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

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

This post was originally written for Mercer Capital’s Family Business Director Blog and offered advice to family business directors based on my observations following the failure of Silicon Valley Bank on March 10, 2023.  This failure was followed by Signature Bank on March 12, 2023, and First Republic Bank on May 1, 2023.  All three banks failed because of deposit withdrawals in excess of the banks’ abilities to fund them.

• Silicon Valley Bank was taken over, or at least substantial assets and liabilities were assumed, by First Citizens Bank & Trust Company (Raleigh, North Carolina).
• Signature Bank was taken over by Flagstar Bank (United Community Bancorp)
• First Republic Bank was taken over by JP Morgan Chase.

As of today, May 19, 2023, the regional banking crisis may or may not be over but the SPDR® S&P Regional Banking ETF (KRE) remains almost 40% below its pre-Silicon Valley Bank high in early February.

Silicon Valley Bank was the first failure and, in many ways, offers some very important lessons for private business owners and directors.  With modest editing, I’ll repeat the original post now.

Introduction

The failure of Silicon Valley Bank will be talked about for years.  What really happened?  What caused SVB to fail?  Was it just the long-term Treasury Securities that everyone has talked about.  Well, no.  SVB was on a self-imposed path to destruction that had been in place and waiting for an adverse change in the economy or a rising interest rate environment to kick it into oblivion.

There are lessons to be learned for family business directors from this recent event.

A Short Digression from SVB?

This post comes from a different perspective than most who will write about the failure of Silicon Valley Bank.

In 1985, Mercer Capital was in two businesses, problem bank consulting and business valuation.  By 1987, we had worked our way out of the consulting business and were solely a valuation firm.  But there are some memories from our consulting days that are relevant to SVB.

I went to a board meeting of Park Bank of Florida in St. Petersburg in the latter part of 1985 to meet with its board of directors.  They had recently announced loan problems and losses and were seeking to hire a consulting firm to help them work through their problems.  Mercer Capital was retained.  Some recollections from that time include:

1. Park Bank had grown very rapidly, increasing total assets from $8 million to $750 million in eight years.
2. The bank went public in 1982.
3. The bank was “profitable” and attractive for those eight years, up to the time that they announced underlying asset quality problems.
4. Management and the directors prided themselves on being creative bankers and, in retrospect, thought they were smarter than other bankers.
5. The bank’s board and management were rather cocky, bragging in marketing campaigns about the bank’s sophistication and elitism.
6. The board and management literally “bet the bank” on their alleged creativity and ability to structure loans “better” than other banks.

The general attitude was different when I met with the board.  They were looking for help and Mercer Capital was retained.  I basically lived in St. Petersburg for several months while we attempted to help management address complex problem loans and to gain control over operating expenses.

Unfortunately, the problems were so deep that a workout was not possible.  In 1986, the FDIC closed Park Bank of Florida.  At the time, it was the sixth largest bank failure in history.

The Lessons

There are several lessons for family business directors from the failure of SVB (and Park Bank of Florida).  We summarize the lessons now, which include:

1. Don’t grow too fast.
2. Don’t grow staffing too fast.
3. Don’t smoke your own stuff.
4. Don’t make “bet the company” decisions.

 There are undoubtedly more lessons to be learned, but four is a manageable number.

Don’t Grow Too Fast

Unless you are a budding Amazon with almost unlimited and believing public and private funding, you cannot grow indefinitely without the prospects for reasonable returns.  Business value is ultimately a function of expected cash flow and its growth and the risks of achieving that expected growth.

SVB was in a race against the banking industry to collect deposits for its balance sheet.  Deposit liabilities are the major source of funding for most banks, and their deposits get deployed into loans, investments and other earning assets.  Let’s look first at total assets.

SVB had total assets of $209 billion at year-end 2002, making it the 16^th largest bank in the country (out of 4,116 banks) at that time.  SVB grew its total assets from $56.1 billion at the end of 2018 to $209 billion at the end of 2021, or at a compound annual growth  (CAGR) rate of 55% per year.  Those are just numbers, but let’s look at them.

SVB grew assets some $13.8 billion in 2019.  To put this in perspective, Sandy Spring Bank, the 107^th largest bank in the nation, had that many assets at year-end 2019.  But Sandy Spring Bank accumulated its $13.8 billion in assets over more than 150 years, not one year.

SVB grew its assets at higher rates and larger dollars in 2020 and 2021.  The bottom line is that SVB was growing its assets each year at amounts equal to some of the largest banks in the country after their many years of historical growth.

The nation’s 4,116 banks grew assets at a 12% CAGR in the three years ending 2021 (versus 55% for SVB).  The focus is on growth to 2021 because growth ceased for SVB in 2022 and slowed significantly for the banking industry as well.

When I was consulting, I talked about the “Law of the Double.”  When a company doubles in size, it is necessary for its management, accounting, finances, human relations, systems, and everything else to adapt to the larger size.

If a company doubles in size in ten years, or at a CAGR of just over 7%, change is evolutionary and occurs for the most part without much pressure.  When a company doubles in size in two years, as SVB did from 2018 to 2020, the internal pressures on systems are incredible, and those pressures got even worse when the bank grew its assets another 83% in 2021.

Silicon Valley Bank grew too fast to maintain proper controls at all levels of the organization.

Don’t Grow Staffing Too Fast

Hiring good people is difficult for almost all businesses when employment is tight or not.  Hiring many good people at the same time is even more difficult.  Take a look at the employment growth at SVB and think in terms of hiring at your company, regardless of its size.

SVB hired 322 net new employees in 2019, 623 employees in 2020 and 2,440 employees in 2021.  Imagine the internal resources necessary to identify and hire that many employees.  Given the numbers above, SVB hired 3,385 employees in three years and grew staff at a CAGR of 30%.  The banking industry staffing grew at a 2% CAGR over the same period.

Assuming no turnover in the 2,818 employees at the end of 2018, this means that employment more than doubled, that well more than half of all employees had less than 2.5 years’ experience, and about 40% of all employees had been with the bank for less than one year.

SVB had very little of what I call “institutional memory.”  How could management train so many new employees?  How could management instill any sense of corporate culture with so much change?  The answer is, they could not.

This kind of growth in a banking business is a precursor of future problems.

Silicon Valley Bank grew staffing too fast.

Don’t Smoke Your Own Stuff

Silicon Valley Bank was founded in 1983 and grew to become a $56 billion bank over the next nearly 40 years to 2018.  Assuming they started with $100 million in total assets, that represented an 18% CAGR over the period.  To put this growth rate in perspective, had SVB grown at 18% per year from 2018 to 2021, it would have been a $92 billion bank, rather than a $209 billion bank.

Management had to believe they had a better mousetrap than other bankers.  The board of directors had to have bought into that mousetrap to allow such uncharacteristic and unprecedented growth.

But money is all green.  Loan and deposit markets are competitive.  Loans are made on the basis of price, service, and quality.

1. Pricing relates to the interest paid by borrowers. Other things being equal, banks offering lower interest rates get the loans.
2. Service is defined by how bankers treat their customers. Service and relationships are important, but they only go so far.
3. Quality is a function of the structure and collateral for loans. Unfavorable structures and inadequate collateral from a bank’s viewpoint can help it gain loan market share.

The bottom line is that growing loans faster than the market for a sustained period of time (33% CAGR to 2021) increases the probability of future problems for a bank.  There has been little talk about loan quality issues at SVB.  It will be interesting to see how the portfolio performs under the new ownership of First Citizens, which needs to hope that the assets were purchased at a sufficient discount to preclude future losses.  Don’t be surprised if there are future problems.

A bank’s management and directorate had to be smoking some of their own dope to believe that it could sustainably outgrow its industry by a large margin.

Silicon Valley Bank’s management and directorate were smoking their own stuff.

Don’t Make “Bet the Bank (Company)” Decisions

Faced with interest margin pressures in the “zero interest rate environment” leading up to the end of 2021, SVB management had options.  Banks are required to engage in what is called “asset-liability” management.  They are required to consider the impact of future interest rate changes on their interest-earning assets and their interest-paying deposits.

When I was Assistant Treasurer of First Tennessee National Corporation in the latter 1970s (now First Horizon), we had to model the impact of interest rate changes for incremental strategies involving loans, investments, or deposit liabilities.  For some of the younger readers, this was before the advent of the personal computer, so we did this modelling by hand.  Strategies that the Finance Committee considered to be too risky were not approved.  The goal of asset-liability management then, as now, is to develop stable and reasonably defensive earning streams.

On October 1, 2011, the common stock of SIVB, SVB’s parent, peaked at $717 per share.  The price then began a steep decline, reaching a low of $230 per share before rallying to $302 per share at the end of 2021.  Management and the board were under tremendous pressure to generate performance that they hoped would stabilize the stock price.

They made the wrong decision.  They took the nearly $100 million in deposit growth from 2021 and put the majority of it into long-term term Treasury securities with maturities in excess of ten years.  At the time that SIVB’s stock price peaked in October 2021, the 10-year U.S. Treasury bond yield was on the order of 0.70%, just off the record low a few days before of 0.64%.

The pressure for yield at SVB and banks in general was historic in nature.  Over a fairly short time in late 2021 and early 2022, in the face of enormous margin and earnings pressure, management elected to invest more than $80 million in long-term (10-year or more maturities) Treasury securities at an average yield of about 1.75%.  The result is in the next figure.

SVB management bet that interest rates would not rise in late 2022 and into 2023.  And they made the bet with about 40% of the bank’s balance sheet.  When rates rose, the bank was not in a position to benefit from reinvesting shorter maturity securities nor in a position to avoid the earnings pressure of low rate, long-term investments in a rising rate environment.  To put things clearly, when rates began to rise, short-term deposit liabilities rose rapidly with no corresponding ability to offset increased deposit expenses by reinvesting maturing assets into higher yielding assets.

The offending securities in the figure above are called “held-to-maturity” and are accorded treatment such that they can be carried on the balance sheet at cost.  However, they do have market values and those are shown above.  The held-to-maturity securities had a cost basis totaling $91 million and a market value of only $76 million at year-end 2022.

There is an inverse relationship between interest rates and bond prices.  When rates rise, bond prices fall.  When maturities are long, bond prices fall a great deal.

The unrecognized loss of $15 million approximated SVB’s equity capital of $15.5 million.  When these financials were disclosed, as the old saying goes, “the jig was up.”

SVB “bet the bank” on an interest rate forecast that few believed in at the time.  And lost.

SVB Failed

The FDIC shut Silicon Valley Bank down on March 10, 2023.  There is talk about a “rush to justice” and that if SVB had had just a little more time it could have weathered the massive deposit outflows that ultimately caused its failure. You see, all the “friends of the Bank” who had massive amounts of uninsured deposits with SVB rushed to get them out as word began to emerge of potential liquidity issues.  Only 3% of SVB’s deposits were under the FDIC limit and therefore insured.  That means that 97% of the deposits were uninsured.  At First Tennessee, we used to call such deposits “hot money.”  It would move in a moment for a slightly higher interest rate.  And it for sure moved out of SVB at a pace that literally broke the bank.

From my perspective, the Silicon Valley Bank had already failed or had failure in its future regardless of the action of the FDIC on March 10^th.

That is not the case for the vast majority of family businesses.  Nevertheless, it is good to take our lessons from whence they come.

Recap for Family Business Directors

What are the lessons for family business directors who are not on the board of Silicon Valley Bank, but of a variety of kinds and sizes of companies around the nation?

We recapped them above, but in summary:

1. Don’t grow too fast. It is hard enough to keep eyes on the ball when growing at market rates for your industry.  The problems are exacerbated if your company is trying to grow at greater rates than your competitors or your industry.  And remember the Law of the Double.  Your management, systems and everything have to adapt to handle that growth.  If you double too quickly, you may not be able to adapt.
2. Don’t grow staffing too fast. This lesson is a subset of the first one, but it warrants separate attention.  Rapid growth of staff decreases average experience, requires substantial training, and dilutes the institutional memory.  It also makes it difficult to inculcate your company’s culture into the new staff.
3. Don’t smoke your own stuff. When things are going well, it is easy to begin to believe that your group is “above average” like all the children in Lake Wobegon.  When managements begin to think this way, it becomes difficult to bring your normal level of judgment and scrutiny to major decisions.  Recall that sage warning that “pride goeth before the fall.”
4. Don’t make “bet the company” decisions. Important decisions must be made, of course, and they always have some risk.  However, companies should avoid, to the extent possible, those individual decisions that can put the entire company at risk.  You’ll know one the next time you see one.

There are, indeed, lessons for family business directors and private company business owners and directors from the failure of Silicon Valley Bank.  Are we suggesting that you should not grow?  Of course not.  But good growth is planned growth that preserves markets or margins or both.  And don’t make “bet the company” decisions.

Comments are welcome.  In the meantime, be well.

Chris

My most recent post, titled Fair Market Value and the Nonexistent Marketability Discount, generated quite a discussion when posted on LinkedIn. In the last week or so it has received 5,600 impressions (whatever those are), 41 Likes, and 29 comments. Most of the discussion has been productive and welcomed!

The post provided a solid rationale that there is no such thing as a marketability discount for controlling interests of companies. One of the questions asked relates to the distinction between lack of marketability and lack of liquidity.  Some would like to say that companies are marketable – they can be sold, but they are not liquid.  And so a discount for lack of liquidity might be appropriate.

This post examines these two concepts, marketability and liquidity, or the lack of one or both in the context of fair market value determinations of controlling ownership interests of private companies.

Important Definitions

The Sixth Edition of Shannon Pratt’s Valuing a Business (with the ASA Educational Foundation) was published in late 2022.  Let’s refer to the book as Pratt’s Sixth Edition.  Chapter 19 is titled “Discounts for Lack of Liquidity and Lack of Marketability.” (p. 419)

The Introduction of Chapter 19 contains the following paragraph:

“These two concepts of lack of liquidity and lack of marketability are related but distinctly different.  As with all valuation adjustments, it is important to identify the base of comparison to which the adjustment relates.  The prior edition of this book defined how liquidity and marketability could be differentiated.  Since that edition, the discussion about these two concepts has evolved.  This chapter presents current thinking on the subject.  No doubt these concepts will continue to be refined.” (P. 420) (emphasis added)

A section of the chapter called “Liquidity and Marketability – Closely Related But Not the Same” introduces the discussion of marketability versus liquidity.  (p. 423)  There are two subsections titled “Liquidity” and “Marketability,” respectively.  Regarding liquidity, the text states:

“The cost of the relative illiquidity of marketable securities is embedded in its price.[1]  In most cases, there is no need for an analyst to adjust the price of a marketable security for the cost of illiquidity.  Indeed, it is embedded in the pricing information from this market, which often forms the basis of comparison in valuing a subject interest.” (P. 421)

[1] Transaction costs also rise with illiquidity.  However, in most circumstances, transaction costs are not factored into the appraisal of the subject interest since the pricing information of frequently traded comparable securities is not adjusted for these factors.”

The International Valuation Glossary – Business Valuation (“the Glossary”) provides definitions of liquidity and marketability and their related discounts.  These are quoted in Pratt’s Sixth Edition.

Liquidity — the ability to quickly or readily convert an asset, business or investment to cash at minimal cost. (P. 422)

Marketability — the ability to quickly or readily convert an asset, business, or investment to cash at minimal cost that reflects the capability and ease of transfer or salability of that property.  Marketability is also affected by, among other things, the particular market in which the asset is expected to transact and the characteristics of the asset. (P. 423)

Discussion of Definitions and Base Values

Both definitions begin with “the ability to quickly or readily convert an asset, business, or investment to cash at minimal cost”.  That is the entire definition of liquidity.

The definition of marketability expands on that concept by adding that marketability “reflects the ease of transfer or salability of that property.”  The definition is further refined to discuss the particular market in which an asset is expected to transact and the characteristics of the asset being valued.

The expansion of the definition of marketability is important in that it provides more than just the quick conversion to cash.  Looking at the entire definition of marketability, I believe that the likely meaning of the ease of transfer is the relative ease of transfer or salability in the particular market and given the characteristics of the asset, e.g., a controlling ownership interest, being valued in relation to the market for entire companies.  After speaking with one member of the committee that created the Glossary, I believe that my interpretation is on-point.

Many appraisers, including the drafters of Chapter 19, want to equate the “liquidity” represented by cash in three days with the “illiquidity” of the time it takes to sell controlling interests.  They suggest that a discount for lack of liquidity is needed because of the time it takes to sell.  There are problems with this reasoning, as pointed out in my last post.

• The definition of fair market value, the standard of value employed in most appraisals, calls for a hypothetical transaction to occur on the valuation date.  All marketing, due diligence and documentation has occurred before or on the valuation date and a hypothetical transaction occurs on the valuation date.  Importantly, the transaction occurs for cash and/or cash equivalent consideration.  There is no “marketing” after the valuation date.  It has already occurred. It is simply incorrect to suggest that a controlling interest should be discounted because of marketing time after the valuation date.
• The concept of marketing before the valuation date is analogous to the concept of exposure time in real estate appraisal.  Exposure time is defined in the Uniform Standards of Professional Appraisal Practice (USPAP) as the: “estimated length of time that the property interest being appraised would have been offered on the market prior to the hypothetical consummation of a sale at market value on the effective date of the appraisal.”There are no concepts of  “marketability discounts” or “illiquidity discounts” in real estate appraisal because it is clear that a property has been assumed to have been on the market for a sufficient time and that appropriate effort has been expended before the valuation date so that the assumed hypothetical transaction reflected by the appraisal (for cash or its equivalent) can occur on the valuation date.The same holds true for fair market value determinations of controlling interests of businesses.  There has been (assumed) sufficient “exposure time” (marketing, due diligence, and documentation) and effort that the hypothetical sale contemplated by the definition of fair market value can occur on the valuation date for cash or its equivalent.  There can be no “marketability discount” or “illiquidity discount” based on time or expense to market companies after the valuation date. 
• As noted above, the cost of any illiquidity of publicly traded securities is reflected in their transaction prices.  When trades occur, we only see one price, the transaction price.
• The very same logic pertains to the sale of controlling interests in companies.  Appraisers use transaction multiples from transactions in similar companies with the guideline transactions method.  Only one price is observed when private company transactions close: the price agreed to by buyers and sellers.  If a transaction had noncash consideration, it is up to the appraiser to put that on a cash-equivalent basis before calculating multiples.  Any cost of illiquidity in the sale of companies is reflected in their prices, just as with publicly-traded securities.
• There is no relevant base value from which either a discount for lack of liquidity or for lack of marketability might be taken.  And no discount has any meaning unless the base value from which it is taken is defined.

Pratt’s Sixth Edition recognizes this fact and considers four possible base values.  I quote and then comment below each possible base value.

“If the appropriate standard of value is fair market value, the price ultimately expected to be reached between a willing buyer and a willing seller – before the costs and risks listed above are considered – is a benchmark from which the discount for lack of liquidity could be taken.” (emphasis in original) (pp. 457-458)

This first suggested base value does not hold water in fair market value determinations.  The price that (hypothetical) willing buyers and sellers agree on for a business is its fair market value.  It is certainly not the benchmark from which an illiquidity discount for a controlling interest should be taken.  Any effect of illiquidity is reflected in the agreed upon pricing.  The price agreed to by a willing buyer and a willing seller is, well, the price.

“The price one might receive in an initial or secondary public stock offering (i.e., the publicly traded equivalent value).” (p. 458)

The price in a potential IPO is simply irrelevant for the great majority of private businesses.  Most companies will never have the size or characteristics to make them attractive public candidates.  They may nevertheless be quite attractive companies.  Further, in IPOs, normally only a small portion of companies are offered to the public.  That is different than placing the entire company on the market.  This is not a relevant base value.

The “publicly traded equivalent value” is a hypothetical concept.  Appraisers value companies at the marketable minority level (financial control), which is also called the “as-if freely traded” value.  It is a hypothetical price at which appraisers assume would be the price at which a private company’s shares would trade if there was a free and active market for its shares.

The as-if freely traded value is not  a benchmark from which a discount for illiquidity for controlling interests might be taken.  The as-if freely traded value is coincident with financial control value, so there is no reason to apply any discount for lack of liquidity.  See the levels of value chart in a prior post.  And see both of the levels of value charts in Pratt’s Sixth Edition (at p. 55 and p. 389).  No such discount is reflected on either chart.

“The price achievable in a private sale of the entire closely held business enterprise.” (p. 458)

If a company achieves a price in a private sale of the entire business, That is the price and value of the business.  This value does not represent a benchmark level from which an illiquidity discount for controlling interests might be taken.

“A control transaction of a publicly funded company.” (p. 458)

Frankly, I am not sure what this means. But it is not a base or benchmark value from which an illiquidity discount for controlling interests might be taken.

None of the base values proposed in Pratt’s Sixth Edition (and in prior editions) will serve as a base value from which a discount for illiquidity for controlling interests might be taken.

Three Examples            

We can discuss the concepts of liquidity and marketability in the context of three specific examples.

The expansion of the definition suggests that marketability may differ for different assets that trade in different markets.  Consider three assets:

1. 1,000 Shares of META Platforms (Facebook). META is trading in the vicinity of $210 per share as I write. An investment of 1,000 shares would have a market value of $210,000.  An investor owning 1,000 shares could issue a sale order today and have cash in her brokerage account in a very short time.  An investor who wants to buy 1,000 of META could place an order and acquire ownership of the asset effective almost immediately.  With either of these transactions (buy or sell), I would pay no brokerage fees if I executed in my Schwab account.  I would not even have to worry about stock certificates since Schwab acts as a custodian for my interests.

What does an investor acquire when purchasing 1,000 shares of META?  He acquires a literal “stock certificate” representing a very, very small but pro-rata claim on all the cash flows of the company, and is the pro-rata beneficiary of any future dividends or stock repurchases.  The shareholders have collectively delegated to or allowed control by METAs management and the board of directors.

The current market price of $210 per share represents the current consensus pricing (per share) for all of META in the market today.  The market is highly liquid.  And META shares are marketable.  And current pricing certainly represents freely-traded pricing (marketable minority)  and financial control pricing.  It is the base price to which any strategic or synergistic premium might be applied — if a potential purchaser expected such benefits.

2. META Holdings, Inc. (the entire company). The market capitalization of META is about $550 billion as I write. I might be able to handle an investment of 1,000 shares of META, but I am not the market for the entire company.  That market is quite limited, but it exists, and is international in nature.  As big as META is, someone or ones would step up if META were “on the market.”If Mr. Zuckerberg were to decide to sell META, it would likely take some time to find a buyer or consortium of buyers.  But what would happen in the meantime?  The company would continue to operate and, hopefully, continue to create value for all its shareholders.  META shares would continue to trade, undiscounted because of any potential sale. There is no discount for lack of liquidity or lack of marketability. If Mr. Zuckerberg and the META board of directors were to talk with potential suitors, rest assured that no suitor would suggest that a discount for lack of marketability or a discount for lack of liquidity is appropriate.  Mr. Zuckerberg would laugh at such a suggestion.Is META, the company, liquid according to the definition of liquidity above? No, it would not be likely to be sold or converted to cash quickly in one day or two or three.  Does anyone care?  Not really.  To reiterate, there is no discount for lack of liquidity or lack of marketability.
3. XYZ Company (100% of equity).  XYZ is a successful professional services firm with revenues of about $25 million, an EBITDA margin of 16%, and no debt.  Earnings are about $4 million and have been growing each year.  There is little seasonality to its earnings and distributions are made on a quarterly basis to its owners.Assume that it will likely take about a year to identify an appropriate buyer and to negotiate and close a sale.  The board commences a sale process.  At the end of three months of “marketing,” the company makes a distribution of $1 million from its earnings to its owners.  At the end of six months and nine months, the same thing occurs. All of this occurs during the marketing period.Assume the XYZ board closed its sale one year after its “marketing” began.  Its owners would take their last $1 million distribution at or just before closing.  And they would receive $30 million cash at closing (7.5x EBITDA).What is the buyer purchasing?  Well, clearly, the buyer desires to step into the shoes of XYZ’s owners and enjoy the benefits of its expected cash flows into the future.  That’s what they just paid for.  There is no discount for lack of illiquidity or marketability.  And there is no basis, in an appraisal of the same company, to apply any discount for future marketing efforts.  In an appraisal, the hypothetical transaction occurs on the valuation date just as the assumed closing of the XYZ sale occurred on the valuation date.

Wrapping Up

In my last post, I concluded that no marketability discount is applicable to controlling the ownership interests of businesses.  In this post, I reached the same conclusion.  Further, there is no discount for illiquidity applicable to controlling interests of businesses.

If someone is able to define different levels from the base value of financial control/marketable minority in terms of differences in expected cash flow, growth, and/or risk, then we can talk about such a discount.

To date, no one has done so.

As always, I welcome your comments on this post. If you’re reading this on LinkedIn, please do comment there.

As always, be well!

Chris

This post provides a discussion of several implications of the definition of the standard of value known as fair market value.  We focus first on the definition of fair market value.  Next we examine the hypothetical negotiations conducted by hypothetical buyers and sellers in fair market value determinations, and the implications of those negotiations.

We then look at the implications for the so-called “marketability discount for controlling interests.” We look at this “discount” from the vantage points of the definition of fair market value, the integrated theory of business valuation, and recurring and incorrect rationales for the discount.

This post is the first in a series of posts in which we will discuss fair market value in more detail.

Fair Market Value Defined

Fair market value occurs at the intersection of hypothetical negotiations between hypothetical willing, knowledgeable and able buyers and sellers.  Therefore, in every fair market value determination prepared by business appraisers, it is critical that both buyers and sellers are present for the negotiation.  A fair market value appraisal should reflect considerations of both buyers and sellers and land at the intersection of their negotiations over the expected cash flows, growth and risks associated with receiving those cash flows, whether for a business or an interest in one.

Every appraisal involves the specification of the relevant standard, or type of value.  Fair market value is the most frequently used standard of value employed by business appraisers.  Many times, appraisers cite a definition of fair market value and list the eight elements listed in Revenue 59-60 in their reports.  For example, the definition of fair market value found in Revenue Ruling 59-60 is:

2.2 Section 20.2031-1(b) of the Estate Tax Regulations (section 81.10 of the Estate Tax Regulations 105) and section 25.2512-1 of the Gift Tax Regulations (section 86.19 of Gift Tax Regulations 108) define fair market value, in effect, as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

Then, the reports will list the eight factors from Section 4 of the ruling.  I call these the “Basic Eight Factors.”

• The nature of the business and the history of the enterprise from its inception.
• The economic outlook in general and the condition and outlook of the specific industry in particular.
• The book value of the stock and the financial condition of the business.
• The earning capacity of the company.
• The dividend-paying capacity.
• Whether or not the enterprise has good will or other intangible value.
• Sales of the stock and the size of the block of stock to be valued.
• The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in the free and open market, either on an exchange or over-the-counter.

Once the definition and eight factors have been listed, there is often little or no consideration of the implications of the definition in the remainder of many valuation reports, although lip service may be paid in report headers that appear to follow the outline of considerations.  These are relevant factors for consideration, but RR 59-60 also states that the elements of common sense, informed judgment, and reasonableness must enter the process of weighing those facts and determining their aggregate significance,

Fair Market Value Reflects Hypothetical Negotiations

The following figure provides a conceptual look at fair market value. The key elements from the definitions are highlighted around the figure.  Hypothetical willing sellers have different interests than do hypothetical willing buyers.

In the world of fair market value:

1. Hypothetical buyers are seeking to acquire expected business cash flows and negotiate price based on their associated risks and expected growth (from their viewpoints).
2. Hypothetical sellers, who, if a transaction occurs, are giving up the expected business cash flows that the hypothetical buyers are acquiring, must consider the very same risk and growth factors (from their viewpoints). They negotiate price based on these factors.
3. Hypothetical (or real) buyers desire to pay the lowest possible price, but that is not fair market value.
4. Hypothetical (or real) sellers desire to receive the highest possible price, but that is not fair market value, either.
5. Fair market value necessarily assumes that:
   • All hypothetical negotiations and marketing of the subject interest have occurred prior to the consummation of any hypothetical transaction, which occurs on the valuation date.
   • Each party to the hypothetical negotiations has taken into account all relevant information that is known or reasonably knowable as of the valuation date.
   • The hypothetical parties have agreed to and signed the documentation customarily needed for a transaction prior to or on the valuation date.
   • A hypothetical transaction occurs on the valuation date.

These above elements are important implications of the definitions of fair market value which are overlooked or misunderstood by some business appraisers, attorneys and judges.  They are necessary, however, for the next element for consideration, the hypothetical transaction itself.

Fair Market Value Assumes a Hypothetical Transaction on the Valuation Date

Fair market value assumes that both hypothetical buyers and hypothetical sellers are both knowledgeable, willing, and able to transact, and that neither acts under any compulsion.  The hypothetical parties negotiate at arm’s length and in their respective self-interests.  And they engage in a hypothetical transaction with the following characteristics:

• The transaction occurs for money or money’s worth, i.e., for a cash-equivalent price.
• The transaction occurs on the valuation date. This fact is critical to understanding fair market value. We address this issue in more depth below.

The hypothetical transactions of fair market value could not occur on the valuation date unless all hypothetical negotiations, including the marketing of the subject interest, had not been concluded on or before that date.  Similarly, the hypothetical transactions could not be concluded unless all customary documentation of the transactions had been completed.  We will focus more on the resulting implications as we proceed.

The purpose of an appraisal is to simulate the hypothetical negotiations of hypothetical willing buyers and sellers and to determine, in the form of an opinion of fair market value, the intersection of their negotiations.  In some appraisals, the hypothetical seller is not present and conclusions are too low to reflect fair market value.  In other appraisals, the hypothetical buyer is not present and conclusions are too high to reflect fair market value.

What brings hypothetical willing buyers and sellers to the intersection point of fair market value?  It is their respective assessments and negotiations regarding the expected cash flows, risks, and growth associated with the subject interest.  Both the interests of buyers and sellers should be reflected in fair market value determinations.

The So-Called “Marketability Discount for Controlling Interests”

The question of whether a marketability discount should be applicable to controlling interests of businesses has been around for a long time.  I addressed the question in an article in the Business Valuation Review of the American Society of Appraisers in 1994.  The answer to the questions was, and still is, of course, no.  I have addressed this issue in several books and numerous articles and blog posts since then.  Nevertheless, many appraisers and several business valuation authors still seem to want to hang on to this non-existent discount of convenience.

The Definition of Fair Market Value

Let’s first address the question based on the definition of fair market value, which represents a hypothetical transaction in a subject interest on the valuation date for cash or its equivalent.  If there is a hypothetical transaction for a controlling interest in a company, say Acme Manufacturing, on the valuation date for cash at fair market value, what possible reason could there be for discounting that value for “lack of marketability?”  It has just been marketed and the interest became fully liquid.

The Integrated Theory of Business Valuation

Next, let’s address the question of marketability discounts for controlling interests from the viewpoint of the integrated theory of business valuation – or just plain common sense.  Any valuation discount represents differences in expected cash flow, growth and risk between one conceptual level of value and another.  For example, the marketability discount, or discount for lack of marketability, represents differences in expected cash flow, growth and risk between the marketable minority/financial control level of value (V = CF_e / (R_e – G_e)).  CF_e represents the normalized expected cash flow of an enterprise (business), G_e represents the expected growth of that cash flow, and R_e represents the risks associated with the business and achieving the expected cash flows.  The familiar Gordon Model represents the value of a business at the marketable minority/financial control level of value.

The nonmarketable minority level of value can be represented conceptually by the equation (V_sh = CF_sh / (R_hp – G_v)).  V_sh is the nonmarketable minority level of value.  CF_sh is the expected cash flow to the shareholder of a subject illiquid minority interest.  CF_sh is almost always less than CF_e because of reinvestments into a business or agency costs imposed by controlling shareholders.  G_v is the expected growth in value of the illiquid minority interest over the expected holding period of the investment (including liquidity assumed at the marketable minority/financial control level of value.  R_hp represents the risks associated with achieving CF_sh, including growth, over the expected holding period of the investment.

Why does a marketability discount (or DLOM) exist?

1. CF_sh is most often less than CF_e
2. G_v may be less than G_e
3. R_hp is almost certainly greater than R_e

The lower cash flows of the illiquid interest and the greater risks create the wedge of lower value called the marketability discount.

Now, let’s try to conduct a similar analysis relative to a marketability discount for a controlling interest.  First, we know that the marketable minority/financial control level of value is defined by the Gordon Model, or V = CF_e / (R_e – G_e).  This is a summary statement of the discounted cash flow model in which normalized expected cash flows of the business are projected into the future for a finite period of time and then, a terminal value is calculated to represent the then value of all remaining cash flows beyond the finite forecast period.

Are the cash flows attributable to a controlling interest any different at the valuation date than those already projected in an appraisal?  Of course not.  It is the same business and the same interest.  It is not possible to define lower cash flows attributable to the subject interest, or greater risks, or slower growth beyond the valuation date.  After all, that is the date on which the assumed hypothetical transaction of fair market value occurs.

Recurring Faulty Rationales for Marketability Discounts for Controlling Interests

Let’s take the analysis a bit further.  Assume we have valued 100% of the equity of Acme Manufacturing, a manufacturer of parts for the automotive industry.  The initial financial control/marketable minority value is $30 million, and you, the reader and the other appraiser, and I agree that this is a reasonable valuation.  The question now is whether a marketability discount should be applied.  In the following figure, I address some of the typical arguments for such a discount and find that they are not correct or reasonable.

To those who would suggest that a controlling interest is “marketable and non-liquid” and therefore a marketability discount for controlling interests should be applied, let me suggest that they articulate what that means in terms of expected cash flows, growth and risks of achieving those cash flows.  Differences in these factors are the only sources of valuation discounts (or premiums).  It cannot be done, so those authors who try to create a fictional level of value are, in my opinion, simply wrong. No one has called me on this position credibly and in writing since 1994.

If you disagree with me, please do not hesitate to comment on this post.  Know, however, that my responses to comments will be in terms of the basic triumvirate of value: expected cash flows, their growth, and the risks associated with achieving them.

In the meantime, be well.

Chris

Mercer Capital began more than 40 years ago.  From the outset, we performed what we call “59-60 work.”  It was fairly universally understood by then that when one does a “50-60” appraisal, it is necessary to include a review of the national economy:

Section 4 (b) The economic outlook in general and the condition and outlook of the specific industry in particular (RR 59-60)

In Mercer Capital’s early years, we struggled with this requirement.  Our first formal National Economic Review (NER) was written in 1985.  We prepared an NER once per year until 1990.  Since 1990, it has been a quarterly publication.

Along the way, our NER gained considerable credibility among appraisers and we began to sell it to other appraisers and appraisal firms.  Why was the NER considered to be a credible source?  It was, and remains, the only regularly published economic review that is written by valuation analysts for valuation analysts.

Are you a business appraiser or other professional looking for a comprehensive resource to keep you informed on the major factors affecting the U.S. economy and one you can include in your work product? Look no further than National Economic Review!

About the National Economic Review

Mercer Capital’s team of business valuation analysts authors a quarterly overview of the national economy that consists of 15-20 pages of in-depth analysis and several pages of exhibits and charts. It covers the following:

• General Economic Overview
• Consumer Spending and Inflation
• Business and Manufacturing Productivity
• Industrial Production and Capacity Utilization
• The Financial Markets
• Housing Starts and Building Permits
• Unemployment and Payroll Jobs
• Interest Rates
• Summary and Outlook

The “Summary and Outlook” section is ideal for inclusion in the text of appraisals and the entire review is appropriate as an appendix or exhibit to reports.

Mercer Capital uses the NER in our own valuation reports.  We use the edition for the quarter ending immediately before or on the valuation date.

Is the National Economic Review for You?

Available subscriptions include:

• One-year (4 quarters) is only $250. That’s only $62.50 per issue.
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• As a bonus when subscribing, you get access to almost 40 years of historical NERs. Now you may think that you don’t need that much history.  But how about appraisals with valuation dates from a few quarters or years ago?  Now that’s when this bonus comes in handy.  Keep in mind that we charge $150 for a single issue for non-subscribers, so this bonus is a real bonus!
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Examine the NER and Subscribe

Take advantage of this phenomenal resource and stay ahead of the curve with the National Economic Review.

The 4th Quarter 2022 issue will be released next week (the week of February 13th) so don’t delay!

To see what a real issue looks like, CLICK HERE to download a PDF.   If you have a current report with a valuation date of December 31, 2019, or in the first quarter of 2020 (watch out for the onset of the COVID-19 Pandemic in March of 2020), you have just received a $150 bonus.

A sample citation for this issue might be:

Source: “The National Economic Review Fourth Quarter of 2019,” as published at www.nationaleconomicreview.net, accessed Month, Day, Year. Subscription required.

There are other versions of national economic reviews.  However, keep in mind that the NER is the only regularly published economic review that is written by business appraisers for business appraisers.  And, we have more historical economic reviews than any other source.  And still more, a brief review suggests that our pricing is more favorable to you than other sources for paid reviews.

For more information and to subscribe, CLICK HERE.

Be well,

Chris

I arrived in Las Vegas early Sunday evening on November 13th for the 2022 AICPA & CIMA Forensic and Valuation Services Conference.  Four Mercer Capitalists are here in person, and three of us are presenting.

• Karolina Calhoun presented yesterday in two sessions on personal goodwill and on a litigation-oriented panel.
• Atticus Frank will present tomorrow and talk about why market multiples differ between and among industries.
• Yours truly will present on a panel addressing some hot valuation issues.  These sessions are always lots of fun.
• David Harkins is attending a three-day, intensive expert witness training session.
• Samantha Albert is also attending, but remotely.

The conference is going well.  I was told that attendance is on the order of 800, so it is a very successful, post-pandemic conference.  I’m glad to be here, even though the time zone change has hit me pretty hard this trip.

A Thought on Normalizing Adjustments

I have heard many appraisers suggest that one should not normalize owner compensation when valuing minority interests “because the minority shareholder cannot change compensation.”  I’d like to address this issue in this post.

Travis Harms and I cover the topic of normalizing adjustments in our book, Business Valuation: An Integrated Theory Third Edition, on pages 117-123.

It is essential to normalize the earnings of operating companies when providing appraisals either at the financial control/marketable minority level or the nonmarketable minority level.  Otherwise, the appraiser is not valuing the appropriate asset.

1. Assume a company has reported an EBITDA of $2.0 million, no cash, and no debt.  Assume further that the appropriate EBITDA multiple is 6x and that the underlying equity discount rate is 14%.  Then, based on reported EBITDA, the company is worth $12.0 million (6 x $2.0 million).
2. Assume further that excess owner compensation and benefits total $1.0 million.  Normalized EBITDA is, therefore, $3.0 million, and the company would be worth $18.0 million.
3. At the financial control/marketable minority level, few would argue that appraisers should not normalize for excessive owner compensation or other benefits.  The company is being valued at the financial control level, and its cash flows appropriately reflect normalized owner benefits.  In this example, the company is worth $18.0 million based on normalized EBITDA.
4. Assume, however, the assignment is to appraise this sample company at the nonmarketable minority level.  Assume further that the owner plans to sell the business in about five years, and that value has been growing at about 10% per year.  There are no expected distributions.
5. The only cash flow that the minority shareholder can expect is the terminal cash flow in about five years.

The question is, what is the appropriate marketability discount?  That discount cannot be determined based on the non-normalized value of $12.0 million.  It does not reflect an appropriate base value from which to estimate a marketability discount, which would be the financial control/marketable minority level of value.  It represents something less with no definition.

1. At the nonmarketable minority level, where hypothetical or real buyers lack control, it is still essential to normalize cash flows.  This is the only way that hypothetical buyers can understand the value of the entire asset, a small interest of which they are buying.
2. Assume that an appropriate holding period premium (to the equity discount rate of 14%) is about 6%.  The required holding period return for investors is, therefore, 20%.
   • The expected terminal value for the illiquid investment based on the financial control value of $18.0 million is about $29.0 million.  The present value based on these assumptions is $11.65 million ($29.0 divided by (1 + 20%) raised to the 5th power).
   • The expected terminal value based on a $12.0 million value with non-normalized earnings is $19.3 million.  Using the same calculation to calculate the present value, the present value would be $7.8 million.

Now we can see why it is essential to normalize when valuing minority interests.  Let’s look at the implied marketability discounts.

• At the financial control level, the implied marketability discount is about 36%, or ((1 – 11.54/18) – 1).
• Based on the non-normalized value, the implied marketability discount is about 35%, or ((1 – 7.8/12.0) – 1)).
• Importantly, the implied marketability discount from the actual financial control value of $18.0 million using non-normalized EBITDA is not 35%, but 57%, or ((1 – 7.8/18) – 1)).

No informed seller would sell at the lower value implied by using non-normalized EBITDA in the appraisal.  And by the way, rest assured that the owner would sell the company based on normalized earnings!

Another Way to Look at It

Assume that we have an LLC holding an income-producing property.  You are asked to appraise a 10% minority interest.  You are told the following about the investment:

• The interest pays a distribution of $100,000 per year.
• The plan is to sell the underlying real property in exactly five years from the valuation date.
• The expected rate of return for the underlying real property is about 8%.
• The expected rate of growth of the underlying real property is about 3%.

What is missing?  Well, the value of the underlying real property is missing.  Nevertheless, you are asked to appraise a 10% interest.  The first thing you want to know is the underlying present value of the property.

In fact, you would likely not agree to conduct the appraisal unless you were provided with reliable information supporting the underlying value of the real property.  Your answer would be markedly different if the underlying property value was $50 million rather than $10 million.

The same is true for the example company above.  No appraiser can reasonably determine the value of an illiquid minority interest in the absence of information about the value of 100% of the underlying company.

Conclusions

There are two conclusions to this post.

First, the AICPA Conference is a good one.  It is good to see so many appraisers from around the country.

Second, I hope that the myth that appraisers should not normalize earnings when valuing minority interests “because the minority shareholder lacks the power to change compensation” will die rapidly.

Wishing good things to all,

Chris