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