Mandelbaum is a 1995 Tax Court Memorandum providing an analysis of the marketability discount issue. The case represents the consolidated cases of three brothers, Bernard, Leon, and Max Mandelbaum. At issue was the appropriate value for minority interest gifts the brothers made to their children on six dates from 1986 to 1990. The parties stipulated the fair market values of the shares of Big M, the family business, at the freely tradable level of value at various dates, leaving the Court to determine only the appropriate marketability discount.
Mandelbaum was written by Judge David Laro (now deceased), who became active in business valuation cases in the years leading up to the publication of the case. Judge Laro spoke about this decision shortly after its issuance at the International Conference of the American Society of Appraisers held in June 1995 in Denver, Colorado and at other venues thereafter.
Regarding the marketability discount issue, the Court reviewed the reports of appraisers for the taxpayers and the government in depth. The taxpayer’s expert employed a shareholder level discounted cash flow analysis akin to the Quantitative Marketability Discount Model, citing an early article on the QMDM in his report. His concluded marketability discount was 75% (and 70% for one date). He also used traditional references to restricted stock studies and to pre-IPO studies.
The appraiser for the government employed primarily a restricted stock analysis and concluded that the marketability discount should be 30%.
The Court concluded that the marketability discount should be 30%, as well, but not as a result of passive acceptance of the government’s appraiser’s opinion.
The Mandelbaum “Benchmark Range”
The Court relied upon the taxpayer’s expert’s analysis of restricted stock studies and pre-IPO studies in establishing a benchmark range of 35% to 45% to compare the other nine factors:
We find that the 10 studies analyzed by Grabowski are more encompassing than the three studies analyzed by Mallarkey. Because Grabowski’s studies found that the average marketability discount was 35 percent, and that the average discount for the IPOs is 45 percent, we use these figures as benchmarks of the marketability discount for the shares at hand.
The “benchmark range” became listed as a factor, so there were ten factors in the Mandelbaum decision. However, given the range, there were only nine other factors, summarized here.
- Financial statement analysis.
- Company’s dividend policy.
- Nature of the company, its history, its position in the industry and its economic outlook.
- Company’s management.
- Amount of control in transferred shares.
- Restrictions on transferability of stock.
- Holding period for the stock.
- Company’s redemption policy.
- Costs associated with making a public offering.
Astute readers will note that the bolded factors are not factors relevant to developing marketability discounts. Rather, financial statement analysis, the company’s history, outlook, and management are factors relevant to the development of value at the marketable minority level. Nevertheless, we follow the Court’s analysis as we proceed.
Judge Laro discussed each of the factors in Mandelbaum and reached a conclusion regarding whether each factor would lead, relative to the benchmark range of 35% to 45%, to an average, above average, or below average marketability discount.
With this benchmark range in mind, recall that there is no economic information in a single restricted stock discount. There is no economic information on the averages of many restricted stock discounts. So the Mandelbaum “benchmark range” begins from a point of providing no economic information with which to discern marketability discounts.
Factor 1: Financial Statement Analysis
The Court missed the analytical boat in the discussion of financial statement analysis. A casual reading of the decision would lead one to believe that Big M was an attractive company. However, its performance was significantly deteriorating over the period of analysis, as can be seen in the figure below.
The Court concluded its financial analysis with the following:
Given the additional fact that Big M’s stores are widely recognized in the industry, we conclude that these factors favor a below-average marketability discount for stock in Big M on each of the six valuation dates. (emphasis added)
The Court appears to have been using a “general attractiveness” argument in reaching its conclusion. Regardless, we move on to the second factor.
Factor 2: Company’s Dividend Policy
Big M paid a small dividend in the first three years of analysis. Then, no dividends were paid for four years. A larger dividend was paid in the last year of analysis.
The Court concluded that the company’s dividend policy favored a below-average marketability discount. There was some confusion between dividends and dividend-paying capacity in the decision. Given recent performance at Big M, the prospects for future dividends was the relevant consideration. Nevertheless, there was a dividend and the court concluded that it should contribute to a below average marketability discount.
Factor 3: Nature of the Company
The Court concluded that the nature of the company and its outlook should lead to a below-average marketability discount. In so doing, factors redundant to its financial analysis were considered:
Investors generally regard the nature of a company, its history, its position in the industry, and its economic outlook as relevant factors for determining the worth of the company’s stock.
These factors are clearly fundamental business elements that are considered in the valuation at the freely traded level.
In the instant case, Big M was not the leader in its industry, its operations, however, were diversified and very profitable as of all six valuation dates. The future of Big M looked bright on each of these dates.
The Court is adding to its “general attractiveness” argument from above, but the facts do not support the conclusion.
Factor 4: Company’s Management
The Court’s consideration of management called for a below-average marketability discount. Management was described as proven, experienced, and well-known in the industry. The Court went on to say:
Based on its track record, an investor would have reason for confidence in Big M’s management team. Big M’s policy decisions have furthered the business of the company as a whole, rather than promoting the interests of only the shareholders belonging to a particular branch of the family.
The quality and effectiveness of management is a fundamental valuation factor and is considered in the valuation at the freely traded level. Management is responsible for the historical record. Performance shows a long-term trend of decline.
The issue of management is yet another argument of “general attractiveness” that is properly considered in the valuation at the freely traded level, prior to the application of a marketability discount. The favorable consideration of an unfavorable trend tends to understate the marketability discount in the Court’s analysis.
Factor 5: Amount of Control in Transferred Shares
The Court concluded that none of the blocks of Big M shares represented control of Big M and that this factor should favor an average marketability discount.
Since the largest block of stock considered in Mandelbaum consisted of one thousand shares, representing a 10.4% interest in Big M, we have no real argument with this point in the context of the Court’s framework.
Factor 6: Restrictions on Transferability of Stock
The restricted nature of the shares favored an above-average to average marketability discount in the Court’s opinion.
When criticizing the government’s expert, the Court indicated that the Shareholders’ Agreements would have a “chilling effect on prospective investors.” When criticizing the taxpayer’s expert, the Court disagrees that the agreements would “severely restrict” marketability, as advanced by the taxpayer’s expert. The Court indicated that “some consideration” of the agreements was necessary. In the Court’s lexicon, it would appear that simple logic requires an appropriate conclusion of above-average to the weight to be accorded to this factor. The description of the shareholders’ agreement in the decision suggests that there were, indeed, severe restrictions on transfer and potentially adverse consequences in the event of the death of an owner.
In the context of the discussion, it appears that the Court believed that most of the taxpayer’s analysis hinged on his comment regarding “severely restricting” marketability to reaching his conclusion of 70% and 75% marketability discounts. My reading suggests that it was only one element. Regardless, we have the Court’s conclusion on this factor.
Factor 7: Holding Period for the Stock
The Court considered the holding period factor to be “neutral” with respect to its concluded marketability discount. The evidence of both experts was disregarded:
Grabowski assumed that an investor in Big M stock must hold his or her stock for 10 to 20 years. Mallarkey assumed a shorter period of 2 years. We are not persuaded by either assumption.
Unfortunately, the expected holding period faced by a hypothetical or real investor is not a matter to be considered as either positive, negative, or neutral, except in the context of similar investments with different holding periods. Most investors making investments in closely held securities do so with some expectations regarding the anticipated length of the expected holding period. Those expectations result from the facts and circumstances surrounding the investment and the entity that is the subject of the investment.
The facts reviewed in the Court’s opinion leave little doubt that a rational investor would expect a lengthy holding period for a minority investment in Big M stock. Based on the facts as presented, I would not consider any holding period shorter than the five to ten year range, and Grabowski’s assumption of a 10 to 20 year holding period is certainly supported by the facts. The holding period factor should be accorded a significantly above-average contribution to the marketability discount in the Court’s framework.
Factor 8: Company’s Redemption Policy
Noting that the record did not indicate whether Big M had set a redemption policy, the Court cited one redemption of 900 shares (representing an estimated 8.5% of the shares then outstanding) “in or about 1974.” The Court concluded that the company’s redemption policy favored a below-average marketability discount.
The sole redemption occurred about 12 years prior to the earliest valuation date in the case, and 16 years prior to the latest valuation date. The Court’s discussion on the issue stated:
Big M did so [the redemption] because Bernard [one of the founding Mandelbaums] needed the money to settle a divorce from his former spouse. We also know that the Shareholders’ Agreements gave Big M the right to purchase its shares before a buyer outside of the Mandelbaum family may do so and does not set a price for these shares.
Given that Big M has previously redeemed shares for the sole benefit of one of its shareholders, we find nothing that would prevent it from later redeeming the shares of a seller at their freely traded value (or greater) in order for Big M to remain family owned. We believe that a hypothetical willing buyer or seller would consider Big M’s prior redemption in a favorable light when viewing the price that he or she would assign to the shares. [parentheticals added]
A single redemption from a family member some 12 to 16 years prior to the valuation dates would seem to provide little comfort to a hypothetical willing investor that his or her shares might be redeemed on a favorable basis at any time in the future.
Factor 9: Costs Associated with an IPO
The Court concluded that costs associated with a public offering of shares favored an above-average to average marketability discount.
Investors consider the costs associated with making a public offering in determining the value of unlisted stock. An above-average to average discount is warranted if the buyer completely bears the cost of registering the purchased stock. The discount is lessened, however, to the extent that the buyer has the ability to minimize his or her registration costs. Registration costs may be minimal to the buyer, for example, if he or she has the right to compel the corporation to register (or otherwise “piggy-back”) the unlisted shares at its expense.
The Court’s analysis indicates some misunderstanding of the nature of public offerings. For a company the size of Big M (at least in the years prior to the fiscal year 1990), the costs of flotation, including brokerage commissions and the expenses of the offering, might run on the order of 10% of the funds raised in an IPO, plus or minus, depending upon circumstances and the size of the offering. This book has not considered the cost of flotation as an important element in determining marketability discounts because, under the most optimistic interpretation, such costs would account for only a small portion of any marketability discount, particularly if discounts at or near the Court’s benchmark range are appropriate. And keep in mind that the costs associated with making a public market are only relevant to companies that can viably make an initial public offering.
The Court reached a conclusion of average, above average, below average or neutral for the nine factors just discussed and concluded that, relative to the benchmark range of 35% to 45%, the appropriate marketability discount should be 30%. I thought about how to show this analysis quantitatively and developed the following figure. For each of the nine factors, a point estimate of the marketability discount was made. These estimates are, of course, imprecise, but estimates something like these will lead to the Court’s concluded 30% marketability discount.
Using the Court’s factors and conclusions relative to the benchmark range, I made some estimates of implied marketability discounts for each factor as shown in the table above. The estimated discounts are shown in the context of the range. The assumed discounts above yield a concluded marketability discount of 30%. Judge Laro did not discuss an analysis like this, but rather, he “estimated” the discount based on his qualitative assessment of the below, above averages and neutrals.
Three of the factors do not relate to the value of interests at the nonmarketable minority level of value. If we just consider the relevant shareholder-level considerations, the average rises to 36.7%.
This so-called “Mandelbaum Analysis” has received a good deal of valuation press over the years. The problem is that it was not workable when written in 1995 and it is not workable today.
I applaud the qualitative analysis relating to the shareholder-level considerations; however, no amount of divining will lead an analyst to reasonable conclusions using this benchmark analysis.
As always, please feel free to comment on this post.