Rethinking Discounts For Lack Of Marketability?

Arthur H. Rosenbloom, Managing Director, CFC Capital, LLC

Over the years, practitioners seeking to quantify discounts for lack of marketability ("DLOM") in going concern valuations for estate and gift tax, ESOP and other purposes have employed a number of techniques to support their DLOMs. In this issue, we review some of the methods historically employed and spotlight some new thinking in the area.

A Look At History

Historically, at least three methods for DLOM quantification have been employed: (i) restricted stock studies based on discounts from publicly traded shares taken in private placements of such securities1; (ii) discounts from IPO prices represented by sales reasonably close to the IPO's effective date, of the same class of common stock as that being registered2 and; (iii) a discount determined as the excess of the current value of the private stock (before consideration of a DLOM) over an amount determined as follows: Estimate a time horizon for the liquidation of the subject interest to arrive at a liquidating price based on an assumed growth of the non-discounted value from the valuation date together with the interim cash flows to the holder. Discount the result back to present value at a rate reflecting the uncertainties associated with illiquidity (the "Quantitative Marketability Discount Model").3

All of these studies have some probative force - none holds the Rosetta Stone on the question of DLOM quantification. In all instances, the size of the block, the character of the company and the presence or absence of liquidity-producing elements like registration rights (each of which is sui generis) can create significant differences in the size of the DLOM. More specifically, the DLOMs derived from current restrictive stock studies understate the DLOM because the liberalization of Rule 144 during the 1990s made restricted stock more liquid and correspondingly, less useful as a proxy for private equity securities. The validity of DLOMs determined through pre-IPO studies is called into question by the potential influence of non-arm's-length transactions (despite proponents' contentions that such influences have been weeded out). Finally, the Quantitative Marketability Discount Model associated with the work of Chris Mercer requires a series of quite subjective estimates, modest variations on some of which (like the discount rate) can result in major changes in the size of the DLOM.

Some New Thinking

The traditional levels-of-value model found in the valuation literature postulates three levels of value respecting equity interests: controllevel value, marketable minority interest value, and non-marketable minority interest value. The DLOM represents the difference between the latter two. A 21st century approach4 to the levels-of-value model recognizes four levels of value - the additional level of value is the restricted stock value level, which lies between the marketable minority interest value and the non-marketable minority interest value. The DLOM is then measured as the sum of the discount in going from the marketable minority interest value level to the restricted stock value level (the "restricted stock equivalent discount") and the discount in going from the restricted stock value level to the non-marketable minority interest value (the "private equity discount increment").

Findings of the proponents of the new methodology suggest that the principal driver of the DLOM is the financial risk profile of the issuer, whose SIC code only minimally impacts the discount. The DLOM is negatively correlated with nine specific factors and positively correlated with three. The nine negatively correlated factors are the company's aggregate market capitalization, the absolute dollar level of its revenues, the issuer's earnings and profit margins, its dividend payout ratio, its total assets, book value, price per share, trading volume and block size in absolute dollars. The three positively correlated factors are block size as a percentage of total ownership, the subject stock's volatility (Black Scholes redux) and the subject entity's market-to-book value ratio.

The model's underlying rationale derives from the indisputable conclusions that private equity is less liquid than most restricted stock and that large block transactions in restricted stock closely resemble private equity, resulting in the following analytical process: (i) determine the restricted stock equivalent discount by performing the traditional restricted stock analysis that considers the factors set forth in the previous paragraph; (ii) determine the private equity discount increment by performing restricted stock studies on larger blocks of stock that are subject to more stringent liquidation requirements under Rule 144, subtracting from this amount the discount determined from a restricted stock study for a universe of otherwise comparable smaller-block stocks; and (iii) add the DLOMs of (i) and (ii) to determine the total DLOM. 5


As in all studies, the devil lies in the details. Space limitations prevent our ability to set forth with particularity the analytical techniques employed in each of the subsets described in the article. Suffice to say however that, at least in the illustration provided in the article cited in Endnote 4, the discount (52%) is higher than those typically observable in many of the older studies, thus commending it to the attention of practitioners required to assert or controvert the discount.

1 We refer. in this regard, to the SEC study of 1971, the Gelman and Trout studies of 1972, the Moroney study of 1973, the Standard Research Consultants study of 1983, the Willamette Management Associates study of 1984, the Silber study of 1991, the FMV Opinions Tax study of 1994, and the Management Planning study of 1996. The results of these studies are concisely summarized in Pratt, Reilly & Schweihs, Valuing A Business, (Fourth Edition, McGraw- Hill, 2000 pp. 396-403) where a range of average discounts was 23.0 - 45.0%

2 Such studies are generally known as the Robert W. Baird & Company or the Emory studies and the Willamette Management Associates studies. These studies are sum marized in Pratt, Reilly & Schweihs, supra, pp. 407-411. The mean and median in the Baird studies are reported as 44% and 43%, respectively.

3 See Z.Christopher Mercer, Quantifying Marketability Discounts, (Peabody Publishing, 1997).

4 See Espen Robak, Liquidity and Levels of Value: A New Theoretical Framework, Shannon Pratt's Business Valuation, Volume 10, Number 10, October 2004. This article is the first in a scheduled three part series.

5 For example, suppose the freely traded value for a minority stock interest is $100. The restricted stock equivalent discount can be determined through a restricted stock study, taking into account the factors that impact the subject company's risk profile. Suppose that amount is $25. In addition, a private equity discount increment of $20 is determined by comparing the restricted stock discounts on large-block transactions to those of smaller-block transactions. The DLOM is then the sum of these, or $45, and the FMV of the subject interest is $55. The 45% DLOM is certainly in line with the discounts suggested by commentators, although courts have often been less generous in their holdings.