Use long-term equity anticipation securities to support discounts for lack of marketability
When the time comes for your client to sell or gift shares of stock in a privately held company, how do you determine the value? Valuation experts use various approaches to arrive at a company's value and come up with a conclusion. Often that conclusion includes a discount to account for the fact that shares of a privately held company can't be bought or sold on a public exchange like the New York Stock Exchange. Valuation discounts — particularly discounts for lack of marketability (DLOMs) — play a major role in your client's estate, tax and gift planning.
But how does an appraiser come up with a discount that a court or the Internal Revenue Service will accept? Appraisers currently use various methods, such as restricted stock studies, to support their DLOMs. But more and more, courts have been requiring appraisers to better substantiate their DLOMs. LEAPS — an acronym for long-term equity anticipation securities — provide a market-based range of value and significant guidelines for a conclusion within that range.
To arrive at a viable DLOM, an appraiser can look at companies that offer publicly traded LEAPS put options. LEAPS offer at least three benefits over other valuation methods that appraisers typically use. LEAPS provide discounts that are date-specific; they are easily observable in public markets by anyone; and they are simple to explain and understand.
LEAPS is an exchange listed option that grants a “buyer (holder) the right, but not the obligation, to buy, in the case of a call, or to sell, in the case of a put, a specified amount of the underlying asset at a predetermined price on or before a given date.”1 During the LEAPS option term, which ranges from six to 26 months, LEAPS “provide a medium to long-term insurance or hedge for stock owners in the event of a substantial decline in their stock.”2
There are over 800 LEAPS listed on several stock exchanges (like the Chicago Board of Exchange) and actively traded. LEAPS are American-style options that can be exercised at any time prior to their expiration date. LEAPS are issued in September, October and November each year and expire on the third Saturday of January, either two or three years later.
For example, if you purchased 100 shares of Procter and Gamble (P&G) stock in November 2009 at $60 per share, you also could have purchased a LEAPS put option for $8 per share. This put option would guarantee that you could sell your stock for the price you paid for it (that is, $60 per share) at any time until mid-January 2012 (approximately 26 months after your original purchase date). Thus, you would be protected against a loss in value of your stock, and at the same time you would be able to take a profit at any time during the 26 months by selling the P&G stock if it increased in value.
A LEAPS put option, purchased at an exercise price that is the same as the underlying stock owned, guarantees against loss in value during the option period. The cost of a LEAPS put option, expressed as a percentage of the price of the underlying stock, is the cost of price protection against the loss of value of the stock during the holding period.3 The risk of loss of value over time is a major portion of the DLOM in a privately held stock.
How to Use LEAPS
So let's assume you have a client who wants to gift a 5 percent interest in a major brand automobile dealership, “Clunker Motors” on Sept. 30, 2008. An appraiser can use LEAPS to determine a minimum DLOM in the valuation of your client's 5 percent interest in Clunker Motors. As of Sept. 30, 2008, three public companies whose business was selling automobiles had LEAPS put options on their stock. (See “How to Use LEAPS,” this page.)
If we further assume that your client's 5 percent interest being gifted has an anticipated holding period of at least 27 months, we can look on the exchange at the discounts for the LEAPS put options of the three public companies and see that at 27 1/2 months, two of the companies have discounts for their put options of over 50 percent. Thus, it's easy for an appraiser to prove a minimum DLOM of 50 percent or more for your client's interest.
Note also how a LEAPS analysis is valuation date-specific. Because every valuation is on a specific valuation date, the LEAPS approach takes into account specific market or industry conditions that may impact stock value. For example, in September 2008, the U.S. automobile industry was experiencing significant turmoil. Had an appraiser used a different approach to arrive at a DLOM — such as restricted stock studies — those studies would have been made years earlier under vastly different industry conditions. Thus, the use of a LEAPS approach captured the effects on value of the major economic turmoil at the time.
How DLOMs Behave
Over the past five years, I've done three studies on the entire universe of LEAPS offerings and have learned some important facts about the costs of price protection and DLOMs.4 One major fact is that discounts change over time, sometimes hourly or daily, in response to changes in the economy, the industry or a specific company. For example, think about the effect on the cost of long-term price protection (that is, the discount) for Starbuck's stock during the week that McDonald's announced its major marketing emphasis on specialty coffees. With thousands of their stores, McDonalds presented a major risk of unknown size to Starbuck's sales volumes. Such unknowns always affect the cost of long-term price protection of a stock.
A second major fact is that DLOMs increase as company size decreases, whether measured by total revenues or total assets. (See “Costs of Price Protection by Revenue,” this page.) If we look at the cost of price protection (the discounts) by revenue size at three different periods of time, we see two things. First, that medians change significantly over time, depending on the date we look at the LEAPS. Second, we see that discounts consistently increase as company revenue size decreases (reading down the columns).
The LEAPS studies also show that single-year profitability factors, such as the percentage of net income to revenues or the percentage of net income to shareholders' equity, have only modest impacts on discounts except for companies with significant losses. (See “Impact on Discounts,” p. 27.) It seems likely that LEAPS market makers take a longer term view of a company's prospects than the results of a single year.
Discounts also vary by industry. For example, let's look at the “technology” industry. In November 2009, the technology industry had a median cost of price protection of 25.6 percent. (See “LEAPS Put Options in the Tech Industry,” p. 28.) However, there are 32 sub-sectors within the technology industry, such as application software and personal computers. The median discounts in the entire technology industry ranged from 17.9 percent to 33.1 percent. It's thus extremely important to define the industry in as much detail as possible, since there can be such a variation in price protection among individual sectors within an industry.
Equally important, note that LEAPS are company-specific. That is, they impound, by definition, many of the factors articulated in the 1995 case of Bernard Mandelbaum, et. al. v. Commissioner.5 In Mandelbaum, the Tax Court set forth 10 factors to consider when evaluating the appropriateness of a DLOM. LEAPS market makers always take into account specific company risk factors in setting the option cost; these are the same risk factors as outlined in Mandelbaum, like long-term financial risk, dividend policy, company management, the nature of the industry, the company's position in the industry and the volatility of its stock. Thus, a comparison of the company being appraised to the companies in the LEAPS group can provide even greater objectivity in the selection of an appropriate DLOM.
It's equally important to be aware of what LEAPS don't contribute. LEAPS have a specific holding period that may be shorter than the holding period for the shares being appraised. LEAPS represent very small, minority share holdings with virtually no control attributes. There are no restrictions on the transfer of LEAPS or their underlying shares, and obviously, there are no possibilities for redemption.
An appraiser shouldn't use a LEAPS conclusion alone without considering all other factors that bear on value. But given the advantages that LEAPS offer, appraisers should consider using a LEAPS approach as a valuable tool to substantiate their DLOMs.
- The Options Clearing Corporation, www.optionsclearing.com/publications/leaps/intro.jsp.
- Chicago Board of Exchange, www.cboe.com/LearnCenter/FAQLEAPS.aspx.
- For purposes of this article, we use the terms “discount(s)” and “cost(s) of price protection” interchangeably. However, we do not argue that the cost of a long-term equity anticipation security (LEAPS) put option is the entire amount of a discount for lack of marketability. Further research and study may prove that there are additional factors to be considered.
- The three LEAPS studies and others are available in their entireties at www.dlom-info.com.
- Bernard Mandelbaum v. Commissioner, T.C. Memo 1995-255 (June 12, 1995).
Ronald M. Seaman is the founder of Southland Business Group, Inc. in Tampa, Fla.
How to Use LEAPS
Compare your client's interest on the valuation date, with discounts of public companies with put options that expire on various dates
|Symbol||Company Name||4/18/09 |
(6 1/2 months)
(15 1/2 months)
(27 1/2 months)
|GPI||Group 1 Auto||19.9%||27.2%||N.A.*|
*N.A. = No option available
— DLOM, Inc. 2010
Costs of Price Protection by Revenue
Discounts increase as company size decreases
|Date of Survey Data |
Months To Expiration
|2009 Option |
|2011 Option |
|2012 Option |
|Number of Companies||897||623||577|
|Range of Middle 50%||13.4%-23.9%||34.0%-49.2%||21.8%-31.8%|
|Revenues of $10 Billion or More|
|Number of Companies||231||216||218|
|Range of Middle 50%||11.3%-16.3%||29.0%-42.0%||19.8%-26.6%|
|Revenues of $1 Billion to $10 Billion|
|Number of Companies||407||281||274|
|Range of Middle 50%||13.6%-21.3%||35.8%-50.1%||23.3%-32.5%|
|Revenues of Less Than $1 Billion|
|Number of Companies||259||126||85|
|Range of Middle 50%||20.3%-33.5%||39.3%-62.3%||27.7%-38.1%|
|Revenues of $500M or Less|
|Number of Companies||171||79||52|
|Range of Middle 50%||22.8%-35.9%||40.8%-61.5%||28.9%-41.8%|
— DLOM, Inc. 2010
Impact on Discounts
Single-year profitability has only a modest effect
As of November 2009, the percentage of net income to revenues in the latest year has only a modest impact on the cost of price protection, except for companies with significant losses.
|Months to Expiration:||2011 Option |
|2012 Option |
|1st Quintile: 25.0% and Higher*|
|2nd Quintile: 24.8% to 15.4%*|
|3rd Quintile: 15.4% to 7.0%*|
|4th Quintile: 6.9% to (11.4%)*|
|5th Quintile: (11.4%) or Greater Loss*|
*Percentage of net profit to sales
— DLOM, INC. 2010
LEAPS Put Options in the Tech Industry
Costs of long-term price protection in November 2009
|Sub-Category||Description||Count||Average Discount||Median Discount||25th Percentile||75th Percentile|
|All Technology Companies||117||26.9%||25.6%||21.7%||31.0%|
|2||Business Software & Services||5||26.1||22.2||21.6||34.5|
|6||Data Storage Devices||5||23.9||24.2||22.9||26.4|
|7||Diversified Communication Services||1||20.9|
|8||Diversified Computer Systems||4||19.3||17.9|
|13||Internet Information Providers||8||24.6||25.7||24.6||26.4|
|15||Internet Software & Services||3||32.0||33.1|
|17||Multimedia & Graphics Software||2||28.3|
|18||Networking & Commun. Devices||4||24.0||23.9|
|20||Printed Circuit Boards||2||30.6|
|22||Scientific & Technical Instruments||2||25.5|
|23||Secutity Software & Services||3||19.5||20.2|
|24||Semiconductor - Broad Line||7||26.2||27.1||21.6||29.3|
|25||Semiconductor - Integrated Circuits||10||30.2||29.6||25.9||31.7|
|26||Semiconductor - Specialized||12||31.9||32.9||23.7||36.7|
|27||Semiconductor Eqpt. & Materials||7||25.6||23.9||23.2||27.3|
|28||Semiconductor - Memory Chips||4||34.2||31.8|
|29||Technical & System Software||2||26.7|
|30||Telecom Services - Domestic||2||21.1|
— DLOM, Inc. 2010