KEY WORDS: Valuation; Discount for Lack of Marketability

EXECUTIVE SUMMARY: The IRS has released to the public a 107 page document entitled “Discount for Lack of Marketability Job Aid for IRS Valuation Professionals.” This document summarizes and evaluates most of the methods that are currently in use for determining a discount for lack of marketability (“DLOM”).

FACTS:

The IRS has released to the public a 107 page document entitled “Discount for Lack of Marketability Job Aid for IRS Valuation Professionals.” This document summarizes and evaluates most of the methods that are currently in use for determining DLOM.

At the beginning of the Job Aid, the IRS makes clear what its alleged intentions are with respect to its issuance:

It is not meant to provide a cookbook approach to evaluating a marketability discount as proposed by a taxpayer or to setting a proposed marketability discount in the case of an independent governmental appraisal. It is emphasized that, all background and existing practices aside, the establishment of a Discount for Lack of Marketability is a factually intensive endeavor that is heavily dependent upon the experience and capability of the valuator. By bringing the included material together in one document, we are striving to make the job of the IRS valuation analyst easier. We do not mean to provide guidance as to reasonable levels of marketability discounts that would prevail in all situational contexts or to imply that the IRS has any policy per se in the evaluation or the determination of such discounts.

The table of contents of the Job Aid is very instructive and is as follows:

Table of Contents
A. EXECUTIVE SUMMARY …………………………………………………………………………… 1
B. NTRODUCTION………………………………………………………………………………………. 3
C. GENERAL MARKETABILITY DISCOUNT INFORMATION …………………………………… 5
1. MARKETABILITY DEFINED………………………………………………………………………… 5
2. FACTORS INFLUENCING MARKETABILITY IDENTIFIED …………………………………….. 6
3. WILLING SELLER CONSIDERATION ……………………………………………………………. 8
4. MARKETABILITY OF MINORITY VS. CONTROLLING INTERESTS …………………………. 9
5. SAMPLE INITIAL IDR ITEMS ON MARKETABILITY……………………………………………10
D. SUMMARY OF APPROACHES TO DLOM……………………………………………………..12
1. BENCHMARK APPROACHES …………………………………………………………………..12
a) Restricted Stock Studies ……………………………………………………………………12
b) Pre-Initial Public Offering (Pre-IPO) Studies………………………………………….19
c) Restricted Stock Equivalent Analysis …………………………………………………..23
d) Cost of Flotation……………………………………………………………………………….25
e) Mandelbaum Factors, Judge Laro, 1995 ………………………………………………27
2. SECURITIES-BASED APPROACHES……………………………………………………………30
a) Long-Term Equity Anticipation Securities (“LEAPS) – Robert Trout, 2003,
and Ronald Seaman, 2005…………………………………………………………………30
b) The Longstaff Study, Journal of Finance, December 1995 ………………………32
c) The Chaffee Study ……………………………………………………………………………35
d) Bid-Ask Spread Method to Determine DLOM………………………………………..36
3. ANALYTICAL APPROACHES………………………………………………………………………..39
a) Karen Hopper Wruck…………………………………………………………………………41
b) Hertzel and Smith……………………………………………………………………………..43
c) Bajaj, Denis, Ferris and Sarin……………………………………………………………..46
d) Ashok B. Abbott ……………………………………………………………………………….50
4. OTHER APPROACHES …………………………………………………………………………..54
a) QMDM (Christopher Mercer) ………………………………………………………………54
b) NICE (William Frazier)……………………………………………………………………….56
c) NERA (David Tabak)…………………………………………………………………………59
d) Partnership Profiles (Partnership Spectrum) …………………………………………62
e) Public vs. Private P/E Ratios in Acquisitions (MergerStat)……………………….65
E. EVALUATION AND RECOMMENDATIONS …………………………………………………….68
1. APPROACHING MARKETABILITY DISCOUNT AS A REVIEWER …………………68
2. APPROACH MARKETABILITY DISCOUNT AS A VALUATOR……………………………….68
3. DEALING WITH MARKETABILITY DISCOUNT IN A REPORT REVIEW UNDER CERTAIN
SPECIFIC SITUATIONS – TYPICAL REPORT LANGUAGE FOR GETTING STARTED …….69
a) Use of Pre-IPO studies to support DLOM……………………………………………..69
b) Use of simple average or median from Restricted Stock Studies ……………..70
c) Use of analytical study results without getting behind data………………………73
d) Use of study results not supported by market data……………………………….. 74
e) Reliance solely on court decisions ……………………………………………………..75
4. SOURCES AVAILABLE TO IRS VALUATION ANALYSTS…………………………………..76
Table of Contents
F. SUMMARY AND CONCLUSIONS ………………………………………………………………..78
G. BIBLIOGRAPHY…………………………………………………………………………………….79
TABLE 1 ANALYSIS OF SEC INSTITUTIONAL INVESTORS RESTRICTED STOCK STUDY.84
TABLE 2 ANALYSIS OF MPI RESTRICTED STOCK STUDY…………………………………85
EXHIBIT A—REVIEW FMV RESTRICTED STOCK MODEL………………………………….86
EXHIBIT B—PRE-IPO STUDIES………………………………………………………………….95
EXHIBIT C—ANALYTICAL APPROACH REVISITED…………………………………………. 98
EXHIBIT D—DLOM FILES ON SHARED FOLDER ………………………………………….106

The following quote describes what the Job Aid purported to do:

First, we will identify the current state of DLOM studies and methods—ranging from the SEC Restricted Stock study prepared in 1971 to the Liquistat database announced in 2007. We will endeavor to explain the intent of the approaches most widely relied upon by practicing valuators as to how each estimates DLOM. We will identify the parameters used in a given approach, the strengths and weaknesses of the approach, the view of the valuation community concerning the approach, and what the courts have had to say about the approach, if anything. The job aid also provides initial IDR questions for examination of DLOM and some sample report language for reviewers to consider in situations where it’s clear that the approach being used by the taxpayer is in error.

The Job Aid sets out a series of so-called factors affecting marketability, divided between subject company factors and subject interest factors, as follows:

Subject Company Factors

• Value of subject corporation’s privately traded securities vs. its publicly traded securities (or, if the subject corporation does not have stock that is traded both publicly and privately, the cost of a similar corporation’s public and private stock)
• Dividend-paying (or distribution) ability and history
• Dividend yield
• Attractiveness of subject business
• Attractiveness of subject industry
• Prospects for a sale or public offering of the company
• Number of identifiable buyers
• Attributes of controlling shareholder, if any
• Availability of access to information or reliability of that information
• Management
• Earnings levels
• Revenue levels
• Book to market value ratios
• Information requirements
• Ownership concentration effects
• Financial condition
• Percent of shares held by insiders
• Percent of shares held by institutions
• Percent of independent directors
• Listing on a major exchange
• Active vs. passive investors
• Registration costs
• Availability of hedging opportunities
• Market capitalization rank
• Business risk

Subject Interest Factors

• Restrictive transfer provisions
• Length of the restriction period
• Length of expected holding period
• Offering size as a % of total shares outstanding
• Registered vs. unregistered
• General economic conditions
• Prevailing stock market conditions
• Volatility of stock

The following quote is very instructive of the IRS general attitude regarding DLOM:

If you are approaching the question of DLOM fresh, either as a reviewer confronted with an unreasonable taxpayer position based on invalid approaches or as a valuator charged with making your own valuation discount decisions, it is often helpful to start with a basic question as relates to DLOM. That question is: “Under the prevailing facts and circumstances and considering the nature of the interest to be valued why is the DLOM not zero?”

Interestingly, the Job Aid instructs IRS personnel on what information to request in audits and how that information (in brackets) affects DLOM:

The evaluation of the appropriateness of a discount for lack of marketability requires the collection and analysis of a substantial amount of information about the entity involved and the subject interest in that entity whose marketability is being considered. We provide below a list of typical inquiry areas that can be put forth in Information Document Requests toward the end of collecting such information. The bracketed notes below each item offer commentary about that item’s relevance in evaluating its contribution to the lack of marketability and/or lack of liquidity determination.

a. History of dividend payments [cash dividends are a “liquid” return on investment, which might lower lack of marketability risk]
b. Salaries and bonuses paid to the Officers of the company, over the five years leading up to the valuation date [especially in companies that don’t pay dividends, Officers’ compensation can provide cash flow to shareholders, which might lower lack of marketability risk]
c. Compensation and/or fees paid to the Directors of the company, over the five years leading up to the valuation date [especially in companies that don’t pay dividends, Directors’ fees can provide cash flow to shareholders, which might lower lack of marketability risk]
d. List of all marketable securities (description, number, cost value) shown on the latest financial statements [cash-equivalent securities might lower liquidity risk on a company-wide basis]
e. List of all non-marketable securities and investments (description, number, cost value) shown on the latest financial statements [can provide information on how long it might take to liquidate non-marketable assets]
f. Breakdown of adjusted cost basis for each of the marketable and nonmarketable assets owned by the company on the valuation date [can provide information on built-in capital gains tax expense to liquidate the company]
g. Indicate if the adjusted cost basis of any of the company’s marketable or non-marketable assets reflects a carry-over cost basis, pursuant to a Section 1031 (or similar type) tax-deferred exchange [can provide information on whether the company pursues available tax-deferral strategies]
h. Current list of shareholders/partners showing the name of each shareholder/partner and the class and number of shares owned by each shareholder as of the valuation date [can provide information on relative ownership distribution and total number of shareholders]
i. Copies of notes receivable (and/or notes payable) between the company and any shareholders, over the five years leading up to the valuation date [loans to/from shareholders might be relevant to evaluating lack of marketability risk]
j. Company articles of incorporation and amendments, by-laws and amendments or partnership agreements and amendments [by-laws might address restrictions or procedures for transfer of shares]
k. Copy of all shareholder agreements (such as buy/sell agreements, stock option agreements stock purchase agreements, etc.) that have been in effect during the five years prior to the valuation date [shareholder agreements might address restrictions or procedures for transfer of shares]
l. All documents pertaining to any sale of the company, a division or unit of the company, or shares (interests) in the company during the five years prior to the valuation date [recent sales/transfers might be might be relevant to evaluating lack of marketability risk]
m. Board of Directors Meeting Minutes, for five years leading up to valuation date [Board meetings might address shareholder requests for sale/transfer of shares]
n. Complete financial statements of the company for the five fiscal or calendar years prior to the valuation date, including balance sheets, income statements and cash flow statements [can provide additional information for evaluating lack of marketability risk]
o. Complete income tax returns for the five fiscal or calendar years prior to the valuation date, including any audit adjustments [tax returns might include details that are not stated within the regular financial statements]
p. Brief history and/or description of the company or the company’s business (may already be included in an appraisal report) [can provide additional information for evaluating lack of marketability risk]
q. Brief statement of duties of subject shareholder’s participation in company operations [can provide additional information for evaluating lack of marketability risk]

COMMENTS:

On the whole, the Job Aid is fairly well done. It is not without some problems. However, the Job Aid left out several other DLOM methods of which I am aware. Additionally, the Job Aid severely and somewhat uncharacteristically (for the Job Aid) criticizes the FMV Opinions restricted stock model, which strongly suggests that the IRS must be seeing a lot of this in use.

CITES: Discount for Lack of Marketability Job Aid for IRS Valuation Professionals- http://www.irs.gov/businesses/article/0,,id=244397,00.html