Business Valuation Resources conducted a survey regarding the Discount for Lack of Marketability (DLOM) over the period from June 30 – July 28, 2021. There were 202 responders to the survey, which was the second such survey (the first was in 2018).
The DLOM Survey consisted of nine questions and a tenth which invited comments from respondents. In this post, we examine the survey results to try to interpret what they mean.
While there were 202 responders to the survey, several of the questions were “select all that apply,” so there are multiple responses from individual responders for several questions. I will interpret and comment as we walk through the questions.
I hope you will take some time to read this post to the end and comment. I take what some appraisers think are wild positions and I am critical of the “theory” used by many appraisers, particularly with respect to the DLOM.
Q1: Which of The Following Methodologies or Tools Do You Use to Estimate a Discount for Lack of Marketability (DLOM)?
The responses are summarized below.
The “winner” by a substantial margin for methodologies and tools used was restricted stock (discount) studies (RSDs).
Virtually all responders use them in some form or another, with 90% picking them. That is astounding to me in that most of the studies were done about 40 to 50 years ago. More on that later.
Even more amazing, 45% selected the pre-IPO studies as a tool of choice. It is simply not possible to relate a pre-IPO discount to an IPO price in any meaningful way. The differences between a pre-IPO price and an IPO price are numerous and make it impossible to infer anything meaningful about an appropriate DLOM for a private company today. As enumerated in Business Valuation: An Integrated Theory Third Edition (Mercer and Harms) on page 325:
- Expected cash flow enhancements as result of the IPO
- Expected risk reductions from the new capital raised
- Higher growth expectations (new capital)
- The IPO “pick-up” in multiple that often occurs
- The selection of a DLOM in the pre-IPO valuation
- The issuance of new shares in pre-IPO stock splits
- Sale of new shares to raise new capital, providing dilution for the shareholders prior to the IPO
- The passage of time between the pre-IPO transaction and the IPO itself
I’ll go out on a limb and say that the use of pre-IPO transactions in DLOM determinations should cease immediately. But appraisers continue to use them, apparently. Some 52.5% of all responses selected RSDs or pre-IPO studies. I would think that younger, financially trained appraisers would rail at this. And one did in response to Question 10:
The restricted stock studies are next to worthless. As a younger analyst in the field (9 years experience), I find it kind of amazing the profession uses them. If they were performed now/today, no one would. With the huge range of discounts and the limited information available, it’s amazing [that] valuation professionals don’t get crucified on litigation cases regarding reliance on RSS…imagine if someone used guideline multiples knowing as little about the guideline group as we have data on the studies.
Right on, young friend! And if these observations are right regarding RSDs, they are right on by a factor regarding pre-IPO studies.
In third place, 48% of responders selected option pricing models.
That was interesting because I seldom see appraisals where option pricing models are used.
In fourth and fifth place in the survey for Question 1 is the Johnson/Park empirical method (Partnership Profiles) and what the survey called “Mercer’s Quantitative Marketability Discount Model (QMDM).” The Johnson/Park method yielded responses from 27% of responders and the QMDM had a 22% response rate. The encouraging thing about these results is that almost half of the responses (99) indicated use of a quantitative, income approach method in determining DLOM. BVR pointed out that the response for the QMDM marked a doubling from the 11% response in the first DLOM Survey in 2018.
Q4: If You Use Restricted Stock Studies, Which Studies Do You Use?
The responses are summarized below.
The Stout/FMV “study” garnered a 76% response rate. From the answers to subsequent questions, the majority of these responses appear to be focused on the former study published by FMV Opinions published in 2004 and not to the Stout Restricted Stock Study and DLOM Calculator (available at BVResources.com). The Willamette study, which dates back to the 1980s and the early 2000s, garnered a 37% response, and Pluris Data had a 22% response. The remainder of the responses were received by academic studies that, with the exception of Herzel and Smith, garnered single digit responses.
The “standard” studies from the 1980s and early 1990s were not mentioned by name, but I suspect that the responses to Question 2 indicate considerable reliance on the old and dated restricted stock studies, a view that is supported by the responses to Question 5.
Q5: If Using Restricted Stock Studies, What Overall Approach Do You Use?
The responses to Question 5 are shown below.
The choices were the “benchmark average approach” and the “restricted stock comparative analysis approach.” The benchmark average approach garnered a 63% response and the restricted stock comparative approach had a 37% response. The focus on the benchmark average approach suggests that many more appraisers are using the benchmark approach than are using a more quantitative comparative approach with one of the available RSD databases.
This response is consistent with my informal survey of reports of other appraisers where it is common to find that the main DLOM method is to list a few restricted stock studies and their averages and specify a range (usually 25% to 45% or so) and then pick a discount from within the range. This tells me that many appraisers have not advanced in their thinking about DLOMs since Shannon Pratt first outlined the “method” in the First Edition of Valuing a Business in 1981. The younger generations of appraisers will have to change that.
More than a third of responders said they use restricted stock comparative analysis. The answer choice described the method as: “The DLOM is based on a comparison of financial characteristics of the subject company to restricted stock that also takes market volatility into account, including a Mandelbaum discussion.” This would seem to suggest that a good number of appraisers are using the Stout data base or the Pluris data base. Users of these databases should read Chapter 8 of Business Valuation: An Integrated Theory.
Q6: Do You Consider the Ten Mandelbaum Factors?
The responses are shown below.
The great majority of appraisers responded by indicating that they regularly or sometimes consider the Mandelbaum Factors. After establishing a benchmark range as the first factor (Judge Laro used 35% to 45% in Mandelbaum), there are nine so-called Mandelbaum factors, and several of them are not relevant to determining marketability discounts. The factors are:
- Financial statement analysis. This analysis is part of the development of the marketable minority value for a business and does not relate to the DLOM.
- Company’s dividend policy. This factor is definitely relevant, but no amount of “Kentucky windage” can discern the impact of no expected distributions relative to a 1% annual yield or a 10% annual yield relative to any benchmark range.
- Nature of the company, its history, its position in the industry and its economic outlook. I’m sorry, Judge Laro, but these factors are part of the business valuation and do not pertain to the DLOM. I had a few conversations with him over the years prior to his passing.
- Company management. Same as prior comment.
- Amount of control in transferred shares. Illiquid minority shares seldom have any control over management. That is the same position that public company minority shareholders are in. If a block had some element of control, it would perhaps decrease risk a bit and decrease the DLOM, but again, “Kentucky windage” won’t help determine how much.
- Restrictions on transferability of stock. Restrictions on transfer tend to increase risk. The “benchmark” shares of public companies were restricted for two years, almost absolutely, and longer, effectively. “Kentucky windage” won’t help ascertain the impact on value, however.
- Holding period of the stock. This is definitely an important factor. Other things being equal, the longer the expected holding period, the greater the period of risk, and the greater the DLOM. However, once again, there is no way to gauge the impact of a longer holding period relative to any benchmark range by “Kentucky windage.”
- Company’s redemption policy. If a company has a regular policy of redeeming shares, the may be nearer-term opportunities for liquidity, which would shorten the expected holding period and might lower the DLOM. However, this is a quantitative matter and not one of judgment.
- Costs associated with making a public offering. For most private businesses, there is virtually no likelihood for going public. This is essentially an irrelevant factor in DLOM determination. Further, the costs of going public were not an issue for the public companies issuing restricted shares so many years ago. They were already public.
Five of the nine Mandelbaum factors pertain to value at the nonmarketable minority level. The other four do not.
Should we ask questions that highlight risks and expected distributions and holding period expectations? Of course. However, Mandelbaum analysis is unsupportable except by “in my opinion,” or “in my judgment.” The questions from the Qualitative Method from the AICPA Practice Aid are a better start for gauging and assessing risks.
I wrote about the Mandelbaum case in Quantifying Marketability Discounts in 1997 and pointed out all of the above and more. Judge Laro specified a benchmark range of 35% to 45% in the case more than 25 years ago. He did not, however, suggest how to gauge any factor as suggesting a relatively higher or lower discount. He did not have to. He was the judge.
The last question for today’s post pertains to a DLOM applicable to a controlling interest.
Q8: Would You Apply a DLOM to a 100% Interest in a Private Company?
The responses are summarized below.
73% of the responders answered “Yes” or “Maybe” to this question. Only 27% answered “No.” Confusion still reigns in the profession regarding this question.
No valuation discount has any meaning unless the base value from which it is taken is defined and specified. When we value businesses at the marketable minority or financial control levels, we determine base values at that level. To develop values at the nonmarketable minority level, we apply appropriate marketability discounts. That’s what the BVR Survey has been addressing up to Question 8.
When appraisers use versions of the Capital Asset Pricing Model to develop values for a businesses, the values are at the marketable minority level of value or the synonymous financial control level. They have valued 100% of the cash flows of these businesses based on the risks associated with those future cash flows. The result is the same when the guideline public company method is used.
If cash flows have been appropriately normalized, the value of 100% of a business has been determined. If that is the desired result, appraisers already have the financial control value. There is no reason to apply a DLOM to that value when valuing a 100% interest.
Consider the following three observations.
- When determining fair market value of a 100% interest of a company, appraisers attempt to mirror the hypothetical negotiations of hypothetical willing buyers and sellers who are negotiating regarding the expected cash flows of the business, their expected growth, and the risks associated with achieving those cash flows. Fair market value is the intersection of their hypothetical negotiations and a hypothetical transaction occurs on the valuation date for cash or cash-equivalent consideration. There is no marketing time after the valuation date. That’s already been done. There are no risks associated with the marketing, because they have already been experienced and accounted for. There is no reason for applying a DLOM for a 100% interest.
- Assume an appraiser has developed a value of 100% of a business at the financial control level of value after examining the expected cash flows, their growth, and the risks associated with achieving them. If he or she applies a DLOM to the interest, it is tantamount to saying that the risk in the base valuation was understated. That’s all that can change. It is the same company with the same expectations for cash flow. We addressed this observation in the last post on this blog. If a company has been properly valued, there is no reason for a DLOM for a 100% interest.
- When developing indications of value at the financial control level using the guideline transactions method, know that every observed transaction had a closing date prior to which all marketing and negotiating had been accomplished. The multiples from those transactions considered that fact and reflected all aspects of the negotiations leading to the closing. Sellers maintained control over their cash flows during the marketing period and any cash on the balance sheet was likely considered in the pricing. Observations of actual closed transactions should inform appraisers that there is no reason for a DLOM for a controlling interest.
The DLOM for a controlling interest is nothing more than a “discount for convenience.” I have said this for years. If an appraiser cannot explain the DLOM for a 100% interest in terms of differences from a base value in expected cash flow, growth, or risk, then he or she had better refrain from using one. And the differences cannot be explained, because there are none.
Here’s to hoping that the 148 appraisers who answered “Yes” or “Maybe” to Question 8 have an opportunity to read this post. They might have to change their minds.
Thanks to BV Resources for conducting the DLOM Survey and for sharing it with the appraisal profession. The major takeaway from my review of the Survey is that our profession has a long way to go in terms of understanding what DLOMs, or marketability discounts, really are.
They are not some magic thing that appraisers apply based on “Kentucky windage.” They only exist to the extent that there are differences from the base value in terms of expected cash flow, growth and risk.
DLOMs do not exist because a handful of restricted stock studies were published 40 or 50 years ago. The discounts in the studies reflected differences in risk between the restricted shares and the public shares of the issuing companies. See Chapter 8 of Business Valuation: An Integrated Theory Third Edition (Mercer and Harms).
See also my recent article in the Summer 2021 Issue of Business Valuation Review, which covers much of the same ground and more. If you are a member of the American Society of Appraisers, the edition has been sent out and is available electronically. If you are not, email me at firstname.lastname@example.org and I will be sure that you receive a copy of the article. I’ll post it on LinkedIn, as well.
Will Frazier has written a review of Business Valuation: An Integrated Theory in the Summer 2021 Issue of Business Valuation Review. If you are a member of the American Society of Appraisers, it is available to you. If you are not, email me at email@example.com and I will send a copy of the review to you. I have already posted it on LinkedIn.