability discount for a controlling interest” in a private business.

In the meantime, be well!

Chris

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