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

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

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

Overview

In this post, we continue the analysis of Friedman v. Beway, a 1995 New York Court of Appeals case that addresses the prevailing judicial interpretation of statutory fair value in New York.  In the first post in the series, we examined certain “principles” regarding fair value espoused in Beway.  In the second post, we reviewed the Supreme Court’s (i.e., the trial court’s) valuation analysis and then discussed additional guidance from Beway and Blake, an earlier New York Court of Appeals case.

In this third post in the series, we examine further guidance from  Beway, discuss why “marketing” has already occurred as of valuation dates in both real estate and business appraisal, then look at a more recent case involving asset holding entities, Giaimo v. Vitale, to see where current “logic” has led the Court of Appeals (First Department) in New York on the issue of marketability discounts in statutory fair value determinations.

In the final post in this series, we examine the actual marketability discounts concluded in statutory fair value matters since about 1985.  The analysis will differentiate between appellate-level and trial court cases that stand and were not appealed.  The results will likely be surprising for those interested in statutory fair value in New York.

Caveat

I have said this before, but it bears repeating: I am not an attorney.  Any analysis that I perform regarding case law in any jurisdiction is conducted from my perspective as a business appraiser and a businessman.  I have and offer no legal opinions.  However, I can examine the logic of relevant cases from business and valuation perspectives and do so in this series on statutory fair value in New York.

More Guidance from Beway

In the prior two posts, we cited certain “principles” regarding New York fair value determinations that suggest to me, as a valuation expert reading the case, that marketability discounts should not be allowed.  Nevertheless, the cat is out of the bag: Beway allowed a 21% marketability discount.  But wait, there’s more from Beway arguing for no DLOMs, including the following:

Consistent with that approach, we have approved a methodology for fixing the fair value of minority shares in a close corporation under which the investment value of the entire enterprise was ascertained through a capitalization of earnings (taking into account the unmarketability of the corporate stock) and then fair value was calculated on the basis of the petitioners’ proportionate share of all outstanding corporate stock (Matter of Seagroatt Floral Co., 78 NY2d, at 442, 446, supra [emphasis added]).

Seagroatt was an operating company.  The petitioner’s expert testified that he took the company’s lack of marketability into account in his capitalization rate and applied no marketability discount.  The Court of Appeals affirmed the reasonableness of this position.

When companies are valued, or when buyers and sellers negotiate over price, they negotiate directly based on the expected cash flows, their growth, and the risks associated with achieving them, as well as the net assets available.  I have been involved in more than one hundred corporate transactions over the last forty years.  There has been no discussion of a value and then a lower value based on a “lack of marketability” in a single transaction.

Companies do not lack marketability.  They sell in a different market than the public securities markets.  The market for businesses is not a market where “cash is available in three days.”  It is unrealistic and incorrect to compare the “marketability” of entire companies with transactions of minority interests in the public securities markets.  Owners of companies have all the rights of ownership during any period of marketing entire companies, including access to distributions and any benefits from growth during the marketing period.

The discount rates developed by business appraisers to appraise companies reflect the risks associated with marketing a business.  When multiples are developed based on comparable transactions, those multiples reflect any consideration of prior marketing since they are calculated on the transaction dates.

Marketing Occurs Prior to the Valuation Date in Real Estate

Similarly, the discount rates (or capitalization rates) developed by real estate appraisers to value real property also take “unmarketability” into account.

For further perspective on the applicability of marketability discounts, we look at the concept of exposure time in real estate appraisals.  Exposure time is defined at the right (from the current edition of the Uniform Standards of Professional Appraisal Practice, or “USPAP”).

Real estate appraisals assume exposure to the market has occurred, often for six to nine months before the valuation date and that a hypothetical sale occurs on the effective date of the appraisal.  The implication is that the appraisal conclusion is a cash-equivalent price.

Exposure time has been considered and is not a reason to justify a marketability discount.  Exposure time is defined in the Uniform Standards of Professional Appraisal Practice (USPAP) as (with numbers and emphasis added):

[1] an opinion, based on supporting market data,

[2] of the length of time that the property interest being appraised would have been offered on the market

[3] prior to the hypothetical consummation of a sale

[4] at market value

[5] on the effective date of the appraisal.

In market value determinations for real estate, it should be clear that the property has been exposed to the market before the valuation date.  We now look at the definition of “market value” in real estate for further clarity (from Advisory Opinion 22 of USPAP).  Numbers and emphasis are added.

“Market value means the most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.  Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

1. Buyer and seller are typically motivated;

2. Both parties are well informed or well advised and acting in what they consider their own best interests;

3. A reasonable time is allowed for exposure in the open market;

4. Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and,

5. The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.” (emphasis added)

The combination of the concepts of exposure time and market value makes clear that when a real estate appraisal is conducted as of a specified valuation date, the exposure/marketing time to achieve the appraised value has already been considered by real estate appraisers.  A hypothetical transaction occurs on the valuation date for cash or its equivalent in pricing.  The figure below shows exposure time in relation to the valuation date in real estate appraisal.

There is no economic reason to discount appraised real estate for lack of marketability.  Any issues regarding marketability have already been considered, as should be clear from the diagram.

What if Real Estate is in an Asset Holding Entity?

Consider a simple example.  A hypothetical New York LLC, 123 Example Street, LLC, owns the apartment building at 123 Example Street. The LLC is a “wrapper” for the underlying real estate. Many properties in New York and across the country are placed in LLC wrappers to minimize legal exposure from the property to the owners of the LLC and to facilitate ownership by multiple owners. LLCs are legal “wrappers” for properties and are generally not considered to impede the value of their underlying real properties.

123 Example Street was appraised as of an appropriate valuation date at $40 million.  That is a cash-equivalent value; the building is the LLC’s only asset.  There are no liabilities. Therefore, the net asset value of the LLC is $40 million.

Following the hypothetical transaction implied by the real estate appraisal, the LLC has the equivalent of $40 million in cash for fair value purposes. If the asset is sold, the cash proceeds can be distributed effectively without cost.

There is no reason to apply a “marketability discount” to the market value of the building because it has been exposed in an open and competitive market for sufficient time to conclude the hypothetical sale on the valuation date.

Similarly, there is no reason to apply a “marketability discount” to 123 Example Street, LLC, because it effectively has only cash.  Some of that hypothetical cash can be used to pay the dissenting shareholder their pro rata share of the $40 million.  Alternatively, the LLC can borrow the funds necessary to pay the dissenting shareholder, using the real property as collateral.

To bring closure to the concept of “marketability” or lack thereof for real estate or companies holding real estate, we examine one other figure.

The actual market data regarding earnings or revenue multiples for companies and capitalization rates for income-producing real estate reflect the fact that all “marketing” has been accomplished before transactions close.

• For business transactions, multiples derived from actual sales are developed as of the date of actual transactions, and those multiples reflect all considerations of the parties to them, leading to final pricing and closing.
• For real estate transactions, capitalization rates derived from actual sales are developed as of the date of actual transactions, and those cap rates reflect all considerations of the parties leading to final pricing and closing.

This logic and the figures above should clarify that there is no economic reason to discount appraised real estate or entities holding them for their lack of marketability.  The appraisal processes take “unmarketability” into consideration.

A Step Backward in Giaimo

Two asset-holding corporations in Giaimo were owned equally by siblings Janet Vitale and Robert Giaimo, with Janet in control.  The combined net asset values of the companies were about $100 million. Janet was buying out Robert’s shares, and the question before the court was the fair value of his shares.

Mercer testified in the 2011 trial conducted by a Special Referee in Giaimo that the appropriate marketability discount for the entities was 0%. Based on exposure time in the real estate appraisals and the high level of liquidity in the market for apartment buildings in Manhattan (per the real estate appraiser), Mercer further testified that there was no reason to discount the underlying real estate. He also testified that if a marketability discount must be applied, the cost of liquidation of the underlying real estate could be considered, which could not reasonably be more than 5% or so.

The Special Referee found that the appropriate marketability discount for each of the two corporations was 0%.

The Supreme Court (the trial court) also held that the appropriate marketability discount was 0% but differed with the Special Referee regarding the rationale for that conclusion.

The Appellate Division, First Department, concluded in 2012 that the marketability discount should be 16%, with the following rationale:

Here, the motion court correctly held that the method of valuing a closely held corporation should include any risk associated with the illiquidity of the shares (see Matter of Seagroatt Floral Co. [Riccardi], 78 NY2d 439, 445-446 [1991]) [ignoring guidance in Vick regarding valuation as if the “entire entity” had been sold]. It also properly rejected petitioner’s contention that this Court’s decision in Vick v Albert (47 AD3d 482 [1st Dept 2008], lv denied 10 NY3d 707 [2008]) limits the application of marketability discounts only to goodwill, or precludes such discounts for real estate holding companies such as the corporations at issue here.

The motion court erred, however, in assessing that the marketability of the corporations’ real property assets was exactly the same as the marketability of the corporations’ shares (see Seagroatt Floral, 78 NY2d at 445-446). While there are certainly some shared factors affecting the liquidity of both the real estate and the corporate stock, they are not the same. There are increased costs and risks associated with corporate ownership of the real estate in this case that would not be present if the real estate was owned outright. These costs and risks have a negative impact on how quickly and with what degree of certainty the corporations can be liquidated, which should be accounted for by way of a discount.

The Appellate Court believed that there are significant costs involved in liquidating real estate holding companies holding attractive apartment buildings in Manhattan other than commissions. I am not aware of other significant costs involved in liquidating an asset-holding company. The court did not elaborate on what expenses of “marketing” might be that would add up to 16% of the net asset values of the two corporations in Giaimo.  The Appellate Court went on to say:

Only respondent’s expert, Jeffrey L. Baliban, quantified what, in his opinion, would be the appropriate DLOM discount. He employed a number of studies of reported sales that bore some related characteristics to these particular corporations. He also employed a build-up method related to anticipated costs of selling the corporation that included real estate related costs and due diligence costs arising in the sale of closely held corporations. The studies and method employed reported a DLOM range of 8% to 30%, with Baliban recommending 20%. Petitioner criticizes all of the data and methods relied upon by Baliban as inapplicable. Neither the Referee nor the motion court addressed these arguments because they never reached the issue of the quantification of the DLOM. (emphasis added)

The various studies referenced by Mr. Baliban related to discounts at the shareholder level of value and not the company level. Having been present at all testimony of the business appraisers, I believe that the Special Referee did “reach the issue of the quantification of the DLOM.” He heard Mr. Baliban’s testimony and his discussion of several studies. He also heard my testimony in which I quantified the DLOM at 0%. The Special Referee then concluded that the appropriate marketability discount was no marketability discount or a 0% marketability discount, a quantified number.

The court failed to understand that 0% is a quantified discount, just like 5% or 16%.

The Appellate Division concluded:

Since the entire record is included on appeal, it is sensible and economical for us to decide this issue rather than remand the issue to the motion court for further consideration (see Wechsler v Wechsler, 58 AD3d 62, 77 [1st Dept 2008], appeal dismissed 12 NY3d 883 [2009]). We find that the build-up method, which makes calculations based upon expected projected expenses of selling a company holding real estate, best captures the DLOM applicable in this particular case. We conclude that a 16% DLOM against the assets of both corporations is appropriate and should be applied. Since the judgments have been paid, petitioner is directed to make restitution in an amount reflecting the discount (see CPLR 5523). (emphasis added)

It may have been “sensible and economical” for the Court of Appeals to decide the issue of the marketability discount in Giaimo, but the rationale employed made no sense from business and valuation perspectives.

The “build-up method” employed by Mr. Baliban made certain calculations “based upon expected projected expenses of selling a company holding real estate.” This so-called “build-up method” is not a recognized valuation method. Based on this evidence, the Appellate Division concluded a marketability discount of 16%. Real estate commissions the real estate appraisers in Giaimo might be on the order of 1.5% to 3.0% for transactions in the range of $50 million or more and up to 5% for smaller transactions. I have personally been involved in well over 100 transactions involving businesses over the last 40 years. I have not seen transaction expenses rise to the level of 16% in any of them.

A footnote comment regarding Mr. Baliban’s “build-up method” is appropriate.  There is nothing improper about “building up” a list of expenses and then totaling them. The conclusion of the build-up of expenses associated with selling a company holding real estate in the Baliban Report was apparently 20%. However, the build up has to make economic sense. The Appellate Court picked 16% as the cost of selling two corporations with very attractive Manhattan rental properties but made no comment regarding why 16% should be the appropriate discount and no comment about the reasonableness of the discount.

To put the court’s 16% marketability discount into some perspective, the combined net asset value of First Ave Village Corp. and EGA Associates was $97.1 million per the Mercer Report. At the Baliban Report’s 20% discount, the implied selling expenses are $19.4 million. At the Appellate Court’s concluded 16% discount, the implied expenses are $15.5 million.  This conclusion is simply mind-boggling.

If the cost of liquidating an asset-holding entity was 16% of the net asset value, no one would put real estate into an asset-holding entity.  The implied marketing expenses make no economic sense.

For further perspective, the NAV was $48.55 million for each of Janet and Robert based on my concluded NAV for the two corporations combined. Applying a 16% marketability discount lowered Robert’s value to $40.8 million, a reduction of 16%. Applying the 16% marketability discount increased Janet’s value to $56.3 million, an increase of 16%. The economic effect of the 16% marketability discount was to transfer $7.8 million of value from Robert to Janet. The shares owned by Robert and Janet were the same class of shares and identical except for the dissolution process. Nevertheless, Janet had shares worth $56.3 million upon closing, and Robert had shares worth $40.8 million for his otherwise identical shares. Janet’s shares were therefore worth 38% more than Robert’s shares.

Contrary to Beway, Robert did not get his proportionate interest a going concern and received unequal treatment relative to Janet’s shares.

Wrapping Up

From an economic standpoint, and business and valuation perspectives, applying a 16% marketability discount in Giaimo is tantamount to applying an implied or implicit minority interest discount of 16%. Whatever one calls the 16% discount, the detrimental economic impact on the selling shareholder is the same. The beneficial impact to the controlling shareholder is, dollar for dollar, equal to the detrimental impact to the selling owners.

From an economic standpoint and business and valuation perspectives, the application of a 21% marketability discount in Beway is tantamount to the application of an implied or implicit minority interest discount of 21%.  Whatever one calls the 21% discount, the detrimental economic impact on the selling shareholders is the same.  The beneficial impact to the controlling shareholders is, dollar for dollar, equal to the detrimental impact to the selling owners.

Recall that the combined net asset values of the nine corporations in Beway were $15.2 million.  Applying a 21% marketability discount reduced that amount by $3.2 million to $12.0 million.  Where did that “lost” $3.2 million go?  It went directly to the controlling shareholders, as illustrated in the final figure for this post.

The first quote in the first post in the series was from the Delaware Supreme Court’s decision in Cavalier (Cavalier Oil Corp. v. Harnett – 564 A.2d 1137 (Del. 1989)

More important, to fail to accord to a minority shareholder the full proportionate value of his shares imposes a penalty for lack of control, and unfairly enriches the majority shareholders who may reap a windfall from the appraisal process by cashing out a dissenting shareholder, a clearly undesirable result.

In the final analysis, the economic effect of applying a 21% marketability discount in Beway “…imposes a penalty for lack of control, and unfairly enriches the majority shareholders who may reap a windfall from the appraisal process…”

The same is true for the imposition of a 16% marketability discount in Giaimo.

Both results are contrary to the preponderance of guidance in Beway regarding statutory fair value determinations in New York.

In the next and likely final post in this series, we will look at the actual marketability discounts applied by New York courts in fair value determinations since about 1985.  As I have alluded, the results are interesting.

In the meantime, be well!  And certainly, please do comment below on this blog or to me personally.

Chris

The last post on this blog began a discussion of Friedman v. Beway, a 1995 New York Court of Appeals (First Department) decision.  Beway is considered by many New York attorneys to be the leading New York case on statutory fair value determinations in New York. In this post, we examine the trial court decision for help in understanding what happened at the Court of Appeals.

As always, I examine cases from business and valuation perspectives.

Net Asset Value is a Beginning Point

At trial in the Beway matter, the Supreme Court (the lower court in New York) held one session in which the net asset values of nine family-owned asset-holding companies were determined to total $128.2 million. The combined net asset values of petitioners’ shares totaled $15.2 million, as seen below.¹

Fair Value is Determined

The second session of the Beway trial addressed the determination of fair value for each entity and in total. The agreed upon combined net asset value was $128.2 million. The petitioners owned the interests indicated in the exhibit above, which was developed in the McGraw Report.

The petitioners’ expert concluded that the fair values for each of the interests were the net asset values of their percentage interests. He concluded the combined fair value was to be $15.2 million. Unfortunately, from my perspective, while his opinion was ignored, it was the “right” conclusion.

The Company’s expert, McGraw (identified as such in Beway), determined the fair value of the nine interests to be $5.9 million through a multi-tiered process of discounting. This conclusion represented a total discount of 61% to the combined net asset value of $15.2 million determined in the first court session.

The McGraw Report provided three methods in arriving at its preliminary conclusion:

• A net asset value method that examined the prices at which a number of publicly-traded REITs were trading. The average REIT discount was 9.8%, but the McGraw Report increased that to 25.0%. There was no discussion of what caused the increase from the 9.8% REIT discount to the concluded 25.0% discount. The indicated values summed to $11.4 million.
• The second method was a closed-end fund analysis. McGraw concluded that the appropriate discount to net asset value was 20% and reached an indicated value of $12.2 million.
• The third method was an investment value analysis. McGraw looked at several publicly traded real estate-oriented companies and used their metrics to apply to the Beway entities. The conclusion with this method was $9.5 million, or a 38% discount to the net asset value.

These three methods were then weighted 40% (net asset value using REITs), 20% (closed end fund analysis), and 40% (investment value method). The concluded value of all nine entities was $10.8 million, or a 29% discount to the net asset values of the nine entities.

This value was then discounted by an additional 45% based on an analysis of several restricted stock transactions (30.4%) and an incremental discount of 14.6% to reflect restrictions on transfers in the various operating agreements.

The Supreme Court evidently discounted a good bit of the discounting in the McGraw Report, accepting only its 30.4% restricted stock discount reduced by a 9.4% REIT discount (the actual discount was 9.8%, but the court used 9.4%), yielding a 21% marketability discount. The Supreme Court’s conclusion relative to that of the McGraw Report as shown below.

The Supreme Court did not accept McGraw’s REIT discount (neither the 9.8% nor the 25%). The Supreme Court did not accept McGraw’s closed-end fund analysis or his investment analysis, either. The Supreme Court’s 21% net discount was applied to the net asset values of the entities.

The Court of Appeals believed that reducing the restricted stock discount of 30.4% by 9.4% (actually 9.8%) was a “double counting” of the reduction for the REIT discount.

There was some confusion in the Supreme Court. The Court of Appeals remanded the matter back to the Supreme Court to address that confusion and to reach a conclusion based on a better understanding of the evidence. Following remand, the concluded marketability discount in Beway remained at 21%, as discussed in our prior post.

Having read the trial transcript of the Supreme Court’s valuation trial and the McGraw Report, it is clear to me why things were unclear there.

Perspective Based on Trial Court and Appeal

We observe the following from this analysis of Beway from business and valuation perspectives:

• The decision affirmed the conclusion that minority interest discounts are not applicable in New York fair value determinations.
• A significant portion of the Court of Appeals decision addressed the kind of value that fair value should be in a New York fair value determination.
• Based on my understanding of the case, any marketability discount should be applicable at the company level and not relate to the shareholder level of value.
• Importantly for a discussion of marketability discounts in 2022, we should note that all of the market evidence cited in the McGraw Report pertained to discounts for minority interests and did not pertain to company-level discounts. We will gain a better understanding of this confusion in the further discussion of the levels of value below.

The major valuation adjustments used in the McGraw report were based on:

• Closed-end fund analysis
• REIT discount analysis
• Restricted stock discount analysis

All of these “discounts” reflect shareholder-level discounts and are not applicable to the nine companies in Beway as whole companies. In other words, the discounts employed in the McGraw Report all pertained to moving from the middle level of the chart below to the bottom level and to developing the values of illiquid minority interests in the subject companies.

This three-level chart was generally understood by 1995 when Beway was decided, although it was not published until 1990. At the time, the application of marketability discounts to move from the marketable minority (middle) level to the nonmarketable minority (lowest) level was common. The McGraw Report applied minority interest marketability discounts to the corporation as a whole, which would now be viewed as inappropriate by most business appraisers.

We learned in the 1990s that the Control Value on the chart above related to strategic acquisitions of companies. As a result, it is inappropriate to use control premium information to infer minority interest discounts.

Marketability Discounts Applicable to Companies, Not Shares

The bottom line is that the “marketability discount” based on restricted stock analysis and the REIT and closed-end fund discounts employed by McGraw and accepted by the Supreme Court were discounts for the minority nature of small ownership interests, contrary to the confused guidance of Blake and Beway. I say confused because it is confusing from business and valuation perspectives.

Beway references the 1985 appellate level decision of Blake, stating:

However, a discount recognizing the lack of marketability of the shares of Blake Agency, Inc., is appropriate, and, under the circumstances of this case, the amount of the discount should be 25%. A discount for lack of marketability is properly factored into the equation because the shares of a closely held corporation cannot be readily sold on a public market. Such a discount bears no relation to the fact that the petitioner’s shares in the corporation represent a minority interest (citations omitted, emphasis added).

Reading this guidance carefully, a marketability discount can be considered “because the shares of a closely held corporation cannot be readily sold on a public market.” The inference is that all the shares of a closely held company cannot be readily sold on a public market. Reinforcing this, the quote goes on to say that a marketability discount “bears no relation to the fact that the petitioner’s shares in the corporation represent a minority interest.” If not, then any applicable marketability discount must exist because a corporation itself is not marketable, and its shares cannot be offered to the public markets.

The direct inference is that any marketability discount must be applicable at the level of the corporation itself rather than applicable to minority shares themselves. This is an important inference.

It follows that evidence reflecting comparisons of (minority interest) publicly-traded shares with restricted stock offer prices is irrelevant for marketability discounts in fair value determinations. These studies relate two different minority interest prices, the public price, and the placement price. They bear no relation to the marketability of any company at all.

Nevertheless, there is a failure to recognize this distinction in a number of New York fair value cases.

We look now at a levels of value chart applicable to asset holding entities to clarify these relationships. There is no concept of strategic control for asset holding entities, so now there are only three levels of value, the financial control/marketable minority value and the nonmarketable minority value.

Any Discount to NAV is “Unfair”

It is generally recognized today that the marketable minority and financial control levels of value coexist. The minority interest discount is generally considered to be very small or nil.

For asset holding entities, net asset value (market value of all assets less liabilities) is the financial control value. In practice, there is no minority interest discount. In New York fair value, there is no minority interest discount.

It should be clear that the imposition of a marketability discount takes the financial control value to the nonmarketable minority level of value, which is not the level of the enterprise.

There is no logic for the application of marketability discounts to entire companies, so the application of any marketability discount is really a disguised minority interest discount and creates “unequal treatment of shares of the same class of stock.”

The example below is similar to an example in our last post.

We look at the illustration “by the numbers.”

1. A corporation or LLC is owned by the controllers and the dissenters at 80% and 20%, respectively.
2. There are 100,000 shares outstanding, so shares are allocated pro rata to ownership.
3. The net asset value (NAV) of the entity has been determined by the appraisal to be $50 million.
4. NAV per share is, therefore, $500 per share, with $40 million apportioned to the controlling owners and $10 million to the dissenters.
5. A marketability discount of 16%, as in Giaimo, is applied.
6. The dissenters’ shares are devalued by $1.6 million. Where does that value go? To the controlling owners.
7. The controlling owners experience an increase in value to $41.6 million, and the dissenters realize a loss of $1.6 million ($10 million to $8.4 million).
8. Value per share for the controllers is now $520 per share, up 4% in Column 9, and the dissenters’ value falls to $420 per share, a reduction of 16%.

The math works the same whether a discount is called “minority interest” or “marketability.” Any discount from NAV for asset holding entities or otherwise determined fair value (financial control) results in a transfer of value from the dissenters to controllers.

This result is contrary to my understanding of guidance from Beway. And, it does not make sense from business and valuation perspectives to forbid a minority interest discount because it is “unfair” to dissenters,” and yet to allow a marketability discount through pained logic which is equally as “unfair.”

We will have one or two more posts related to Beway in the near future.

In the meantime, please comment on the blog below or to me personally.

Be well,

Chris

¹ Mercer Capital obtained the transcript of the Supreme Court trial in the Beway matter. We also obtained the valuation report prepared by Kenneth W. McGraw on behalf of Patricof & Co. Capital Corp (“the McGraw Report.”) The table below is excerpted from Exhibit 2 of the McGraw Report.

New York has been one of only a very few states allowing the imposition of marketability discounts in statutory fair value appraisal processes. Like nearly all other states, New York case law prohibits the use of minority interest discounts in fair value appraisals.

In this post, I will provide a review of a portion of a leading New York case in which the New York Appellate Division, First Department addresses the issue of minority interest and marketability discounts in statutory fair value determinations. As always, I review cases from business and valuation perspectives. I am not a lawyer; however, business appraisers are required to have a working knowledge of statutory and case law that are relevant to determinations of business value.

In a later post, I’ll review the Supreme Court’s (the lower court) decision in Beway to provide an understanding of the facts of the case that led to the Appellate Division’s decision. Following that, I will provide an analysis of historical marketability discount determinations in all (or, at least close to all) New York appellate court decisions addressing the issue. Readers will likely be surprised at the results.

Beway on Fair Value

The leading appellate level decision on the definition of fair value in New York is Beway, (Friedman v Beway Realty Corp., 206 A.D.2d 253, 614 N.Y.S.2d 133 (1st Dept. 1995).  Citing the Delaware Supreme Court case of Cavalier (Cavalier Oil Corp. v. Harnett – 564 A.2d 1137 (Del. 1989), Beway refers to the portion of the Cavalier decision that states:

More important, to fail to accord to a minority shareholder the full proportionate value of his shares imposes a penalty for lack of control, and unfairly enriches the majority shareholders who may reap a windfall from the appraisal process by cashing out a dissenting shareholder, a clearly undesirable result.

Beway goes on to discuss several “principles” of law relating to statutory fair value determinations. (emphasis added below):

Several principles have emerged from our cases involving appraisal rights of dissenting shareholders under Business Corporation Law § 623 or its predecessor statute.

(1) The fair value of a dissenter’s shares is to be determined on their worth in a going concern, not in liquidation, and fair value is not necessarily tied to market value as reflected in actual stock trading (Matter of Fulton, 257 N.Y. 487, 492).”The purpose of the statute being to save the dissenting stockholder from loss by reason of the change in the nature of the business, he [or she] is entitled to receive the value of his [or her] stock for sale or its value for investment” (id., at 494 [emphasis supplied]).

(2) The second principle does not inform any position on marketability discounts and is omitted.

(3) Fair value requires that the dissenting stockholder be paid or his or her proportionate interest in a going concern, that is, the intrinsic value of the shareholder’s economic interest in the corporate enterprise (Matter of Cawley v SCM Corp., 72 N.Y.2d 465, 474).

(4) The fourth principle does not inform any position on marketability discounts and is omitted.

(5) Determinations of the fair value of a dissenter’s shares are governed by the statutory provisions of the Business Corporation Law that require equal treatment of all shares of the same class of stock (Matter of Cawley, supra, at 473).

Principles (1), (3) and (5) relate directly to the applicability or not of marketability discounts.

Principle (1) requires that fair value “…be determined on their worth in a going concern. The same principle says further that “…he [or she] is entitled to receive the value of his [or her] stock for sale or its value for investment”  Principle (1) is inconsistent with the imposition of marketability discounts in fair value determinations.

Principle (3) is direct. “Fair value requires that the dissenting stockholder be paid for his or her proportionate interest in a going concern…”  The guidance goes on to describe fair value as “…the intrinsic value of the shareholder’s economic interest in the corporate enterprise.”  As with Principle (1), Principle (3) is inconsistent with the imposition of marketability discounts in New York fair value determinations.

Principle (5) provides the clearest guidance of all. Fair value determinations “…are governed by the statutory provisions of the Business Corporation Law that require equal treatment of all shares of the same class of stock”

This point from Principle (5) needs to be clear. Assume the following:

• The net asset value of an asset holding entity is $50 million
• There are 50,000 shares outstanding, so net asset value is $1,000 per share.
• A dissenting shareholder owns 5,000 shares or 10% of the entity.
• If a marketability discount of, say, 16% is allowed (as in Giaimo), the dissenter’s shares would be valued at $840 per share ($1,000 per share x (1 – 16%)), and his shares would be worth $4.2 million, or a total discount of $0.8 million.

What about the controller’s shares? The net asset value of the 90% controlling interest is $45 million. If a discount of $0.8 thousand is added to her value, they are worth $45.8 million. The controller’s 45,000 shares are, therefore worth $1,018 per share, or 21% greater than the $840 per share value for the dissenter. That is hardly “equal treatment of all shares of the same class of stock.”

Beway apparently did not consider additional guidance from Cavalier that pertains to the appropriateness of marketability discounts in fair value determinations in Delaware. A few paragraphs prior to the first quote from Cavalier above, we find:

Cavalier contends that Harnett’s “de minimus” (1.5%) interest in EMSI is one of the “relevant factors” which must be considered under Weinberger’s expanded valuation standard. In rejecting a minority or marketability discount, the Vice Chancellor concluded that the objective of a section 262 appraisal is “to value the corporation itself, as distinguished from a specific fraction of its shares as they may exist in the hands of a particular shareholder”. We believe this to be a valid distinction. [emphasis added]

The point is that Cavalier allows neither marketability nor minority interest discounts. If I quoted a business appraisal resource as supporting my opinion, that support would be undermined if, on review, that same source provided conflicting guidance two pages earlier and I did not somehow reconcile the apparent discrepancy in my report.

In the final analysis, the trial court allowed a 21% marketability discount in Beway. After providing the guidance noted above and much more that effectively argues for no marketability discounts, the Appellate Division, First Department did not disagree with the discount allowed by the lower court. The case was remanded to the Supreme Court to reconcile what the Court of Appeals thought was an apparent discrepancy in the lower court’s marketability discount. The final marketability discount, after remand, was 21%.

Beway clearly allowed unequal treatment of the same class of stock. It did not provide a value representing a proportionate interest in a going concern. And it did not provide the value of the dissenters’ shares and investments, rather charging them for illiquidity. Beway is difficult for me to understand. But then, I’m just a businessman and a valuation guy. However, as we will see in the near future, the final marketability discount in New York Appellate Court decisions has been 0% in half of the cases since 1985.

As always, please feel free to comment on this blog or to me personally. I’m interested in your feedback. In the meantime, be well.

Chris

There Is a Problem in Business Appraisal Land

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

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

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

And now for a bold conclusion at the outset:

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

And that’s a problem.

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

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

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

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

The definition of “Credible” in USPAP 2006 is:

CREDIBLE: worthy of belief.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What Is the Problem in Business Appraisal Land?

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

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

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

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

Try it.  You might like it.

Be well,

Chris

In Business Valuation: An Integrated Theory Third Edition (Mercer and Harms), we discuss the organizing principles of the “world of value.”  The Principle of Expectations is the first such principle.

Definition.  The value of a business is the present value of all expected future cash flows and their growth, discounted to the present at a discount rate reflective of the risks associated with the receipt of those cash flows.

Every business appraisal has a forecast of expected future earnings, either explicit or implied.  We discussed this concept in a recent post.  It should go without saying, but these forecasts should reflect reasonable expectations.  However, sometimes, the forecasts in business appraisal reports reflect unrealistic expectations.

One of the most frequent problems seen in appraisal reports today is the use of projected earnings that bear little or no resemblance to those of the past.  These projections often lack any explanation of how the rose-colored glasses through which they view a business reflect realistic expectations for the future of a business.  The projections phenomenon is so common that it has been given a name: hockey-stick projections.

In a deposition a number of years ago, I was asked how a bank with currently low earnings could possibly meet the projections found in bank management’s own current capital plan for the next five years.  The deposing attorney accused me of unrealistically relying on the capital plan, which was prepared by his client for regulatory review in the normal course of business.  How could any bank possibly achieve a hockey-stick set of projections. (Parenthetically, this was a statutory fair value matter in which the bank had squeezed out my client. The bank wanted a low result, of course; however, my client, a large minority shareholder, wanted at least a reasonable result).

I referred the attorney to the exhibit in our report that compared the previous five years’ performance with the earnings and returns of the capital plan.  There, it was clear that the projected returns (on assets and equity) were within the levels achieved by the bank in the previous few years, and below the current level of the bank’s peer group.  Value today is a function of expectations for future performance – and the expectations used were in line with past performance, management’s stated plans, management’s business plan, and the performance of similar banks.

Valuation analysts should remember that every going-concern business appraisal reflects, either implicitly or explicitly, a projection of expected future performance.  If the expectations imbedded in the valuation are not realistic, the resulting conclusions will be flawed.

Until next time, be well.

— Chris

Get your copy of Business Valuation: An Integrated Theory Third Edition (Mercer and Harms), which is available on Amazon.com.

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

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

Background

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

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

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

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

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

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

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

Analysis

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

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

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

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

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

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

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

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

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

A Recent Survey

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

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

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

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

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

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

Conclusion

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

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

In the meantime, be well!

Chris

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