Introduction and Conclusion

My musings on the use of restricted stock discounts to estimate marketability discounts (or DLOMs) have led me to the conclusion: Restricted stock studies/discounts cannot be used to estimate DLOMs in any credible, standards-compliant manner.  Three of the first four Mercer’s Musings posts address this issue.

• Mercer’s Musings #1: USPAP and the Internal Revenue Service
• Mercer’s Musings #2: Using Restricted Stock Studies to Support Marketability Discounts
• Mercer’s Musings #3: Marketability Discounts re Two Hypothetical Minority Interests
• Mercer’s Musings #4: Factors to Consider in Valuing Partial Ownership Interests

This fifth post in the musings series takes a look at the usefulness of pre-IPO discounts in estimating marketability discounts.  Astute readers will know the conclusion of this musing at the outset.  To give the answer away: Pre-IPO discounts/studies cannot be used to estimate DLOMs in any credible, standards-compliant manner.

What is a Pre-IPO Discount? – 1

Begin at the very beginning.  A pre-IPO discount measures the difference between the price at which a transaction occurred in an illiquid minority interest of a company relative to the price at which it subsequently went public by engaging in an initial public offering (IPO).

Exhibit 8.21 (Mercer-Harms Business Valuation: An Integrated Theory Third Edition) (“IT3”) illustrates how pre-IPO discounts are calculated.  The hypothetical, pre-IPO transaction in this example occurred at a (split-adjusted) price of $6.50 per share, and the subsequent IPO price was $13.00 per share.

The calculated pre-IPO discount is 50% in the example, and is consistent with the medians and averages of discounts found in several older pre-IPO studies (which are cited in Chapter 8 of IT3.  The question is: What does that 50% pre-IPO discount mean or imply for the valuation of illiquid minority interests in private companies today?

Economic Information in Pre-IPO Discounts?

As with control premiums and restricted stock discounts, it is clear that the pre-IPO discount measures only the difference between two prices.  The information we can glean from this definition and example is limited to the following:

• A transaction occurred at some point prior to an IPO (perhaps three months, six months, nine months, or a year or more)
• The pre-IPO price was $6.50 per share
• The price at the subsequent IPO was $13.00 per share
• The pre-IPO price was $6.50 per share, or 50% lower than the IPO price
• The IPO price was $6.50 per share higher than the pre-IPO price, or 100% higher than the pre-IPO price

There is no direct economic information in this example of a pre-IPO discount that can shed light on the appropriate marketability discount for any private company.  Further, there is no direct economic information in any averages of groupings of pre-IPO discounts that can shed light on appropriate marketability discounts for any private companies.

As with the restricted stock studies examined in earlier posts in this series (linked above), there is no economic evidence in the older pre-IPO studies cited in IT3 (Emory, Willamette, Hitchner, etc.).  The older studies cannot provide help in developing marketability discounts today.

What is a Pre-IPO Discount? – 2

The disconnect between a pre-IPO discount and any bearing on valuing illiquid minority interests of private companies (and marketability discounts) becomes clearer in a picture.  The following figure is adapted from Figure 8.26 of IT3.

Examining the same hypothetical transaction, we find:

• A pre-IPO transaction occurred six months prior to the date that a hypothetical company engaged in its initial public offering.  That transaction took place at $6.50 per share.  See the left side of the figure above.
• Whether there was a formal appraisal or not at the pre-IPO transaction date, there was an implied  marketable minority/financial control (base) value for that entity at that date.  In the figure above, that is $10.00 per share on the left side.  This $10.00 per share value was likely unobserved unless the transaction was based on an appraisal. But it was there.
• The $6.50 per share pre-IPO price represented a 35% discount to the base price of $10.00 per share.  Whether the base price was $9.00 per share or $11.00 per share or some other price is irrelevant to this analysis.  The transaction almost certainly represented a discount to the marketable minority/financial control value at the time.  If it were not so, the pre-IPO transaction would likely not have occurred.  The purpose of many pre-IPO transactions is to enable insiders to acquire as much stock as possible at the lowest possible prices.
• Six months later, there was an IPO at $13.00 per share, as reflected on the right side of the figure.  We observed the pre-IPO price of $6.50 per share and now see the IPO price of $13.00 per share.
• The implied pre-IPO discount is 50% (1 – $6.50/$13.00).  However, the pre-IPO studies can make no comment about the implied 30% “IPO pick-up” in pricing that often occurs with IPOs, and which did occur in the example.
• The observed pre-IPO discount of 50% is actually a combination of the relief of the unobserved 35% marketability discount in the pre-IPO transaction and the unobserved 30% IPO pick-up.

A direct result of this analysis is that pre-IPO discounts are not “marketability discounts” at all.  They reflect a combination of factors as we have just concluded.  Pre-IPO discounts, therefore, do not provide “evidence” of marketability discounts at all.

There are more moving parts that the figure above does not take into consideration, some or all of which influence the difference between the pre-IPO price of $6.50 per share and the IPO price of $13.00 per share in unknown directions (see below).

The Valuation Advisors Lack of Marketability Discount Study and Valuation Ratios

The Valuation Advisors Lack of Marketability Discount Study is available at the link on the Business Valuation Resources website.  This study is introduced with the following:

Defend your discounts for lack of marketability with the most current data in the Valuation Advisors Lack of Marketability Discount Study. This robust, online database includes 18,700+ pre-IPO transactions, including 2,300+ non-U.S. deals covering 45 countries. This must-have tool enables you to reference actual DLOMs for companies with similar characteristics to your subject company and ensures you have the most convincing data available. (emphasis added)

The suggestion is that the Valuation Advisors Lack of Marketability Discount Study can be used, in effect, to conduct a form of the Guideline Public Company Method as defined in the ASA Business Valuation Standards in “Statement on Business Valuation Standards (SBVS) – 1.”  According to SBVS-1, valuation ratios from comparable public companies can be used, with appropriate adjustments, to apply to earnings or other metrics of a subject company in order to estimate the value of the subject entity.  I wrote about this issue at length in a prior blog post: RSD -4: Restricted Stock Discounts are Not Valuation Ratios, a part of a series I wrote examining restricted stock discounts and studies (available at this link).

The same analysis is applicable to pre-IPO discounts, which also are not valuation ratios.

SVBS-1 states the following:

V. Valuation ratios derived from guideline public companies (italics added with my comments in brackets [])

A. Comparisons are made through the use of valuation ratios. The computation and use of such ratios should provide meaningful insight about the value of the subject company, considering all relevant factors. Accordingly, care should be exercised with respect to issues such as:

1. The selection of the underlying data used to compute the valuation ratios [all that is available are the pre-IPO discounts, which are not valuation ratios at all]
2. The selection of the time periods and/or the averaging methods used for the underlying data [the data in the Valuation Advisors Study dates back to 1985-1986 timeframe (almost 40 years ago).  As with restricted stock data bases, much of the data is quite old and simply not relevant to valuations today]
3. The computation of the valuation ratios, which may be derived by relating prices of the guideline public companies to the appropriate underlying financial, operating, or physical data of the respective guideline companies [It should be clear that no valuation ratio can be calculated using a pre-IPO discount]
4. The timing of the price data used in the valuation ratios (in relationship to the effective date of the appraisal) [dated, as indicated just above]
5. How the valuation ratios were selected and applied to the subject’s underlying data

The International Valuation Glossary – Business Valuation defines a valuation ratio by defining Multiples:

Multiple — a ratio calculated as the value of a business or security divided by Economic Income or a non-financial metric. Also known as market multiple, pricing multiple, or valuation ratio. (bold in original, italics added)

The following figure replicates Exhibit 6-3 of IT3 (p. 182) and provides common examples of valuation ratios.

Pre-IPO discounts (and restricted stock discounts) measure the difference between two prices only.  These discounts do not relate the value of a public company divided by economic income or financial metrics as indicated in the definition of Multiple above and as illustrated in the figure above.  Take one pre-IPO discount.  Take the average of several or many pre-IPO discounts, regardless of how “comparable” the individual entities may be to a private subject company.  My conclusion is the same.

Pre-IPO discounts are not valuation ratios, and cannot be derived from public companies and applied to subject companies.  

Value is a Function of Expected Cash Flow, Growth and Risk

We know that the value of a business is a function of its expected cash flows, their expected growth, and the risks associated with achieving the cash flows.  In other words, the value of a business is a function of three important factors, expected cash flow, risk and growth.

The value of an interest in a business is a function of the expected cash flows to the interest (which are derivative of the expected cash flows of the business itself, the growth of those cash flows, including a terminal value at the end of an expected holding period, and the risks associated with achieving those cash flows.  In other words, the value of an interest in a business is a function of three important factors, expected cash flow, risk and growth.

The Valuation Advisors Lack of Marketability Discount Study provides limited information on the companies that went public.  That information includes (per the link from the Business Valuation Resources website):

• Industry or business description
• Revenues
• Operating income
• Operating profit margin
• Assets
• Date of transaction or IPO
• NAICS or SIC code

The data also includes the calculated pre-IPO discount for each transaction.  We query the data base for IPO companies in the same SIC Code as a subject private company that an appraiser is valuing as of a current date.

Valuing an Illiquid Minority Interest of a Private Company

The following figure illustrates available information regarding the averages of the assumed guideline company group from the Valuation Advisors Study.  The data shown are not from an actual run of the data base but are shown for analysis and perspective.  Also included are additional data points for reference and information about the subject private company.

The question that must be addressed is: How will information about companies that went public and had prior pre-IPO transactions (information on the left side above) assist the valuation analyst in developing a marketability discount for a private company (information on the right above) being valued in March, 2024 (or any current date)?  Assume that all of the IPO companies are in the same SIC Code as the subject company, and, like the subject company, they were all profitable, so they are “comparable” to an extent.

The average pre-IPO discount for the sample of 50 transactions in the figure above is 38%.  The range is from a low (premium) of (5%) to a high of 53%.

The appraiser has developed information about the subject company and the subject 15% interest.  The private company is profitable and has a 15% operating margin.  The WACC for the subject company is 12.5%, with an equity discount rate of 15% (not shown).  The private company is expected to pay a dividend that will yield 6.5% based on the marketable minority value of $18 million.  Based on her analysis, the appraiser concludes that the dividend can be expected to grow at about 5% per year over an expected 8 to 10 year holding period.

There is no information at all on the left side of the figure above that informs the appraiser about the value of the 15% subject interest.  For that to be true, the left side would have to provide insight into expected cash flows and their growth, and none is available.  It could also inform the appraiser about the risk associated with the subject 15% interest over the holding period, and none is available.

Assume that the appraiser concludes that the appropriate marketability discount should be 38%, or the average pre-IPO discount above.  That would value the company at the nonmarketable minority level at $11.2 million ($18.0 x (1 – 38%).  Given the expected dividend yield of 6.5% (based on the $18 million marketable minority value (or $1.17 million per year for the private company), the implied yield would be 10.4% ($1.17 / $11.2).  Is that reasonable?  There is no information on the left side of the figure to address the question.

Now assume that, based on a change of expectations, the appraiser believes that the expected holding period for the interest should be 3 to 5 years.  What is she to do?  Nothing changes on the left side of the figure and the facts have changed on the right side.  What should the marketability discount be?

Other Issues with Pre-IPO Studies/Discounts

There are a many moving parts to pre-IPO transactions and the pre-IPO discount in addition to the factors already discussed.   These factors include the following:

• The passage of time between the pre-IPO transaction and the IPO itself
• The further passage of time, perhaps years, between the pre-IPO transaction and the current valuation date for any appraisal
• Expected cash flow enhancements (at the very least, from earnings on cash raised in the IPO)
• Expected risk reductions as result of the new capital
• Higher growth expectations than before the IPO given the new capital raised
• Issuance of new shares in pre-IPO stock splits
• Sale of new shares to raise new capital for the company and resulting dilution for existing shareholders
• Ongoing access to the public markets

As with companies engaging in historical restricted stock transactions, relatively few companies that engage in IPOs were paying dividends or distributions.  Many companies that appraisers are called upon to value do provide such shareholder-level cash flows.

I wrote about these differences in Quantifying Marketability Discounts, which was published in 1997 (and no longer in print), concluding at that time that pre-IPO studies could not be used to help assess marketability discounts.  We reached the same conclusion in all three editions of Business Valuation: An Integrated Theory (2004, 2007, 2021).

These above characteristics are particular to each IPO candidate, and have nothing to do with the corresponding characteristics of any illiquid minority interest in any private company that appraisers might be valuing today.  In other words, they cannot inform appraisers about the impact on value of the critical factors of expected cash flow, risk and growth that define the value of illiquid minority interests of private companies at the present time.

Valuation analysts cannot reasonably expect to hold all these factors equal or account for them in a manner that enables the pre-IPO discount studies to offer valid evidence for the development of marketability discounts for illiquid minority interests in private businesses.

Conclusion

To restate the conclusion from the beginning: Pre-IPO discounts/studies cannot be used to estimate DLOMs in any credible, standards-compliant manner.

As always, comments, criticisms, or insights are welcome.

Chris

My current series of blog posts is titled “Mercer’s Musings.”  In the first three “musings,” I addressed USPAP and the Internal Revenue Service and concluded that the answer to the question of whether to comply with USPAP is “Why not?”  And the answer holds regardless of any certifications appraisers might hold.

The second and third musings address the issue of marketability discounts and conclude that it is not possible to comply with any valuation standards, whether USPAP or not, using only averages of restricted stock studies as a basis for “guessing” marketability discounts.  The third musing illustrates the depth of analysis necessary to reasonably address the complexities and nuances in valuing illiquid minority interests of private companies.  The first three musings are linked here for ease of reference.

• Mercer’s Musings #1: USPAP and the Internal Revenue Service
• Mercer’s Musings #2: Using Restricted Stock Studies to Support Marketability Discounts
• Mercer’s Musings #3: Marketability Discounts re Two Hypothetical Minority Interests

This fourth musing examines the guidance found in “Procedural Guideline -2 (PG – 2) Valuation of Partial Ownership Interests” in the ASA Business Valuation Standards.  Procedural Guidelines (PG) are designed to provide more detailed guidance for consideration by business appraisers than found in the base standards themselves.  Procedural Guidelines are not binding, but they are instructive of the degree of analysis that might be considered.

PG – 2 Valuation of Partial Ownership Interests

Mercer’s Musings #4 will now address a portion of PG-2: Valuation of Partial Ownership Interests.  The first section of PG-2 is its “Preamble,” which provides an overview of the intent of the guideline.  The second section is called “General Principles,” where readers find a discussion of the concept of partial ownership interests, the wide range of possibilities that are raised when such interests, and guidance regarding the differences between valuing businesses versus interests in them.

This post addresses the lengthy third section of PG-2, which is called “Factors to consider.”  The hypothetical valuation presented in Mercer’s Musings #2 and “solved” in Mercer’s Musings #3 considered a significant number of factors in developing marketability discounts for two dissimilar, 10% interests in two identical companies.  We now turn to PG-2 to provide an outline of the wide range of considerations that should be in appraisers’ minds with they begin to value partial ownership interests.

We begin with a quote from the beginning of Section III.  My comments are provided in red.

III. Factors to consider

A number of factors may be appropriate to consider in valuing partial ownership interests. The
following list is not intended to be all-inclusive. Items on the list may or may not be applicable in
specific valuation situations.

A. The purpose and definition of the valuation engagement in accordance with BVS–I General
Requirements for Developing a Business Valuation, including the applicable standard (type) and
premise of value.

B. Factors related to the underlying enterprise or asset, including:

1. The value of the underlying enterprise or asset, if applicable.
2. Enterprise-level or asset-level tax effects, if relevant.

Every appraisal must have a stated purpose and definition of the valuation (i.e., the standard of value).  The beginning point of the valuation of a partial ownership interest is almost always the value of the underlying business or asset.  This is the “base value” that has been addressed in a number of posts on this blog.  The guideline also suggests that enterprise- or asset-level tax effects might need to be considered.

C. Factors related to the subject partial interest, including:

1. Provisions in the organizational and governance documents that affect the rights,
restrictions, marketability and liquidity of the subject interest. Documents to consider may
include partnership agreements, articles of incorporation, bylaws, operating agreements,
buy-sell agreements, investment letter stock restrictions, option agreements, lock-up
requirements or others that may be relevant.

Analogous to Standards Rule 9(4), of the Uniform Standards of Professional Appraisal Practice, appraisers are instructed to examine the underlying corporate documents that might increase or decrease the risks of holding minority interests in businesses. 

C2. Applicable laws and regulations. Business examples include statutory rights to demand
dissolution of a corporation under state law, restrictions on transfer pursuant to SEC Rule
144, and many others. An asset example is included the right to partition.

C3. The existing ownership structure and configuration.

C4. Access to, availability of, and reliability of information regarding the underlying asset or
entity.

C5. The relevant pool of potential buyers, if any.

C6. Market data on transactions in similar markets, if any. Potentially similar markets might
include private placements in publicly or privately syndicated entities (including restricted
stock transactions, pre-IPO transactions, and transactions in publicly traded limited
partnerships) or tenants-in-common arrangements, etc.

Paragraphs C2 through C6 should be familiar to most business appraisers.  We must take applicable laws and regulations into account.  It is fairly standard to consider the ownership structure and configuration and influence that management might have on the value of illiquid minority interests.  The question is: How can appraisers do that?  Purely qualitative analysis seems to fall short. 

Access to reliable information is certainly an important factor since investors desire to know the factual backgrounds of their investments.

The relevant pool of hypothetical buyers is also important.  For example, if an interest has a value of $100 thousand, there may be a considerable number of potential investors.  If the interest has a value of $10 million, the pool of buyers would likely be both limited and sophisticated.  These are important considerations.

And certainly, it is important to examine relevant transactions in interests similar to a subject interest or in the interest itself.  Valuation inferences can sometimes be made from knowledge of past transactions. 

Paragraph C7 (below) focuses on the expected holding period for an investment.  This is analogous to the guidance in Standards Rule 9-4(d) of USPAP, which requires examination of holding period and interim benefits. Note, however, that many factors may influence the expected holding period. This is true because the expected holding period can seldom be estimated with certainty.  As a result, Paragraph C7.k suggests that appraisers might need to consider a relevant range of expected holding periods.

C7. Expected holding period for an investment in the subject interest, including consideration of
such factors as:

a. The extent to which the expected holding period may be uncertain.

b. Defined expiration or termination dates contained in the governing documents, or
other external factors, that may precipitate a foreseeable liquidation or sale of the
underlying entity.

c. Analysis of the age, health and other characteristics of the other owners and/or key
managers, which could provide information about the possible timing of a sale or
liquidation by the controlling owner(s).

d. The history of transactions (if any) involving partial (or possibly controlling)
interests of the subject enterprise or asset, including recapitalizations or stock
repurchases that have provided liquidity to shareholders.

e. The potential market for similar enterprises or assets (e.g., is the industry
consolidating?).

f. The emerging attractiveness of the entity for equity offering, sale, merger or
acquisition.

g. Provisions in the governing documents or buy-sell agreements, or under law or
regulation either prohibiting, restricting or allowing transfer of the subject interest.

h. Rights and powers attributable to the subject interest that may enable a sale of the
subject entity, asset or the interest itself, against the will of the other owners.

i. Historical actions of management and/or the directorate, which may provide
information about their policy and intentions regarding eventual sale of the entity or
asset, or receptivity to a potential sale or repurchase of partial interests.

j. The existence, depth and functioning of markets that might be available for interests
similar to the subject interest.

k. The appropriateness of considering a range of expected holding periods and exit
possibilities.

As suggested above, the expected holding period for an investment in a partial ownership interest can seldom be known with certainty.  Therefore, it is important for appraisers to examine the factors that might influence the length and uncertainty of the holding period.  There are a number of such factors.  For example, the governing documents of a partnership may provide for a specific termination date.  A controlling shareholder may be older and in poor health, which could trigger a potential sale of the business within a foreseeable period.

Most private companies that have been around for many years have histories of shareholder buy-outs, share repurchases, or other transactions in their shares (or interests).  If there is significant potential for future transactions, the expected holding period might be relatively shorter; and, if not, relatively longer.

It is not necessary to comment on every item in the list above with potential impacts on the expected holding period.  However, it is necessary for business appraisers to consider these factors.  In the final analysis, the length (or range) of expected holding periods may have a significant impact on the value of particular interests.  Think in terms of the time value of money as we look at the next factor to consider in valuing illiquid minority interests, that of expected economic benefits.  Know also that whether an appraiser makes a specific assumption regarding the expected holding period of an investment, there is an implicit assumption (or range of assumptions) implied by his or her conclusion.

C8. Expected economic benefits associated with the subject interest, which come from interim benefits (dividends or distributions) and a terminal cash flow when the investment is sold or liquidated.

a. Expected interim dividends or distributions to the interest, which may differ from
the expected benefits (cash flows) generated by the entity or asset as a whole.
Interest-level benefits may be affected by such factors as:

(1) The history of dividends or distributions, including both timing and amounts.

(2) Current or expected future distribution policy.

(3) Preferential dividend claims.

(4) Enterprise-level and/or interest-level tax characteristics.

(5) The outlook for one-time and/or irregular dividends or distributions.

(6) Circumstances with controlling owners that may increase (or decrease) the likelihood of future interim benefits.

Simply put, the expectation of dividends or distributions from investments in partial ownership interests is important to investors, whether hypothetical in the context of fair market value determinations, or real investors who put real money at risk.  The impact of expected distributions on present value cannot be estimated qualitatively.  The determination of the present value of expected future cash flows is inherently a quantitative exercise.

The final cash flow for minority interests is the expectation of a terminal value at the end of the expected holding period.

b. The expected terminal cash flow at the end of the expected holding period(s), which may be a function of such factors as:

(1) Possible future transactions involving the enterprise or asset as a whole, or
transactions in the subject interest itself.

(2) Current (valuation date) value and expected growth in value of the enterprise or
asset to the end of the expected holding period(s).

(3) Growth in value may be a function of expected earnings retention (distribution
policy) and the amount of and effectiveness of expected reinvestment in the
entity or asset.

If there is no expectation of future dividends, the only future cash flow is the expected terminal value.  Interim cash flows reduce risk, as seen in the hypothetical valuations in Mercer’s Musings #3.  To estimate the terminal value, it is necessary to have the current value of a business at the marketable minority/financial control level of value.  From that base, the analyst must estimate the expected future growth in value of the business over the expected holding period based on its expected business plan.  The terminal value is then estimated at the end of the expected holding period (or over a range of expected holding periods).

Paragraph 8 above, with its sub-paragraphs a. and b., provides guidance on how to examine the history of dividends or distributions, or one-time (special) dividends as a means of developing expectations for future distributions.  Once again, examining the history of owner/management needs for cash from a business can influence the outlook for future cash flows for all owners.  Certainly, preferential dividend claims can also enhance the certainty of future cash flows to illiquid interests.

The next section examines the required holding period return, or the discount rate necessary to reflect the risks associated with achieving the expected cash flows from a minority interest.

C9. Required return for investing in the subject interest. The required return may consider risks
other than risks related to the enterprise or asset as a whole, including, for example:

a. The expected length and uncertainty of the holding period.

b. The likelihood of dividends or distributions (i.e., expected distribution policy).

c. The costs of due diligence efforts required to acquire the subject partial interest.

d. The costs of monitoring the investment over the expected holding period, including
issues related to the expected receipt of timely and reliable information concerning
the investment.

e. Required returns on similar investments or investments with similar investment-specific liquidity and holding period characteristics.

f. The risk of tax liabilities from pass-through profits without guaranteed tax
distributions in entities such as limited liability companies, Subchapter S
corporations or partnerships.

g. The difficulty and cost of marketing the subject interest.

h. The risk of involuntary dilution when no preemptive rights are provided in the
articles of incorporation or bylaws of a corporation.

i. The degree of control conveyed by the subject interest.

The required holding period return is the sum of the base equity discount rate of the subject business plus an aggregate holding period premium that is estimated by appraisers.  This holding period premium is the same holding period premium demanded by investors in restricted stocks.  Keep in mind that with a restricted stock transaction, the only reason for a discount is that investors demand a “holding period premium,” or higher discount rate than for the underlying public security.  This should be clear because the expected cash flows and growth are precisely the same.  Since risk is greater, restricted share prices are lower than the public price, therefore yielding restricted stock discounts.

Appraisers sometimes think that it is not possible to estimate holding period premiums.  However, the same appraisers estimate company-specific risk premiums on a regular basis.  We do so in the context of alternative returns for similar investments.  The same is true for holding period premiums in the valuation of illiquid minority interests of private companies.

C10. Ownership-level tax effects, if relevant.
C11. Prior transactions in the subject interest, entity or asset, and their relevance to a given
assignment.

Appraisers can examine the impact of ownership-level taxes as well as prior transactions in the subject interest.

D. Interaction of the factors listed above, and their cumulative impact on the degree of control,
marketability and liquidity of the subject interest.

Paragraph D is a catchall reminding appraisers that the various factors noted above may interact with each other. 

Conclusion

There is a great deal more to valuing illiquid minority interests than “guessing” at a marketability discount based on vague references to dated and non-comparable restricted stock transactions or studies.

All appraisers would be well-served to read PG – 2 Valuation of Partial Ownership Interests in the ASA Business Valuation Standards.  Doing so should provide a different and more realistic view of the valuation of illiquid minority interests of private companies than is held by many appraisers.

Chris

In Mercer’s Musings #2, we discussed the old and cold data on restricted stock transactions that have been misused by appraisers for decades.  My conclusion is that the various restricted stock studies are inadequate to meet current business valuation standards and that they should not be used as a basis for “guessing” the magnitude of marketability discounts for illiquid interests of closely held businesses.  This conclusion applies to all appraisals, including those prepared for the Internal Revenue Service.

Some readers of this blog will want to disagree and say that the use of restricted stock studies to develop DLOMs is an “accepted” methodology for IRS-related appraisals.  Whether “accepted” or not, the qualitative use of averages of studies is inadequate to develop reasonable conclusions regarding marketability discounts given the wide variety of valuation situations facing business appraisers.  It seems that many business appraisers simply want to keep their heads in the sand and avoid changing at almost any cost.

Basic Valuation Review

The Value of a Business

The value of a business is the present value of all expected cash flows from the business (into perpetuity) discounted to the present at a discount rate reflective of the risks associated with achieving those cash flows.  In other words, value is a function of expected cash flow, growth, and risk.

Every appraisal of every business entails an examination of expected cash flows (using income capitalization methods, discounted cash flow methods, guideline public company methods, or guideline transaction methods).  Appraisals also consider growth (long-term growth rates or finite period growth rates in a DCF method and then a long-term terminal growth rate).  In guideline public company or guideline transaction methods, expected growth may be implied in the selected multiples or considered specifically by business appraisers. And appraisers develop discount rates that reflect the risks associated with achieving expected cash flows (or multiples from markets that have risk embedded in them).

Business appraisers cannot value businesses without explicit (or implicit depending on valuation methodology) consideration of their expected cash flows, the growth of those cash flows, and the risks associated with achieving the cash flows of the businesses being valued.

The Value of an Interest in a Business

The value of an interest in a business is similarly defined by the expected cash flow to the interest, the expected growth in value of the interest over the expected holding period, and the expected terminal value of the interest at the end of the expected holding period.  That terminal value is normally assumed to be the expected value of the business at the marketable minority/financial control level at the end of the expected holding period of the interest.  These expected cash flows to the interest are then discounted to the present (or to the valuation date) at a discount rate reflective of the risks associated with achieving the expected cash flows to the interest.  This definition of the value of an interest in a business parallels the definition of the value of a business noted above.

The discount rate of the business of which a subject minority interest is a portion is the base level of risk for the subject interest of the business.  Hypothetical buyers of interests of businesses recognize that there are additional risks, above the risk of the business, to the prospective buyer of such an interest.  That incremental risk can be described as a holding period premium, which is necessary to appropriately reflect the risks associated with achieving the expected cash flows to the interest.  The sum of the discount rate of the business and the holding period premium can be called the required holding period return appropriate for the interest.

Why would any business appraiser who knows that valuation is a function of expected cash flows, growth, and the risks associated with achieving them not think about the hypothetical in quantitative terms?  However, when business appraisers use averages of restricted stock studies to attempt to “guess” at marketability discounts, they are basing their conclusions on a very weak form of qualitative analysis.

Valuation Premiums and Discounts

Recall from Mercer’s Musings #2, we quoted the ASA Business Valuation Standards regarding premiums and discounts.  The quote is from “BVS VII, Valuation Premiums and Discounts.”:

II. The concepts of discounts and premiums

C. A discount or premium is warranted when characteristics affecting the value of the subject
interest differ sufficiently from those inherent in the base value to which the discount or premium
is applied.

D. A discount or premium quantifies an adjustment to account for differences in characteristics
affecting the value of the subject interest relative to the base value to which it is compared.  (bold in original, italics added)

Paragraph II.C states, paraphrasing, that discounts and premiums quantify adjustments to account for differences in characteristics affecting the value of the subject interest.

Recall the figure in Mercer’s Musings #2 that showed averages, medians, a few standard deviations, and ranges of discounts in various studies of restricted stock discounts.

Nothing in this figure addresses the expected cash flows of minority interests in any businesses, their expected growth, or the risks associated with achieving those cash flows.  Therefore, nothing in this figure can enlighten business appraisers about the appropriate marketability discounts for minority interests in any business.  It really is that simple, in spite of the desire of many appraisers to keep doing things the old way.

Restating the Hypothetical

The hypothetical posed in Mercer’s Musings #2 calls for the valuation of 10% interests in two identical corporations at the marketable minority/financial control level of value.  The hypothetical is repeated below.

As seen in Lines 1 to 6, Company A and Company B are alike in all respects leading to identical valuations of $10 million each at the marketable minority/financial control level of value.  The hypothetical then describes two 10% minority interests that have the same pro rata value of $1 million at that same level (Lines 7 and 8).  The interests differ significantly from that point on.  The interest in Company A has a high dividend yield and slow expected growth (Lines 9 to 13).

The interest in Company B has a much lower dividend yield and much higher expected growth.  Note that the combined dividend yield (3%) and expected growth (9%) total 12%, or less than the discount rate for Company B of 13%.  This suggests that there are sufficient agency costs (like excess owner compensation) that reduce the overall base expected return by 1% for the interest in Company B relative to the interest in Company A (13%).

The hypothetical calls for estimates of marketability discounts for each of the interests for five-year expected holding periods and ten-year expected holding periods.  The beginning point for the required holding period returns is the 13% discount rate for each of Company A and Company B.  The hypothetical provides a required holding period return of 18% for the interest in Company A, representing a 5% holding period premium to the base discount rate.  The given required holding period return for the interest in Company B is 19.5%.  It should be intuitively obvious why the required return for Company B exceeds that of Company A.

The expected cash flow stream for the interest in Company A is more favorable to investors than the cash flow stream for the interest in Company B, so an additional holding period premium to the base discount rate of 13% is needed.  This is clear in the following figure, which provides the expected cash flows for the interests in Company A and Company B based on the assumptions in the hypothetical.  For simplicity, we show only the first five years of the total forecast period of ten years.

We can observe the following about the expected cash flow streams of the interests in Company A and Company B.

• Looking at the far right of the figure, the interest in Company A delivers cash flow more rapidly (32% is expected over the holding period and 68% in the terminal value) than the interest in Company B (only 11% over the expected holding period and 89% in the terminal value.  The hypothetical recognized this fact and called for a higher required holding period return for Company B (19.5%) than Company A (18%).  Interestingly, Company B delivers slightly more total cash flow ($1.734 million) than Company A ($1.706 million), but the timing of expected receipt is delayed, therefore increasing the riskiness of the interest in Company B.  These differences will define a portion of the differences in the values of the interests.
• The interest in Company A is expected to have quarterly distributions, so the mid-year discounting convention is used in estimating its value.
• The interest in Company B is expected to receive dividends at the end of each year, so the end-of-year convention is used.  The differences in discounting conventions will also impact the relative values of the interests in Company A and Company B.

We can pull it all together now with a few more calculations.  The figure will show only five years of projected cash flows, but the conclusions for the ten-year expected holding periods will also be shown for further perspective.

The figure shows all key assumptions of the valuations of the 10% interests in Company A and Company B.  We observe the following regarding Company A’s interest at the top portion of the figure.

• The expected distributions and terminal value are calculated on Lines 1 thru 3, repeating the projections of the figure above.
• Present value factors are calculated based on the assumed required holding period return of 18% and the mid-year discounting convention.
• The present value of all expected cash flows for the 10% interest in Company A for a five-year expected holding period is $925,055, which represents an implied marketability discount of about 7.5% (i.e., 1 – $925,055/$1,000,000).
• The implied marketability discount for the ten-year expected holding period is $839,978, which represents an implied marketability discount of 16.0%.

These discounts, some will say, are very low.  The reason for the relatively modest discounts is that the investment in the interest in Company A represents an attractive investment.  In the context of a fair market value determination, the hypothetical negotiations of hypothetical willing buyers and sellers would recognize the “characteristics of the investment” and reflect them in its pricing.

Now we look at calculations for the 10% interest in Company B at the bottom of the figure.

• The expected cash flows are repeated from above on Lines 11 to 13.
• Present value factors are calculated based on a 19.5% required holding period return and the end-of-year discounting convention, with the present values of expected cash flows calculated on Lines 16 and 17.
• The present value of all expected cash flows for the 10% interest in Company B for the five-year expected holding period is $748,817, which represents an implied marketability discount of 25.4%.
• The present value of all expected cash flows for the ten-year expected holding period is $588,560, which represents an implied marketability discount of 41.4%.

These discounts happen to fall within the broad range of 25% to 45% from the restricted stock studies summarized above.

The discounts for the 10% interest in Company A do not fall within this range.  What should we think about that?  Well, the range of restricted stock discounts in the summary figure above is from a minus 30% (that’s a premium or a negative discount) to a high discount of 91%.  The estimates of marketability discounts for Company A’s interest certainly fall within that broad range.  However, that fact provides no support for any concluded marketability discount.

Concluding Observations

We have just conducted two shareholder-level discounted cash flow analyses to estimate marketability discounts for two dissimilar minority interest investments.  It should be clear at this point that the hypothetical cannot be solved by using the “old and cold” averages of restricted stock studies.

Mercer’s Musings #4 will address the concept of valuation premiums and discounts in the context of the levels of value, which, according to some, is not a settled issue.  We will see.

In the meantime, be well, and, of course, please do comment either on the blog or on the post when it is placed on LinkedIn.

Chris

Mercer’s Musings #1 addressed the topic of compliance with USPAP and the Internal Revenue Service.

This second musing addresses the use of restricted stock studies to support marketability discounts in gift and estate tax appraisals prepared for the Internal Revenue Service (or for anyone, for that matter).  This musing is addressed to all appraisers, regardless of which valuation credential(s) they hold.  Chapter 8 of Business Valuation: An Integrated Theory Third Edition (by Mercer and Harms) (“Integrated Theory 3”) contains a detailed discussion regarding restricted stock transactions.  I’ll try to be brief but effective in this musing.

Restricted Stock Transactions

Figure 8.1 from Integrated Theory 3 defines and illustrates a Restricted Stock Discount (RSD) for a hypothetical public company issuing restricted shares in a private offering.

The exhibit is fairly basic and illustrates a single, hypothetical restricted stock transaction involving a publicly traded company that issued restricted stock on a given date.  What do we know based on this restricted stock transaction?

• The restricted stock transaction occurred at $15.00 per share.
• PubliCo’s unrestricted shares sold at $20.00 per share at the time of the transaction.
• The restricted stock transaction occurred at a price that was $5.00 per share lower than the freely trading shares ($20.00 – $15.00).
• The restricted stock transaction was 25% lower than the price of PubliCo’s otherwise identical but freely trading shares.
• PubliCo’s unrestricted shares closed at a price $5.00 per share higher than the restricted stock transaction price.
• PubliCo’s unrestricted shares closed at a 33.3% premium to the restricted stock transaction price.

These facts are all we know about this restricted stock transaction.  There is absolutely no economic information in this or any restricted stock transaction.  An RSD simply measures the difference between two prices.  RSDs are not value drivers like EBITDA, gross profit, number of cases, or any other value drivers.

If there is no economic information in a single restricted stock transaction, how much economic information is there in an average of 30, 50, 400 restricted stock discounts in the tired and old restricted stock studies?  The answer, of course, is none.

Restricted Stock Studies

There are perhaps 20 or more restricted stock studies of one kind or another.  Sixteen of the most prominent studies are summarized in the following figure, which is based on Exhibit 8.15 of Integrated Theory 3.

The figure highlights six studies at the top.  Note the range of averages and medians.  These studies, based on restricted stock transactions occurring up through 1982, or more than forty years ago, were the basis for what I call a long-lasting “appraisers’ folly” regarding restricted stock discounts.  These six studies and their bare statistics created the myth that restricted stock discounts “tended” to be in the broad range of 25% to 45% and in the narrower range of 35% to 45%. And more than a few appraisers use these stale and tired studies to guess at marketability discounts in 2024.  Nevertheless, most appraisers have never read the studies, which are referenced in Exhibit 8.15 of Integrated Theory 3.

The total number of restricted stock transactions noted in the figure above is 1,647, not accounting for transactions that were examined in multiple studies.  About 80% of all transactions in the studies occurred between 1966 and 2006, or going on twenty years ago.  Only about 275 transactions have been examined since 2006.  Both the studies and the transactions are “old and cold.”  The pricing and discounts of these ancient studies have nothing to do with private company valuation in 2024.

Restricted stock analysis is a very weak form of guideline public company analysis.  What would you (or a court) say if I created a guideline public company group for a valuation as of December 31, 2023, consisting of companies that existed twenty years ago, and based my analysis on multiples calculated as of December 31, 2003?  Even assuming almost perfect “comparability” of the group with my subject company, you would call me crazy — or worse.  The pricing and multiples from 2003 have no bearing on the value of my private company in 2023.

It has been argued that restricted stock discount analysis is a method “accepted” by the IRS and the Tax Court that has been used for years.  Whether such analysis is “accepted” or not, the old data has no relevance for valuations occurring at the present.  If you disagree with this rather strong statement, feel free to comment on this blog with your rationale for such relevance.

If there is no economic evidence in one restricted stock transaction, there is none in the 1,647 transactions summarized in the figure above.

A Hypothetical Valuation Situation

Let’s assume that all the restricted stock information available to an appraiser (or you) is contained in the figure above.  If you have more evidence not included above, feel free to use it.  Now assume the following example to determine marketability discounts for 10% interests in two companies that are identical except as noted in the figure below.  The valuation date is January 31, 2024.

Looking at the valuation characteristics of the Companies:

• Company A and Company B have identical discount rates and long-term growth rates (and cap rates and price/earnings multiples).
• They also have identical net (after-tax) earnings and, therefore, values at the marketable minority/financial control (MM/FC) level of value (Lines 1 to 6 above).

The hypothetical calls for the determination of appropriate marketability discounts for two 10% interests, one in Company A and the other in Company B.  Looking at the valuation characteristics of the two interests, we note:

• They have identical values at the MM/FC level of value (Lines 7 and 8 above).
• Company A’s annual dividend for the 10% interest is $100,000, which provides a 10% expected dividend yield based on the MM/FC value of the interest.  The dividend will be paid quarterly, so the mid-year discounting convention is assumed.
• Company B’s annual dividend for the 10% interest is $30,000, which provides a 3% expected dividend yield.  This dividend is paid at the end of each year, so the end-of-year discounting convention is assumed (see these assumptions on Line 11).
• The expected growth in value of Company A over the expected holding periods is 3% (Line 12), which is identical to the long-term expected growth in value for Company A (Line 2) [Line 1 (13%) minus Line 10 (10%), or (3%)], The expected growth in the dividend is 3%, or the same as the expected growth in value of Company A (Lines 12 and 13).
• The expected growth in value for Company B over the expected holding periods is 9% (Line 13).  Given that the discount rate for Company B is 13% (Line 1) and that the expected dividend growth and growth in value for Company B is 9% (Lines 12 and 13),  we can assume that there are sufficient agency costs (e.g., excess owner compensation) to lower the overall base return for the interest from 13% (the discount rate for Company A is 13%) to 12% (for Company B).
• Now assume that we desire to estimate marketability discounts for the two 10% interests assuming expected holding periods of five and ten years for each interest (Line 14).  Liquidity will occur at the end of each of the expected holding periods at the MM/FC level.
• The hypothetical assumes that the appropriate required holding period return (i.e., the discount rate for the holding period) is 18% for the interest in Company A.  That represents a 5% premium to the discount rate for Company A itself.  This is because holding a 10% interest in business entails more risk than Company A itself.  Assume for purposes of the hypothetical that this 5% “holding period premium” is reasonable and supported by market evidence (including from the restricted stock studies above).
• The assumed required holding period return for the interest in Company B is 19.5%, or 1.5% greater than the comparable interest in Company A. The investment in the 10% interest in Company B is a riskier investment than the comparable interest in Company A.  The annual dividend is much lower and, although expected growth is greater, the return on expected growth in value is deferred, leaving the greatest portion of return to the end of the expected holding period.  Think time value of money.

While Companies A and B are identical as noted above, the 10% interests in them represent two distinctly different investments.  The interest in Company A is a high cash flow and slow growth investment.  The interest in Company B is a more rapidly growing investment with a much smaller dividend yield (and modest agency costs).

Recall the guidance from USPAP Standards Rule  9-4(d) noted in Mercer Musing #1.

(d) An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of the extent to which the interest appraised contains elements of ownership control and is marketable and/or liquid.

Comment. An appraiser must analyze factors such as holding period, interim benefits, and the difficulty and cost of marketing the subject interest…

If any reader is able to articulate cogent reasons for the marketability discounts applicable to the 10% interests in Companies A and B for five and ten-year expected holding periods using only the information in the studies above, I will personally donate $1,000 to St. Jude Children’s Research Hospital in his or her honor.  Given the facts assumed in the hypothetical, appraisers cannot “analyze the effect on value, if any,” of the differing valuation characteristics of the two 10% interests using a qualitative analysis.  The hypothetical provides two different sets of cash flows, two different risk profiles, and two separate expected holding periods.  Think about the discounted cash flow method for companies.

What Does SSVS (VS 100) Say?

It has been said that holders of the ABV and CVA designations are not required to follow USPAP.  What are they required to do?  We examine SSVS issued by the AICPA:

Statement on Standards for Valuation Services (VS Section 100) issued by the AICPA states the following about the application of discounts (Paragraphs per Standards, emphasis added):

.40

During the course of a valuation engagement, the valuation analyst should consider whether valuation adjustments (discounts or premiums) should be made to a pre-adjustment value. Examples of valuation adjustments for valuation of a business, business ownership interest, or security include a discount for lack of marketability or liquidity and a discount for lack of control. An example of a valuation adjustment for valuation of an intangible asset is obsolescence.

.63

This section should [formatting changed]

(a) identify each valuation adjustment considered and determined to be applicable, for example, discount for lack of marketability,

(b) describe the rationale for using the adjustment and the factors considered in selecting the amount or percentage used, and

(c) describe the pre-adjustment value to which the adjustment was applied (see paragraph .40).

Looking at the figure summarizing the restricted stock studies above, it would appear to be difficult or impossible to make a reasonable determination of the appropriate marketability discounts.  Following this guidance from SSVS, an appraiser could:

a. Identify the need for a marketability discount.

b. Describe a rationale for using a marketability discount.  For example, referencing a levels of value chart, the appraiser could say that the rationale for using the discount for lack of marketability is to recognize the difference in valuation characteristics between the pre-adjustment value ($10,000,000 for both companies at the marketable minority/financial control level of value) and the nonmarketable minority level of value, which is appropriate for an illiquid, minority interest of a business.  The appraiser would run into a problem, however, when trying to describe the “factors considered in selecting the amount or percentage used.”  There is no ability to do this from the data provided.

c.  As noted in b., describe the pre-adjustment value.

There is simply no information in the restricted stock studies (summary statistics or information on companies paying dividends) to enable an appraiser to satisfy the basic requirements of SSVS as quoted above.  Let me provide the following caveat.  I am not a CPA and do not hold the ABV designation.  Neither do I hold the CVA designation (I do hold the ABAR designation of the NACVA).  I have, however, studied and worked to develop the ASA Business Valuation Committee (as a member of the Valuation Standards Committee for nearly thirty years and as its Chair for several years) and the International Valuation Standards of the IVSC as a member of its Professional Board for a number of years.

The fact that appraisers have “guessed” at marketability discounts for decades using the filters above does not make such guessing correct or standards-compliant for the Internal Revenue Service or for any other purpose.

Determining the appropriate marketability discounts for 10% interests in Companies A and B must be, at least substantively, a quantitative exercise.  While the marketable minority/financial control values are equal and the companies have almost identical earnings and risk profiles, the subject interests have significantly different valuation characteristics and expected cash flows over the (assumed) five and ten year expected holding periods.  To the best of my knowledge and understanding, these differences cannot be realistically examined qualitatively.  Appropriate quantitative assumptions must, of course, be made; however, those assumptions must be made considering common sense, informed judgment, and reasonableness, the trilogy of considerations from RR 59-60.

ASA Business Valuation Standards

The ASA Business Valuation Standards provide fairly specific guidance on the application of premiums and discounts in “BVS-VII Valuation Premiums and Discounts.”

II. The concepts of discounts and premiums

C. A discount or premium is warranted when characteristics affecting the value of the subject
interest differ sufficiently from those inherent in the base value to which the discount or premium
is applied.

D. A discount or premium quantifies an adjustment to account for differences in characteristics
affecting the value of the subject interest relative to the base value to which it is compared.  (bold in original, italics added)

These ASA standards make clear that the reason that valuation discounts and premiums exist is to recognize the impact on value of “characteristics affecting the value of the subject interest”, which may vary between an illiquid minority interest and the equity value of the business as a whole.

An appraiser limited only to the information summarized above about restricted stock studies would, like an appraiser attempting to follow SSVS, not be able to meet the requirements of these basic standards.  At least that is my interpretation based on the quoted standards and the data limitations using restricted stock studies to determine marketability discounts.

What’s an Appraiser to Do?

Determining the appropriate marketability discounts for 10% interests in Companies A and B must be, at least substantively, a quantitative exercise.  Granted, appropriate assumptions must be made, but they must be made while remembering the trilogy of common sense, informed judgment, and reasonableness from RR 59-60.  We will address this basic quantitative derivation of marketability discounts for Companies A and B in Mercer Musings #3.  Feel free to comment, either on the blog post directly or on LinkedIn when the post is published there.

In the meantime, I hope you are well.

Chris

Many years ago, I wrote a column for the Business Valuation Review that the editor, Jay Fishman, FASA, called “Mercer’s Musings.”

In this blog and with this post, I reintroduce “Mercer’s Musings” because I would like to reflect on a number of seemingly unsettled issues in the business valuation world.

This first musing relates to the need (or not) to comply with the Uniform Standards of Professional Appraisal Practice promulgated by The Appraisal Foundation in gift and estate tax appraisals prepared for the Internal Revenue Service.

In a previous post on this blog, I wrote:

… appraisers who must follow USPAP, and that includes all members of the American Society of Appraisers and any appraisers conducting appraisals for gift and estate tax purposes or for other purposes involving the federal government, these standards apply. The rules apply, practically, to almost all appraisers, including those holding ABV and CVA designations (emphasis added).

I said “practically” because I had not seen a specific requirement for business appraisers to follow USPAP; however, I did rely on the advice of a number of prominent gift/estate tax attorneys who had advised me that following USPAP was, in their opinion, required for IRS-related appraisals.

Some have said that I am wrong on this point. Let’s address this.

Upon a bit of research, it is clear that any (real estate) appraiser who performs appraisals of properties for mortgages must comply with USPAP.  That, apparently, is a fact.

Regarding business appraisers, I cannot find a direct requirement that USPAP be followed.  However, I can say that a number of high-end gift and estate tax attorneys have suggested to me that the requirement exists.

It is clear that appraisers holding the AM, the ASA, and the FASA designations from the American Society of Appraisers must comply with USPAP for all appraisals rendered, including those related to gift/estate taxes. We must also comply with the ASA Business Valuation Standards and the Principles of Appraisal Practice and Code of Ethics of the American Society of Appraisers.

The question for today is: Should appraisers credentialed by the other two major credentialing societies in the United States, i.e., the AICPA (ABV designation) and NACVA (CVA designation), comply with USPAP in gift/estate tax-related appraisals?

This is a different question than: “Are all appraisers required to comply with USPAP…”

Qualified Appraisals and Qualified Appraisers

According to § 1.170A-17(a)(1) of the Internal Revenue Code, which defines the term “qualified appraisal” for charitable gifting appraisals as:

(a) Qualified appraisal —

(1) Definition.

For purposes of section 1.170(f)(11) and §1.170A–16(d)(1)(ii) and (e)(1)(ii), the term qualified appraisal means an appraisal document that is prepared by a qualified appraiser (as defined in paragraph (b)(1) of this section) in accordance with generally accepted appraisal standards (as defined in paragraph (a)(2) of this section) and otherwise complies with the requirements of this paragraph (a).

(2) Generally accepted appraisal standards defined. For purposes of paragraph (a)(1) of this section,generally accepted appraisal standards means the substance and principles of the Uniform Standards of Professional Appraisal Practice, as developed by the Appraisal Standards Board of The Appraisal Foundation. (emphasis in original, bold added)

The term qualified appraiser is also defined as:

Qualified appraiser.  A qualified appraiser is an individual with verifiable education and experience in valuing the type of property for which the appraisal is performed.

1. The individual:

a. Has earned an appraisal designation from a generally recognized professional appraiser organization, for the type of property being valued; or

b. Has met certain minimum education requirements and 2 or more years of experience in valuing the type of property being valued. To meet the minimum education requirement the individual must have successfully completed professional or college-level coursework obtained from:

i. A professional or college-level educational organization,

ii. A professional trade or appraiser organization that regularly offers educational programs in valuing the type of property, or

iii. An employer as part of an employee apprenticeship or education program similar to professional or college-level courses.

2. The individual regularly prepares appraisals for which they are paid.

3. The individual is not an excluded individual (defined later). (bold in original, emphasis added).

Examining the Definitions

Qualified appraisers must deliver qualified appraisals according to the cited regulations for appraisals for the IRS pertaining to charitable giving.  Many attorneys suggest that the definitions are also relevant for gift/tax-related appraisals.

It is clear that appraisers holding credentials of the American Society of Appraisers must comply with USPAP and the ASA Business Valuation Standards of the ASA. It is also clear that appraisers holding the ABV (Accredited in Business Valuation) credential of the AICPA must comply with the Statement on Standards for Valuation Services (VS Section 100).  Similarly, appraisers holding the CVA (or predecessor designations) of the National Association of Certified Valuation Analysts (NACVA) must follow its Professional Standards.

Recall the last paragraph in the definition of “qualified appraisal” from above:

(2) Generally accepted appraisal standards defined. For purposes of paragraph (a)(1) of this section, generally accepted appraisal standards means the substance and principles of the Uniform Standards of Professional Appraisal Practice, as developed by the Appraisal Standards Board of The Appraisal Foundation. (emphasis in original, bold added)

To help address the question, I again consulted with several prominent tax attorneys. One attorney I talked to said there appears to be some “wiggle room” in the definition of qualified appraisal quoted above. There is a small difference between saying that a qualified appraisal must comply with USPAP and the actual language in the regulation.

Another attorney I consulted said any appraiser who does not comply with USPAP “is asking for a Daubert methodology challenge” and any appraiser who does not follow USPAP is “opening himself or herself up to ‘admitting’ that he or she did not comply with USPAP.”

The first question this attorney said he would ask an appraiser not complying with USPAP, even though complying with another set of standards, is:

Question: “Does your appraisal report comply with the Uniform Standards of Professional Appraisal Practice?”

If your response to the question is “No,” it could be problematic.

If your response is “No, but I don’t have to comply,”, it might still be problematic.

You would have to “prove” to the Court that the standards you followed were a) “generally accepted appraisal standards,” and b) that those standards “conform to the substance and principles of the Uniform Standards of Professional Appraisal Practice, as developed by the Appraisal Standards Board of The Appraisal Foundation.”  

An appraiser who chooses not to comply with USPAP is open to questions comparing his or her standards with those of USPAP.  For example, USPAP’s Standards Rule 9-4(d) states:

(d) An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of the extent to which the interest appraised contains elements of ownership control and is marketable and/or liquid.

Comment. An appraiser must analyze factors such as holding period, interim benefits, and the difficulty and cost of marketing the subject interest.

Equity interests in a business enterprise are not necessarily worth the pro rata share of the business enterprise interest value as a whole.  Also, the value of the business enterprise is not necessarily a direct mathematical extension of the value of the fractional interests.  The degree of control, marketability and/or liquidity or lack thereof depends on a broad variety of facts and circumstances that must be analyzed when applicable. (bold in original, italics added)

Suppose an appraiser complying with other standards and not USPAP was asked: “Do your standards contain “…the substance and principles of the Uniform Standards of Professional Appraisal Practice, as developed by the Appraisal Standards Board of The Appraisal Foundation?”

It took just a couple of minutes to determine that there is no mention of a holding period, interim benefits, or distributions in either the AICPA’s SSVS or NACVA’s Professional Standards.  The only mention of dividends in the Professional Standards is in a list of factors from Revenue Ruling 59-60.  There are two mentions of dividends in SSVS, in definitions of equity cash flow and invested capital net cash flow.  This is not a criticism of either set of standards.  However, a non-complying appraiser is open to the obvious question:

“Did you not comply with USPAP to avoid this very specific guidance?”

Conclusion

So my last question in Mercer’s Musings #1 is my answer to the first question above:

“If I held an ABV credential or a CVA credential and did not hold the FASA designation, why wouldn’t I insure that my tax-related appraisals comply with USPAP?”

Appraisersi emptor.

As always, comments are welcome.

Until next time, be well!

Chris

My co-author, Travis W. Harms, CFA, CPA/ABV, and I have been doggedly insisting that business valuation questions, issues, premiums, discounts, and more be viewed through the combined lens of expected cash flow, its expected growth, and the risks associated with achieving the expected cash flows. See our Business Valuation: An Integrated Theory, Third Edition (“the Integrated Theory”).  This should not be surprising because the value of a business can be summarized using those three concepts:

Value = CF(1) / R – G

The equation is, of course, the familiar Gordon Model, which capitalizes next year’s expected cash flow, CF(1) by the difference between the equity discount rate, R, and the expected growth in cash flows, G.  The assumptions for this equation, which we call the fundamental valuation equation, are straightforward.  The equation summarizes the discounted cash flow model when CF(1) is expected to grow at the constant growth rate of G into the indefinite future, and all cash flows are reinvested in the business at the discount rate of R or paid out to investors (or some combination of reinvestment and payout). So the valuation triumvirate is expected cash flow, growth, and risk.

If business value is a function of expected cash flow, growth, and risk, it follows that differences in value between conceptual levels of value are a function of differences in expected cash flow, growth, and risk between conceptual levels of value.  Until the latter 1990s, it was thought that buyers of companies paid premiums (over publicly-traded prices of targets) for elements of control.  The current view is that buyers of companies pay for expected changes, post-acquisition, in combined cash flows and potentially reduced risk.  Unfortunately, the valuation literature appears slow to recognize this change in thinking from paying for control (or lack thereof) to paying for relevant value based on the expected cash flows of a business or an interest in a business from the viewpoints of market participants at the respective levels.

Control Premiums Causation: Cash Flow and Risk Differences or Degrees of Control?

We look at the Sixth Edition of Valuing a Business (“VAB6”), which was published in 2022, for an example description of the cause of valuation premiums and discounts.  Early in Chapter 3, we find a mention of the valuation triumvirate (page 54):

A given business or business ownership interest is likely to have more than one value at a given valuation date.  This multiplicity of values is attributable to the different perspectives from which one may consider the value of a business or business ownership interest.  Valuation analysts have traditionally referred to the available perspectives as levels of value.  While a variety of charts have been offered by analysts and observers over the years, the Exhibit 3-2 includes the primary components that are common to all such charts.

Exhibit 3-2 identifies four distinct levels of value and four discounts or premiums that relate the levels to one another.  The different levels of value , and the corresponding discounts or premiums, are rooted in differences in economic income and risk [i.e., expected cash flow, growth and risk] from each different perspective represented on the exhibit.” (emphasis added)

Exhibit 3-2 is a virtual duplicate of the figure on the right side of Exhibit 2.15 in the Integrated Theory (p. 52).  In the Integrated Theory, Travis and I explain at length that the different conceptual levels of value mark different views of market participants at each level.  For example, strategic buyers in Exhibit 3-2 view the expected cash flows of a business differently than financial buyers.  Strategic buyers do not pay for elements of control, per se, but for what they can do with acquired business to, for example, increase overall cash flows and growth through synergies or strategic benefits, or to reduce overall risk by the combination of operations.

Chapter 17 of VAB6 is titled “Control versus Lack of Control: Premiums and Discounts.”  After introducing the concept in Chapter 3 that valuation premiums and discounts are a function of differences in expected cash flow, growth, and risk between conceptual levels of value, VAB6 does not revisit the concept in Chapter 17. Instead, VAB6 appears to try to explain differences in levels based on varying degrees of control or lack thereof.  For example, Exhibit 17-1 of VAB6 appears as follows.

This is a conceptual view of valuation premiums and discounts. However, it is not an operative view.  There is no reference to valuation methods that enable valuation analysts to determine the value of degrees of control.

We know that a valuation premium has no meaning unless the base to which it is to be applied is defined.  Further, we know that a valuation premium is warranted only when the characteristics affecting the value of the subject interest differ sufficiently from those inherent in the base value to which the discount or premium is applied.  These thoughts reflect common sense, but they also reflect guidance from the ASA Business Valuation Standards at “BVS-VII Valuation Premiums and Discounts.” The same guidance applies to discounts taken from defined base values.

Focus on the $8.00 per share “publicly traded equivalent value” or “stock market value” as if freely traded in Exhibit 17-1.  Presumably, that is a base value to which premiums might be applied.  The figure then shows a “standalone control premium” of 25%, which leads to a “value of control shares standalone” of $10.00 per share.  Presumably, per the chart and text, the $2.00 per share difference between the $8.00 per share “base value” and the $10.00 per share standalone control value is caused by a greater degree of control than at the as-if-freely-traded value.  Three questions come to mind:

• Does a 25% premium in value exist just for standalone control?  Probably not.
• If it does exist, how would it be possible to quantify the $2.00 per share “value of control”?  It is not addressed.
• What market evidence might be available to help the appraiser quantify this difference? None, really.

The conceptual view in Exhibit 17-1 of VAB6 does not take the extra step of connecting “elements of control” with differences in expected cash flow, growth, and risk discussed.

Is Chapter 17 of VAB6 Behind the Times?

Eric Nath, ASA, wrote an article in 1990 that suggested that publicly-trading pricing for public companies reflected control values.  That article began an evolution in thinking about the use of control premiums. Valuing a Business, Third Edition, published in 2000, contained a levels of value chart with four levels, rather than the three conceptual levels previously thought to exist.  But that chart, like the figure above, focused only on differences in control to explain differences in value from the perspective of different market participants.

I have written and spoken since the latter 1990s that the relationship between financial control and marketable minority value levels is as shown in Exhibit 3-2 of VAB6, i.e., as overlapping or coincident.  Indeed, what we write in the Integrated Theory aligns nicely with another credible source,  Valuations in Financial Reporting Valuation Advisory 3: The Measurement and Application of Market Participant Acquisition Premiums published in 2017 by The Appraisal Foundation.

Two short sections are quoted below to place the discussion of this post into the perspective of expected cash flow, growth and risk (emphasis added).

Premiums for control have long been a focus in business valuation.  Through the early 1990s, it was generally accepted that the publicly traded price of a company’s shares represented the value of a minority interest and that, if the goal was to value a control interest, a “premium for control” would be added to the value of equity indicated by that publicly traded price. That premium generally came from market evidence in which the price paid to acquire an entire company was compared to the publicly traded price of that same company’s shares prior to the acquisition.  However, in the late 1990s, this concept came into question and views have since been changing. Various points have been made regarding why the [financial] control value of an entity might be no greater than that indicated by its publicly traded price.

In any case, it has become widely accepted that the market evidence supplied by comparing the acquisition price to the publicly traded price does not represent a premium for conceptual control but, rather, represents a premium linked to actual changes that can be made by exercising that control. Control, and whether one has it, is not really the focal point. What matters is that, after an acquisition, the acquired company is now under different management/stewardship. A price higher than the publicly traded price might be reasonable if the new management and/or combined entity expect(s) improved cash flow or growth or reduced risk. [i.e., expected Cash Flow, Risk and Growth]. If no improvements or risk reduction could reasonably be expected, there may be little ability for an acquirer to pay a price higher than the publicly traded price and still generate a reasonable return on its investment. In such cases, the control value may approximate the publicly traded price. (emphasis added)

Valuation Advisory #3 clearly indicates that market participants are not paying for “control” but rather for the positive enhancements in value that might be expected under new management through increasing expected cash flow, or growth, or reducing risk.

The view of the source of differences between strategic control pricing and freely traded pricing espoused in Valuation Advisory #3 is consistent with the Integrated Theory and with the levels of value chart labeled Exhibit 3-2 above.  The view that, in some or most cases, control value may approximate the publicly traded pricing is also consistent with the Integrated Theory.

Interestingly, there is one footnote mention of Valuation Advisory #3 in Chapter 17 of VAB6, and it is not on point regarding differences in the levels of value. A further footnote reference to Valuation Advisory #3 in VAB6 is also not on point.

After years of advancement in valuation thinking, Chapter 17 could have made (but does not make) the connection between control premiums and differences in cash flow, growth, and risk.

Time for a Change in Valuation Thinking

Is it time for a realistic change in thinking about the levels of value?  Yes.  Control premiums between levels of value of whatever name are not caused by differing perceptions or degrees of control.  They are caused by differences in expected cash flow, risk, and/or growth from the viewpoint of relevant market participants at the different levels of value.

I’ve been writing and speaking about the broader issue of valuation theory and how we should be looking at valuation and valuation premiums and discounts since the mid-1990s or pushing towards thirty years. It is past time for substantial changes in the way that many business appraisers approach valuation questions and issues.

We have not discussed valuation discounts in this post; however, the arguments for the cause of discounts relating to degrees of control or lack thereof, versus those relating to differences in expected cash flow, growth, and/or risk between conceptual levels are parallel.  More on that later.

In the meantime, be well.

Chris

There Is a Problem in Business Appraisal Land

There were significant changes in Standards Rule 9-4 of the  Uniform Standards of Professional Appraisal Practice regarding the development of business appraisals between 2005 USPAP and 2006 USPAP. The changes relate to moving from following procedures and considering approaches to a focus on developing “credible appraisal results” and analyzing “the effect on value, if any” or a number of quite specific valuation factors.

There were changes to Standards Rule 9-4(a) and 9-4(b) that shift emphasis to credible appraisal results and to introduce a focus on intangible assets for the first time. Standards Rules 9-4(c) and 9-4(d) were completely new and require appraisers to “analyze the effect on value” of a number of very specific factors that we will discuss in the comparisons below. I have focused on the changes and additions, which remain essentially unchanged in the 2020-2021 USPAP (the current version).

I have discussed these changes and additions in numerous speeches and publications, including on this blog. They are important because, as I have said many times over the years, appraisers who must follow USPAP, and that includes all members of the American Society of Appraisers and any appraisers conducting appraisals for gift and estate tax purposes or for other purposes involving the federal government, these standards apply. The rules apply, practically, to almost all appraisers, including those holding ABV and CVA designations.

And now for a bold conclusion at the outset:

Many appraisers who focus on using restricted stock studies and pre-IPO studies as a basis for determining marketability discounts for illiquid minority interests have historically not been and are currently not providing standards-compliant appraisals for their clients.

And that’s a problem.

Changes to USPAP Standards Rules 9-4(a) in 2006

The first figure sets Standards Rules 9-4(a) and 9-4(b) side by side so we can focus on what changed and, perhaps, discuss some of the whys of the changes.  I have placed comments regarding changes in brackets in the figures that follow. They will be available to anyone choosing to copy the figure for quotation or other use. I will also discuss those comments in the text of this post for flow and completeness.

The change in the Introduction to Standards Rule 9-4. The first change is a shift from focus on collecting and analyzing appropriate information subject to the “scope of work” to a focus on collecting and analyzing information “necessary for credible assignment results.” The term “credible assignment results was mentioned four times in USPAP 2005.  The term is used some 30 times in 2006 USPAP through Standards Rule 10.  This was a significant change to the standards. What is the purpose of standards anyhow but to encourage appraisers to provide credible assignment results. This guidance is unchanged to the present.

The change in Standards Rule 9-4(a). The 2005 version on the left provided potential confusion for appraisers.  It was necessary to use “one or more” and “all relevant approaches” with sufficient data. The 2006 version says to use “one or more approaches that are necessary for credible assignment results.” The importance of this shift is emphasized by the fact that the term “credible assignment results” is used only four times in 2005 USPAP. It is used some thirty times through Standard 10 (Business Valuation, Reporting). This guidance is unchanged to the present.

The definition of “Credible” in USPAP 2006 is:

CREDIBLE: worthy of belief.

Comment: Credible assignment results require support, by relevant evidence and logic, to the degree necessary for the intended use. (emphasis added)

USPAP 2006 tells appraisers that to be worthy of belief, assignment results must be supported by appropriate evidence and logic “to the degree necessary for the intended use.” The definition remains unchanged through 2020-2021 USPAP. What, though, is “relevant evidence?”  We will see shortly.

Standards Rule 9-4(a) was changed in 2006 to state that appraisers should select valuation approaches that are necessary for credible assignment results, rather than, as in 2005, the guidance was to use approaches that apply to the specific engagement. The overriding goal of USPAP beginning with USPAP 2006 has been credible assignment results.

The Comment to Standards Rule 9-4(a) was deleted. It stated that all relevant approaches should be used, but that “inapplicable” approaches did not have to be used. The absence of this Comment and the change in Standards Rule 9-4(a) make it clear that the goal is, indeed, credible assignment results over any other guidance.

Changes to USPAP Standards Rules 9-4(b) in 2006

Standards Rule 9-4(b) provides a list of specific factors that need to be considered. In 2005 USPAP, appraisers had to “include in the analysis, when relevant, data regarding” the seven factors.  In USPAP 2006, the mandate is: “An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of” the factors. The standards have gone from “including data” to required analysis to ascertain the effect on value. Changes to Standards Rule 9-4(b) are shown in the following figure.

There are seven specific factors in USPAP in both the 2005 and 2006 editions. 2006 USPAP adds consideration of intangible assets (b)(ii). It also changes (b)(v) to refine guidance from 2005.  The factor is not “sales of capital stock or other ownership interest in similar business enterprises.” The other business interest could be privately owned or publicly traded based on this guidance. This guidance, together with (b)(iv), which pertains to transactions in the stock of the business being appraised, eliminated the need for the guidance in the second half of the Comment in 2005 USPAP.

The takeaway from this review of changes to Standards Rule 9-4(b) is that we have moved from a world of “including in the analysis, when relevant data regarding” the factors to one of “when necessary for credible assignment results, analyze the effect on value, if any” of the factors.

New Standards in Rules 9-4(c) and 9-4(d) in 2006

2006 USPAP added two entirely new rules, Standards Rules 9-4(c) and 9-4(d), which have been ignored, for the most part, by business appraisers. The new rules are provided in the next figure.  While this focus in on changes made in 2006, there has been virtually no change in Standards Rule 9-4 since then, so the comments are as appropriate in 2022 as they were in 2006.

Standards Rule 9-4(b) provided a list of factors to analyzed. Standards 9-4(c) and 9-4(d) extend the list of factors in meaningful ways while maintaining the guidance about analyzing the effect on value, if any, if needed for credible assignment results. Factors required for analysis in Standards Rule 9-4(c) include:

• Buy-sell and option agreements
• Investment and letter stock agreements
• Restrictive corporate charter or partnership agreement clauses
• Similar features or factors that may influence value

Standards Rule 9-4(c) requires analysis of the impact of buy-sell agreements, operating agreements, partnership agreements, restrictions in corporate charters, restrictions in partnership agreements and, by implication, restrictions in any other type of corporate agreement. It then goes on to add that appraisers should consider (i.e., analyze the effect on value, if any) similar features or factors that may influence value. This would include applicable laws and regulations.

USPAP 2006 does not tell appraisers the how of analyzing these factors required by Standards Rule 9-4(c), but the mandate to do so is clear. One good place to go for additional factors to consider under 9-4(c) is “PG-2 – Valuation of Partial Ownership Interests,” a Procedural Guideline in the ASA Business Valuation Standards.

Standards Rule 9-4(d) goes beyond corporate documents and laws and regulations. It begins to address specific factors that influence the values of illiquid minority interests (and perhaps, businesses and intangible assets as well). The new factors include:

• The extent to which the interest has elements of ownership control
• The extent to which the interest is marketable and/or liquid
• Holding period (i.e., the expected holding periods of investment for illiquid minority interests)
• Interim benefits (i.e., the expectations for dividends or distributions to the illiquid minority interest over the expected holding periods of illiquid minority interests
• The difficulty and cost of marketing
• A broad variety of facts and circumstances that could influence the degree of control, marketability and/or liquidity (or lack thereof) must be analyzed when applicable.

Each of Standards Rules 9-4(c) and 9-4(d) begins with the instruction:

An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of – the factors.

A good place to go to find a list of a broader list of facts and circumstances that could influence value would be the same “PG-2 – Valuation of Partial Ownership Interests” noted above. This procedural guideline provides six detailed pages of discussion of the valuation of partial ownership interests.

What Is the Problem in Business Appraisal Land?

The problem raised by changes in USPAP between 2005 and 2006 and continuing to the present is that the required analysis to determine the effect on value, if any, cannot be accomplished using comparisons with dated restricted stock and/or pre-IPO transactions. It is just that simple. The required analysis can only be accomplished using methods under the income approach.

The value of an interest in a business is the present value of all “interim benefits” (expected future benefits to the interests, or dividends and distributions), discounted to the valuation date over the “holding period” (i.e., a reasonable estimate of the expected holding period or a range of estimates). The terminal benefit is implied, because illiquid minority investments are assumed to be liquidated at the end of their expected holding periods to achieve the objectives of the investments. The discount rate (or required holding period return) should reflect “the difficulty and cost of marketing the subject interest” and the risks of the holding period of the “degree of control, marketability and/or liquidity (or lack thereof.” In other words, the the discount rate should include the risks of the expected holding period that are in addition to the risks of the underlying business (or assets, if the entity is an asset holding company).

The problem raised by the changes in USPAP between 2005 and 2006 and continuing to the present is that appraisers cannot deliver standards compliant appraisals of illiquid minority interests using traditional (market approach) guideline public company or transactions methods involving comparisons with restricted stock and/or pre-IPO transactions. And yet every appraisal I have seen by other appraisers using only these methods has averred compliance with USPAP.

A number of methods have been developed under the income approach to valuation. The Quantitative Marketability Discount Model (QMDM) is one of them. The QMDM is a shareholder level discounted cash flow model. This model will help appraisers to follow the guidance of Standards Rule 9-4(c) and render standards-compliant appraisals of illiquid minority interests in business entities. QMDM focuses on interim benefits, the holding period, and the risks associated with marketing, as well as enabling appraisers to “analyze the effect on value, if any” of the various factors mentioned in the standard.

Try it.  You might like it.

Be well,

Chris

Introduction

This eleventh post in the Deja Vu series involving restricted stock studies addresses an issue that is rarely mentioned in the context of the studies – of the impact of dividends on restricted stock discounts (RSDs). Shareholder returns come in two forms, current income or dividends (or distributions) and capital appreciation, as can be seen in this simple graphic.

It is important to understand the impact of dividends on the value of illiquid minority interests of companies because many closely held and family businesses pay dividends. I recently found a 2008 version of the FMV Opinions Restricted Stock Database that I purchased back then on our system. It is similar to the 2004 version I used to write Deja Vu #8: Review of the FMV/Stout Restricted Stock Database. This 2008 version had information on 477 restricted stock transactions, up from 430 transactions in the 2004 version. All the additions were for 2004 and earlier years, so it is essentially the same database. There are 244 pre-April 1997 transactions in the 2008 version, down from 248 transactions in the 2004 version. Perhaps a few transactions were scrubbed.

The FMV/Stout database is the only restricted stock study that enables the analysis of dividends since this is one of the fields in the database. There is simply insufficient detail in all the other studies discussed in this Deja Vu series. Of these 244 transactions, only 24 involved companies that paid dividends, or less than 10% of the transactions.

There were 231 transactions after April 1997, when the SEC’s period of restriction was reduced from two years to one year (up from 182 transactions in the 2004 version). Only two of these companies paid dividends, rendering this portion of the database useless in analyzing the impact of dividends on restricted stock discounts.

Conclusions prior to the analysis: dividend paying companies:

• Had lower RSDs than non-dividend paying companies, with a median of 13.2% versus 21.9% for non-dividend payers. Given two otherwise identical investments where one pay a dividend and the other does not, the dividend payer should be more valuable (and have a lower RSD).
• Were also bigger and had higher market capitalizations and better operating performance, on average. So relatively more attractive companies that pay dividends tend to have lower RSDs than non-dividend payers. Excluding specific information on dividends, that was the conclusion of the Silber Study, which was published in 1997, or more than thirty years ago, and was the subject of Deja Vu #6: The Silber Restricted Stock Study (1981-1988 Transactions).
• With only 24 transactions involving dividends that occurred between 1981 and 1995, the Stout/FMV database is not useful to help estimate the impact of dividends on RSDs.

Dividend-Payers Have Lower Restricted Stock Discounts

We pulled the 24 dividend payers out of the pre-1997 portion of the database. This left 220 non-dividend-paying transactions in the two-year category, which we used as a basis to compare the dividend-paying transactions. What did we learn? We will look at the analysis in a series of tables to focus on specific aspects of the transactions.

From the first figure, we make a few observations. First and most obvious, look at the bottom right of the figure. The median RSD for dividend-paying companies was 13.2%, which is significantly lower than the median RSD for the non-dividend-paying companies.

• The transactions occurred between 1981 and 1995 (or many, many years ago).
• At least ten of the transactions involved banks, insurance companies, or other financial entities, which are very unlike the remainder of the companies in the non-dividend paying portion of the database.
• At least three transactions involved real estate companies. So financials and real estate account for more than half of the 24 transactions.
• Seven of the companies paying dividends traded on the New York Stock Exchange, while only three of the 220 non-dividend paying companies traded there.
• The median and average restricted stock discounts for the dividend paying stocks were about 13%, while the comparable discounts for non-dividend paying stocks were 22%-23% (bottom right of the figure).

Market Pricing and Restricted Stock Discounts

The next figure examines the offer amounts, size of the transactions, and market pricing of the dividend-paying restricted stock issuers.

We make observations from the second figure.

• The dividend-paying stocks are not penny stocks. The average stock price was $17.60 per share, while the average for non-dividend-paying stocks was $7.43 per share. Eight of the non-dividend paying stocks traded at less than $1.00 per share. Another 28 traded in the range of $1-$2 per share. 59 stocks traded from $2-$5 per share, and another 40 stocks traded between $5-$7 per share. This is not a hard analysis, but readers can get the picture that the non-dividend paying stocks were, for the most part, speculative businesses.
• The median offer amount (amount of the transaction) was $14.7 million for the dividend-paying stocks, while the median for non-dividend paying stocks was $4.0 million. The corresponding averages were $17.5 million and $10.1 million, respectively. We made a separate calculation excluding five large transactions involving Republic Industries (not shown). Excluding those transactions, the median and average discounts for non-dividend-paying stocks were $4.0 million and $6.9 million, respectively. The median excluding the five transactions remained the same; however, the average discount fell from $10.1 million to $6.9 million.
• The average and median percentage of shares owned by the restricted stock investors after the transaction was about 10.5% for dividend paying stocks, while these statistics for non-dividend paying stocks were about 11% to 13%, or not too dissimilar. However, we just saw that the dividend paying stocks received more dollars from their offerings than did the non-dividend paying stocks.
• The median market value of equity (MVE) for dividend-paying stocks was $133 million, and the average MVE was $248 million. For non-dividend paying stocks, the median MVE was $46 million, while the average was $122 million. Excluding the five transactions involving Republic, the average MVE fell to $74 million. The non-dividend paying stocks were considerably smaller than the dividend paying stocks in terms of MVE.
• The differing natures of the two groups of transactions can be seen when looking at the price/book value multiples. The median P/B multiple for dividend paying stocks was 1.7x, while the average was 2.2x. For non-dividend paying stocks, the median P/B multiple was 5.9x, and the average P/B multiple was 27x, indicating a range of speculative pricing for the non-dividend payers.

Earnings, Risk and Dividends, and Restricted Stock Discounts

We examine earnings, risk factors, and dividends in the third figure.

In this final figure, we look at other aspects of performance and risk for the dividend-paying companies relative to the non-dividend paying companies. We make a number of observations.

• Dividend paying companies are larger in terms of revenue than non-dividend paying companies. Median revenues for the dividend-payers was $118 million, compared with only $10.5 million for non-dividend payers.
• The dividend-paying companies are much more profitable, on average than non-dividend paying companies. The median pre-tax income for dividend-payers was $9.3 million, with a median operating margin of 22.5%. The median pre-tax income for the non-dividend payers was a loss of $1.2 million.  
• Stock price volatility for the dividend-paying companies was 0.37 (median) versus 0.73 (median) for the non-dividend payers. The smaller, less profitable companies had higher volatilities than did the larger, more profitable dividend-payers.
• Finally, The dividend paying stocks had a median dividend of 2.3%, while the non-dividend paying stocks had a yield of 0%.

Conclusion

We started with a figure indicating that the total return for an illiquid (or any) investment is the sum of the expected dividend yield and expected capital appreciation. For illiquid investments, these expectations are over the reasonably expected holding periods for investments. It is the expectation of future returns that give present value to investments. We have just seen very little information about dividends in the Stout/FMV Restricted Stock Database. The available information suggests that the presence of dividends, larger size and better performance yielded lower RSDs for dividend-paying companies relative to those who did not pay dividends.

It would appear that the expectation of future dividends has an inverse relationship to marketability discounts. Some level of dividends in an investment would mitigate the marketability discount for otherwise similar investments with no dividends. The expectation of larger future dividends relative to smaller future dividends would mitigate the marketability discount for the higher dividend-paying investment. This is just common sense.

Unfortunately, in large part, the business appraisal profession has ignored this common sense when estimating marketability discounts since Shannon Pratt reported on four restricted stock studies in his first (1981) edition of Valuing a Business (link is to 6th edition).

Any study or analysis that does not directly consider the impact of expected future dividends on the value of illiquid minority interests of companies is flawed. Readers who have made it this far are directed to Deja Vu #10: Valuation Theory is the Same for Businesses and Business Interests: V =f(CF, G, and R). A more in-depth resource would be Business Valuation: An Integrated Theory Third Edition (Mercer and Harms).

I’m going to close with something of an analogy. Estimating the value of illiquid minority interest using restricted stock studies (i.e., estimating the marketability discount) is like estimating the value of a business without considering the expected future income stream. Refer to the initial figure. There is no information in any restricted stock study to help business appraisers estimate the value of expected future dividends. And what about the terminal value that gives rise to capital appreciation? That is also an expected future cash flow. It is time for many appraisers to rethink their methods for developing marketability discounts.

Business appraisers routinely use the discounted cash flow model to value entire businesses. While a growing number of appraisers use a discounted cash flow model to value illiquid minority interests of businesses (22% according to a recent Business Valuation Resources Survey), the majority of appraisers continue to rely on restricted stock studies and pre-IPO studies in their marketability discount determinations.

The previous nine posts in this Deja Vu series have shown the uselessness of methods based on dated restricted stock or pre-IPO studies.

• Deja Vu #1: SEC Rule 144 (Pre-1997) as Background for Restricted Stock Discounts
• Deja Vu #2: The SEC Institutional Investor Study (Published 1971)  (Average Discount = 26%)
• Deja Vu #3: The Gelman (1972) (Average Discount = 25%) and Trout (1997) (Average Discount = 34%) Restricted Stock Studies
• Deja Vu #4: The Moroney Restricted Stock Study (1993) (Average Discount – 35%)
• Deja Vu #5: The Maher Restricted Stock Study (1976) (Average Discount = 35%)
• Deja Vu #6: The Silber Restricted Stock Study (1981-1988) (Average Discount = 34%)
• Deja Vu #7: The Mandelbaum Factors and “Benchmark Analysis” (1995)
• Deja Vu #8: Review of the FMV/Stout Restricted Stock Database
• Deja Vu #9: Pre-IPO Discounts Do Not Provide Valid Evidence for Marketability Discounts

This 10th post in the series looks back at the discounted cash flow model for businesses, then summarizes the model as it can be applied to interests in businesses or illiquid minority interests. The same valuation theory applies to both.

The Discounted Cash Flow Model for Businesses

The value of a business is defined by its expected cash flows and their growth, forecasted into perpetuity, and discounted to the present at a discount rate reflective of the risks associated with achieving those cash flows. In practice, valuation analysts routinely use a two-stage discounted cash flow model to develop value indications for businesses. First, there is a forecast of cash flows for a finite period, say five years, or until the cash flow forecast stabilizes. The value of all remaining cash flows after the finite forecast period is captured in the terminal value, which is, effectively, a capitalization of earnings or cash flows at the end of the forecast period. These cash flows are discounted to the present at an appropriate discount rate and equity value is determined. For simplicity, we will focus on the DCF model as applied to equity cash flows.

The two-stage model can be summarized in the following figure from Chapter 9 of Business Valuation: An Integrated Theory Third Edition.

The left side expression is the sum of present value of expected cash flows for a finite forecast period, discounted to the present at the equity discount rate appropriate for the business. The right side expression develops the terminal value in the numerator while the denominator reduces that future value in year f to the present. We can describe the enterprise DCF model in the following table.

The discussion should not be controversial to this point. However, we now look at the discounted cash flow model as applied to minority interests of businesses. We do so in the same manner as with the business DCF model.

The Discounted Cash Flow Model for Interests of Businesses

The value of a minority interest in a business is the present value of the expected cash flows to the interest over a reasonable expected holding period, including the realization of the terminal value at market value at the end of the expected holding period. The discount rate to reduce interest cash flows to the present is the equity discount rate (R) plus an increment of risk associated with the interest that is not present with the business itself. The DCF model for interests of businesses is, like the model applied to businesses, a two-stage model, which can be described in the following figure.

Unlike the business DCF model, which considers 100% of the equity cash flows of a business, the shareholder model considers only those cash flows expected for the interest being valued. The left side expression forecasts expected cash flows to the interest (CFsh) for the expected holding period (or over a reasonable range of expected holding periods). These cash flows are discounted to the present at the discount rate (Rhp), which is the sum of the equity discount rate R for the business and a premium for incremental risks associated with the interest.

The right hand equation develops the expected terminal value in the numerator. This is estimated based the expected equity value of the business at the end of the expected holding period. The denominator reduces that value to the present. The sum of the two expressions provides the value of the interest in the business, which is denoted as Vsh.

The marketability discount (or DLOM) is determined by the relationship between the value of the interest and the value of the business (or a pro rata share of the Veq(mm), or marketable minority/financial control value).

We can describe the shareholder level model for the interest in parallel with the business DCF model in the following figure.

In qualitative terms, we have just described the Quantitative Marketability Discount Model (QMDM), which is a shareholder-level discounted cash flow model. Shareholder level DCF models like the QMDM have distinct advantages over most other methods because they focus on the interest being valued in relation to the business it is part of. Several qualitative comments are appropriate.

1. Expected Holding Period. Every minority investment is made with the expectation for a finite expected holding period. The investment is made today, the expected benefits accrue over the holding period, and the investment is sold at (business) market value at the end of the expected holding period (or at a premium or discount to this expected value as the appraiser believes appropriate). No one knows the future with certainty because, as Yogi Berra said, “It hasn’t happened yet.”  But we have to make reasonable assumptions about the expected holding period (or a range of expected holding periods), whether short, intermediate or long, based on known facts at a valuation date. Appraisers cannot punt on this assumption because of lack of certainty.
2. Expected Dividends/Distributions. It should be obvious, but an interest that makes a regular distribution is worth more than an otherwise identical interest that does not. Appraisers cannot judge the difference in shareholder value in qualitative terms. Expected future dividends have present values and their present values must be calculated by developing an appropriate discount rate.
3. Expected Growth in Distributions. Consider two similar interests in businesses with identical expected dividends for the first year. For one business, there is no expectation for the dividend to grow. For the other, there is expected growth of 5% per year. The latter is clearly worth more than the former. The difference in value, however, cannot be judged qualitatively.
4. Timing of Distributions. Consider to otherwise identical interests. The first has a dividend that is paid annually, at the end of each year. The second interest expects the same annual distribution as the first, but it will be paid quarterly. The difference in value based on timing of distributions is a quantitative question, and not a qualitative one.
5. Growth in Value of the Business. Virtually every valuation of a business interest begins with a valuation of the business. That value represents the financial control/marketable minority value, which is the base value from which any discounts are taken. In order to estimate the terminal value at the end of expected holding periods, appraisers must make assumptions about the expected growth in value of the business over that time horizon. Factors such as expected return on equity, expected distributions, agency costs in the form of non-pro rata dividends, or suboptimal investments can inform the assumptions.
6. Required Holding Period Return. Appraisers develop equity discount rates when valuing businesses. We must develop required returns for illiquid minority investments, as well. There are a number of resources available to assist in estimating incremental risks associated with interests. But appraisers cannot punt on this issue, because all the expected future cash flows to interests being valued must be brought to their present values.
7. Value to Shareholder. The value to the shareholder, or the value of the interest, is the present value of the expected future benefits, both interim distributions and terminal value, discounted to the present at the required holding period return.

The marketability discount is determined based on the relationship between the value to the shareholder and the business value, as shown above, or, to repeat:

Concluding Thoughts

I reviewed all of the studies in this Deja Vu series except Quantifying Marketability Discounts, which introduced the QMDM and was published in 1997. That was some twenty-five years ago. I reviewed the FMV Stout Restricted Stock Database in 2005 in a second book on valuing shareholder cash flows. And we introduced the QMDM as a shareholder level discounted cash flow model to provide a reasonable method/model to estimate shareholder level values and marketability discounts. The first edition of Business Valuation: An Integrated Theory was published in 2004. The second edition was published in 2008. The current Third Edition was published in 2021.

The theory for valuing businesses and business interests is the same valuation theory. Value is a function of expected cash flows, their expected growth, and the risks associated with achieving the cash flows.

Be well,

Chris

Restricted stock transactions cannot be used to estimate marketability discounts for illiquid interests in private companies. That was my conclusion in Quantifying Marketability Discounts (out of print) in 1997, and that is our opinion in Business Valuation: An Integrated Theory, Third Edition currently.

In the earlier book, I performed a detailed quantitative analysis to prove why there were too many moving with pre-IPO transactions for them to provide credible evidence for current marketability discount determinations. There is a more qualitative analysis in the current book leading to the same conclusion. This post examines pre-IPO transactions qualitatively in a more visual fashion.

What Is a Pre-IPO Discount?

A pre-IPO discount is a discount reflected by the difference between two prices.  The first price is the price at which a transaction occurred with a minority interest of a private company in the months prior to when it ultimately engaged in an initial public offering.  The second price is the price recorded for the newly public company in its IPO. The following figure provides the definition of the pre-IPO discount and then provides an example calculation of a discount from a hypothetical transaction.

In this post, we examine one hypothetical Company that had a pre-IPO transaction and then, six months later, engaged in an initial public offering.  We then look at the dispersion of pre-IPO discounts in the early pre-IPO studies prepared by John Emory.  Finally, we make some observations and conclusions regarding pre-IPO studies and discounts and also relate back to the earlier posts discussing restricted stock discounts.

A Hypothetical Pre-IPO Transaction/Discount

The following diagram illustrates the hypothetical pre-IPO transaction described above.  We walk through the transaction “by the numbers” to be sure that we fully describe a transaction and the moving parts involved.

1. The pre-IPO transaction occurs on a specific date, say January 31, 2020.  The transaction occurs based on the hypothetical Company’s historical performance and outlook, with the likely knowledge that there is at least the possibility of an initial public offering in the foreseeable future.  The transaction is occurring in all likelihood because certain insiders are hoping to gain or increase positions in the Company’s shares at low prices in anticipation of the IPO.
2. There is a pre-IPO transaction.  Perhaps it was based on an appraisal as of that date.  In that event, there would be a marketable minority value indication in the report of, say, $10 per share (V = CF / (R – G)).  Say that the expected cash flow is $1.00 per share and that the discount rate is 14% and the expected growth is 4%.  V = $1.00 per share / (14% – 4%), or $10.00 per share.
3. Assume that the report developed a marketability discount of 35%.
4. When applied to the $10.00 per share marketable minority value, the marketability discount yields a pre-IPO transaction price of $6.50 per share.  In the event that there was no appraisal, there was an unobserved but implied marketable minority value, an unobserved but implied marketability discount, and, of course, the pre-IPO transaction price of $6.50 per share for the illiquid minority shares being purchased in the pre-IPO transaction.
5. The pre-IPO price was determined based on the financial statements and historical performance and expectations of the Company leading to the transaction date.  The Company was capitalized as shown on its balance sheet.  There was no new capital from an IPO transaction that might increase expectations for cash flow and growth and provide expectations of lower risk.  In other words, the Company was a private business, perhaps with the hope or expectation of a future public offering, but certainly, on January 31, 2020, any future IPO transaction was uncertain.
6. Time passes.  Let’s say that an investment banker was retained and a public offering was set into motion.  The IPO is set to go off on July 31, 2020, or six months after the pre-IPO transaction date.
7. The IPO occurs on July 31, 2020
8. The initial price is $13.00 per share, which represents a 30% premium to the pre-IPO marketable minority value of $10.00 per share.  This “IPO pickup” is unobserved, but in all likelihood, it is there in some amount.
9. Comparing the IPO price of $13.00 per share with the pre-IPO transaction price of $6.50 per share, we can observe that the pre-IPO transaction occurred at a 50% discount to the IPO price.
10. The pre-IPO price is, of course, unchanged from the transaction pricing six months prior to the IPO.
11. What has changed in the six months between January 31, 2020, and July 31, 2020?  With the passage of time, the Company’s performance presumably continued to improve.  Market conditions could have improved and industry conditions for the Company could have improved, as well. The IPO raises millions of dollars in new capital, the majority of which likely is invested into the Company to fuel future growth.  This investment changes expectations for cash flow and growth in cash flow. IPOs are generally preceded by stock splits to get shares into a reasonable pricing range.  New shares are issued, diluting the ownership of pre-IPO shareholders.  This new capital serves to reduce risk and to increase expectations for growth relative to the marketable minority value of $10.00 per share at the pre-IPO transaction date.  Relative to the pre-IPO marketable minority value (#2 above), the IPO price might be calculated as follows.  V = $1.00 per share / (13.0% – 5.3%) = $13.00 per share.  The expectations for reduced risk and enhanced growth decrease the capitalization rate for the IPO (R – G) relative to the capitalization rate at the pre-IPO transaction date.  And this simple example has not considered the impact of changes in expectations for cash flow based on new investment.  Changes in expectations like this are, in all likelihood, the sources of the “IPO pickup” of 30% that occurred.  In addition, there could be some degree of speculation built into the IPO pricing.

The diagram above should make it clear that the Company, six months after the pre-IPO transaction, has changed.

• On January 31, 2020, the hypothetical Company was a privately owned business with its own historical performance and outlook.
• Six months pass in our example.  We do not know what changes were made at the Company in anticipation of the initial public offering.  Perhaps a restructuring was necessary.  Perhaps new management was brought in to strengthen the management team.  Perhaps a lot of things.  In any event, the Company had to deal with the passage of time and the anticipation of the IPO.
• With the IPO, the Company raised millions of dollars, the great majority of which was invested to strengthen the Company, reduce risk and increase growth expectations.

What does the 50% pre-IPO discount tell us about these important changes that are the direct cause of the enhancement in value from pre-IPO days to the public offering time?  Absolutely nothing.  What does the pre-IPO discount tell us about the appropriate marketability discount for a current subject interest?  Absolutely nothing.

What Does an Average of Pre-IPO Discounts Tell Us?

As with restricted stock transactions, there is no economic evidence in any pre-IPO discount.  And there is no economic evidence of an average of hundreds or thousands of pre-IPO discounts.  A pre-IPO discount is not a valuation driver and cannot be used to apply to a marketable minority/financial control value to estimate a marketability discount.  In the example above, the pre-IPO price was $6.50 per share and the IPO price was $13.00 per share.  The calculated pre-IPO discount is 50%.

John Emory performed pre-IPO studies beginning in the late 1970s and continuing for more than twenty years.  The Emory studies were examined in Quantifying Marketability Discounts.  The average discounts for the various studies were generally in the 40% to 45% range, with standard deviations in the range of 18% to 20%, indicating considerable variability (just as with the restricted stock discounts discussed earlier in our Deja Vu series).  To illustrate this variability and to show that any use of averages from the studies (Emory’s or any of the other studies) was not meaningful, the following diagram showing the scatter of Emory study results for a number of studies was shown in Quantifying Marketability Discounts.

Note that some pre-IPO discounts were negative, which says that some pre-IPO transactions occurred at prices higher than the ultimate IPO prices.  Some pre-IPO transactions occurred at very large discounts of 60% to 80% or more relative to the ultimate IPO prices. The picture should make it clear that the calculation of an average of pre-IPO discounts merely hides the great dispersion of the actual discounts and provides no meaningful economic information.

Pre-IPO studies continue to the present date.  The Valuation Advisers Lack of Marketability Discount Study is available at www.bvresources.com.  This study contains some 17,000 transactions, including some 2,300 transactions in foreign countries.  The study allows sorting in a number of fields, including industry or business description, sales, assets, operating income, operating profit margin, NAICS or SIC code, and, of course, the dates of pre-IPO transactions and the IPOs themselves.

Concluding Observations from the Deja Vu Series

Restricted stock and pre-IPO studies are the most commonly cited sources of market evidence for marketability discounts applicable to illiquid minority interests in private companies.  Yet, as we have demonstrated in this Deva Vu series thus far, the observed discounts from these studies do not provide direct economic evidence for such application.

• In the case of the restricted stock studies, the observed discounts are ultimately a function of the expected holding period and the holding period premium to the base return. These two factors give rise to observed restricted stock discounts.  While the implied holding period premiums may provide a useful benchmark when estimating returns on illiquid minority interests in private companies, additional parameters (the period until liquidity is expected, future capital appreciation, and interim cash flows during the period of illiquidity) are required to develop the appropriate marketability discount.  The observed restricted stock discounts are not directly applicable to illiquid minority interests in private companies.
• Pre-IPO discounts relate the price at which illiquid minority shares are transacted to a subsequent initial public offering price for the same company. However, the IPO itself changes the nature of the pre-IPO company.  As a result, the observed discounts include both the impact of illiquidity and the changing characteristics of the company.  Since valuation analysts are generally not able to separate the two components, the observed pre-IPO discounts do not provide relevant evidence for the marketability discounts applicable to illiquid minority interests in private companies.

The value of a business is the (present) value of all expected future benefits to be derived from it into perpetuity and discounted to the present at a discount rate reflective of the risks associated with achieving those cash flows.  Virtually one disagrees with this statement.

The value of an interest in a business is the (present) value of all expected future benefits to be derived from the interest (which are derivative of business cash flows).  Those cash flows are:

• Expected interim benefits such as dividends or distributions
• Over the expected holding period of the investment
• Including the expected terminal value at the end of the expected holding period
• Discounted to the present at a discount rate reflective of achieving the expected benefits of the interest

The restricted stock studies and pre-IPO studies tell nothing directly about these benefits and simply cannot be used as a basis for developing marketability discounts for illiquid minority interests of businesses.  We can learn and infer some useful information from restricted stock transactions that is helpful in the kind of analysis suggested by the definition of the value of an interest in a business.

It is time for the business appraisal profession to wake up and apply the same valuation principles used when valuing businesses to the valuation of interests in them.

In the meantime, be well,

Chris