A new way to calculate discounts for lack of marketability finds that DLOMs for private companies should be dramatically larger than what's currently being claimed
Perhaps nothing in business valuation is more controversial than the discount for lack of marketability (DLOM).1 This one adjustment can have a sizable impact on clients' tax obligations. So, naturally, one question frequently lingers in attorneys' minds at the end of estate-planning engagements: Did the business appraiser select an appropriate discount?
We offer a way to calculate DLOM using a unique empirical approach that directly compares privately held companies to publicly traded counterparts.
We set out to understand the size of DLOMs by comparing the subject of the discounts, privately held companies, to the bases from which discounts should be applied. These relevant bases include publicly traded firms considered as guideline public companies and public market benchmarks from which cost of capital data are obtained. We created a database of 1,328 matched pairs and 9,765 matched industry pairs using transactions from 1995 to 2008. Our results indicate that entity-level discounts average between 68 and 70 percent, which are significantly larger than those reported in other databases and from other studies. We believe one of the main reasons our discounts are larger is because we captured, from privately held company transactions data, the actual value associated with the expected probability of a public market liquidity event. In other words, a matched pairs approach allowed us to calculate the discounted value associated with the expected probability of private firms becoming public firms at some point in the future.
Our study also adds support to the theory that DLOMs for controlling interests do in fact exist and are sizable.
Calculating the Discount
There exist a number of methods to calculate DLOM. They include the examination of restricted stock, initial public offerings (IPOs), acquisitions, options, theoretical methods and others. In recent years, restricted stock and IPO studies have been among the more popular approaches, in part because they rely on actual transactions data and have the benefit of established databases for appraisers to access. As a result, these approaches have been fairly well received in the courts.2
But there are criticisms of the restricted stock and IPO methods. One of their major drawbacks is they presume a relatively immediate, near-certain and significant public market liquidity event. Such an assumption may be unreasonable for a typical private company.
Studies that rely on IPO and restricted stock data consider privately negotiated transactions that occur, at most, two years before a liquidity event, but the majority of cases are of closer proximity. With restricted stock, current regulations require a minimum holding period of six months.3 In 1997, when Securities Act Rule 144 relaxed the holding period from two years to one year, calculated DLOMs dropped significantly.4 The recent relaxation to six months is expected to produce even smaller discounts.
As a result, these privately negotiated transactions are most frequently conducted with an expectation that shares will be publicly traded and thus liquid in the foreseeable future. Therefore, transactions data from restricted stock and IPO studies reflect lower discounts for lack of marketability from a favorable liquidity expectation that is not generalizable to the typical privately held company.
Furthermore, the proliferation of the private capital markets, particularly in the last decade, has changed the exit plans that private companies typically pursue. In a recent research report by the Pepperdine Private Capital Markets Project, private equity groups report that, of all their exit plan options, they plan to sell just 9 percent of their portfolio companies in an IPO.5 This new reality puts into question the appropriateness of the IPO and restricted stock studies built on a foundation of expected public market liquidity.
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Applying the Discount
Over the years, there's been a lot of debate about whether private companies should even be subject to a DLOM. Many have argued that, if in fact one exists, it would be smaller than typical DLOMs for minority positions. Part of this reasoning resides with an assumption, on a broader discount level, that the DLOM will be offset, to some degree, by a premium for private company control. We investigated this issue.
Eric W. Nath, a San Francisco-based appraiser, in a June 1990 article in the Business Valuation Review, “Control Premiums and Minority Interest Discounts in Private Companies,” asserts that publicly traded firms trade at or near their control values.6 The implication is that valuation based on an analysis of public companies should provide a value that is similar to a controlling interest value. This insight is important as it provides us with the opportunity to investigate and make direct comparisons between privately held and publicly traded entities.
Our research improves upon the current methods of calculating DLOMs by making direct comparisons between private and public companies across various industries and time — without a bias associated with an expected public market liquidity event. This research utilizes a matching approach to quantify the size of the DLOM. It also provides support for Nath's hypothesis that publicly traded firms trade at or near their control values.
Perhaps most strikingly, our study suggests that appraisers are not taking large enough DLOMs.
The application of discounts and premiums in business valuation depends on the base from which the value was developed. DLOMs apply when appraisers rely on public market data to infer a value for privately held companies. We therefore focused on two important appraisal situations in which this occurs:
- methods that rely on public comparables; and
- income approaches that rely on public market cost of capital data.
We determined discounts relative to similar publicly traded firms. For income approaches that rely on the major cost of capital sources, we employed a similar universe of public companies to determine discounts. This consistency is not present in other popular DLOM studies.
We calculated the DLOMs using two valuation metrics for each benchmark while controlling for year and industry. We used Pratt's Stats,7 a private business transaction database, and Compustat,8 a database of financial, statistical and market information, in our study. The first benchmark was based upon matched pairs from public market comparables. This part of the analysis utilized matched pairs that linked each private firm sale transaction reported from the Pratt's Stats database with a similarly sized9 publicly traded comparable firm10 from the Compustat database for the same year and industry.11
For this benchmark, we focused our study on transactions from 1995 to 2008 involving the sale of privately owned firms in the United States with revenues above $10 million at the time of the transaction. Specifically, we examined those private companies that were large enough to have a publicly traded comparable. By identifying this frontier where the sizes of private and public companies overlapped, we were able to control for other influences and study the DLOM. This resulted in 1,328 matched pairs.
Once the pairs were created, we relied on two commonly used valuation metrics to determine discounts: market value of invested capital to sales (MVIC/Sales) and market value of invested capital to earnings before interest, taxes, depreciation and amortization (MVIC/EBITDA). To create a direct comparison,12 we adjusted Compustat data to create an MVIC comparable and then computed the discounts according to the following formulas:
DLOMSALE = [1 - (MVIC/Sale for private firm) / (MVIC/Sale for public firm)]
DLOMEBITDA = [1 - (MVIC/EBITDA for private firm) / (MVIC/EBITDA for public firm)]
Second, we calculated DLOMs with another benchmark by matching each Pratt's firm with an industry average from Compustat.13 Each private firm transaction from Pratt's Stats was matched with the industry average14 based on year and the three-digit code from the North American Industry Classification System (NAICS). This approach utilizes the same base that is employed when using public market cost of capital data. This resulted in 9,765 matched pairs.
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The chart “Matched Firm and Matched Industry Discounts” on this page illustrates, by year, the discounts from both benchmarks15 — matched firm and matched industry — along with summary information from the Fair Market Value Restricted Stock Study and Valuation Advisors' Lack of Marketability Discount databases.
Our matched firm discounts across all years average 69.5 percent and range from a low of 61.1 percent in 1999 to a high of 80.9 percent in 2005. Our discounts calculated based upon the industry benchmark average 68.2 percent and range from a low of 60 percent in 2003 to a high of 73.6 percent in 1997. These results are larger than the FMV Restricted Stock Study average of 17.9 percent and the Valuation Advisors' Lack of Marketability Study average of 47 percent.
The magnitudes of our discounts are consistently and significantly larger than other valuation studies that are currently published and adopted by the business valuation community. Restricted stock studies have not found the DLOM to be more than 45 percent. The 1997 pre-IPO study by John D. Emory Sr. (now chairman of Emory & Co, LLC in Milwaukee) found a median DLOM of 66 percent occurred just once, during 1980 to 1981.16 Three acquisitions studies, published by Stanley Block (2007), Micah Officer (2006) and Josh Koeplin with Atulya Sarin and Alan Shapiro (2000), all found that the median DLOM did not exceed 32 percent for domestic transactions.17
This chart shows that our discounts fluctuate with economic changes and are consistently larger regardless of whether we are comparing to an individually selected matched firm benchmark or the industry in general. It also highlights the magnitude of the differences between the FMV Restricted Stock Study, the Valuation Advisors' Lack of Marketability Study and our study results.
We continued our analysis by examining the DLOM across 14 different sectors.18
“Industry Grouping” on page 40 summarizes the discounts by sector grouping. Again, we observed a significant amount of variability. For matched firms, the transportation industry revealed the lowest discounts at 38.6 percent, while the highest was recorded in the wholesale industry at 88.1 percent. For industry matches, the lowest discount also was recorded in the transportation industry at 55.5 percent, while the largest was in professional services at 83.7 percent. Again, we observe fairly consistent average discounts for both matched firms as well as industry averages.
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Just the Facts
The Internal Revenue Service and the federal courts have consistently opposed significantly large DLOMs for private firms and interests in them. Still, some recent court cases, such as Litman v. United States,19 have made the courts reexamine DLOMs. Our study supports the argument that entity-level DLOMs can average 68 percent to 70 percent when private and public firms with similar characteristics are compared. While the magnitude of these DLOMs may startle some, the facts speak for themselves — and could help persuade the authorities.
- Although many appraisers are now making a distinction between liquidity and marketability, we continue with the more generalized use of the term “lack of marketability,” which would include the effect of illiquidity.
- Rod P. Buckert, “Deconstruct the Studies,” Trusts & Estates, March 2004, at pp. 56-61; Lance S. Hall, “The Preferred Method,” Trusts & Estates, February 2007, at pp. 37-40; Annika M. Reinermann, “Lack of Marketability,” Trusts & Estates, February 2008, at pp. 28-31.
- In 1997, Securities Act Rule 144 reduced the holding period on private placements from two years to one. Effective Feb. 15, 2008, the period was reduced to six months.
- The Fair Market Value Restricted Stock Study database at www.bvresources.com indicates a median discount of 20 percent for two-year holding periods and 16.18 percent for a one-year holding period based on a transaction month calculation. No results are reported for transactions falling under the current six-month holding period.
- “Pepperdine Private Capital Markets Project Survey Report” August 2009, http://bschool.pepperdine.edu/research/pcmsurvey/.
- Eric W. Nath, “Control Premiums and Minority Interest Discounts in Private Companies,” Business Valuation Review (June 1990), at pp. 39-46.
- Pratt's Stats is published by Business Valuation Resources and has been used to examine private firms' transactions in recent studies such as the one published as a working paper in 2007 by Gus De Franco, Ilanit Gavious, Justine Yiqiang Jin, and Gordan D. Richardson, “The Private Company Discount and Earnings Quality.”
- Compustat (formerly known as Compustat PC Plus) provides relatively complete financial data for more than 13,000 publicly traded firms. See Paula F. Heermance, “Research Tools and the Art of Business Appraisal,” Trusts & Estates, November 1997, at pp. 64-78.
- Matched pairs were created with both sales and earnings before interest, taxes, depreciation and amortization (EBITDA).
- Comparable firms were selected from the universe of NYSE, NASDAQ, and AMEX listed companies.
- We used the three-digit North American Industry Classification System (NAICS) code to match the industry. This corresponds to an industry sub-sector match.
- Consistent with Koeplin et al., infra note 17, we computed the market value of invested capital (MVIC) for Compustat firms by summing market capitalization, long-term debt, preferred stock, current portion of long-term debt, and then subtracted cash and marketable securities.
- We adjusted the Compustat data to create an MVIC comparable.
- Using NYSE, NASDAQ, and AMEX companies.
- For presentation efficiency, we averaged EBITDA and sales discounts for lack of marketability (DLOMs).
- John D. Emory, Sr. “The Value of Marketability as Illustrated in Initial Public Offering of Common Stock,” Business Valuation Review, Vol. 16, No.3, September 1997, at p. 125.
- Micah Officer, “The price of corporate liquidity: Acquisition discounts for unlisted targets” (Working paper, 2006); Josh Koeplin, Atulya Sarin, and Alan Shapiro, “The Private Company Discount,” Journal of Applied Corporate Finance 12 (No. 4, Winter 2000), at pp. 94-101; Stanley Block, “The Liquidity Discount in Valuing Private Companies,” Journal of Applied Finance (October 2007) available at www.encyclopedia.com/doc/1P3-1503010681.html.
- Based on the Bureau of Labor Statistics Standard for sector aggregation., www.bls.gov/bls/naics. We excluded utilities, arts, education services and other services due to an insufficient number of sample observations.
- Litman v. United States, Nos. 05-956T, 05-971T, 06-285T (Aug. 22, 2007).
Maretno Agus Harjoto (far left) is an assistant professor of finance and John K. Paglia is an associate professor of finance at Pepperdine University in Malibu, Calif. Paglia is also a managing director at PCG Business Valuations in Camarillo, Calif.