Do Not Be Too Quick to Discount
A Discount for Controlling Interests
This article examines studies and judicial decisions addressing the use of DLOMs where there are controlling, 100% ownership interests, followed by review of a recent client assignment that illustrates the importance of being well versed with the valuation theory in this area.
The application of discounts for lack of marketability (DLOM) to valuation of controlling ownership interests in privately held companies has been the subject of much discourse, and dispute, in the gift and estate tax arenas.Â In its discount for lack of marketability job aid (Job Aid),1 the IRS stated:
There is little dispute that minority interests in non-publicly traded entities lose value due to lack of marketability. Â However, the issue of applying a discount for lack of marketability to a controlling interest is a controversial issue amongst valuators [footnote omitted]. Â Some believe that there should be little or no discount for lack of marketability on a controlling interest, while others believe there should be a discount applied.Â Most agree that any marketability discount for a controlling interest should be less than the discount for a minority interest in the same entity.
The next page of the Job Aid contains the following sentence: â€śAmong valuators who apply DLOM to controlling interests, it is generally agreed that DLOM of a controlling interest is less than that of a minority interest.â€ť Â However, readers of the Job Aid should keep in mind that each of its pages contains the statement that, â€śThis Job Aid is not Official IRS position and was prepared for reference purposes only; it may not be used or cited as authority for setting any legal position.â€ť Â Also, James R. Hitchner states, â€śWhile some experts support a discount, there remains no direct empirical evidence to support a discount for lack of marketability/liquidity for a controlling interest. Â Remember that all the initial public offering and restricted stock studies deal with minority interests and not controlling interests.â€ť2
All the above commentary is probably true, and business valuation professionals must take into account all of the facts and circumstances surrounding each company being valued. Â Rev. Rul. 59-60 3 is the foundation for most business valuations that are prepared in conjunction with gift and estate tax returns. Â Section 3.01 of that ruling, titled â€śApproach to Valuationâ€ť reads as follows:
A determination of fair market value, being a question of fact, will depend upon the circumstances in each case. Â No formula can be devised that will be generally applicable to the multitude of different valuation issues arising in estate and gift tax cases. Â Often, an appraiser will find wide differences of opinion as to the fair market value of a particular stock. Â In resolving such differences, he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science.Â A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment, and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.
Section 4.02 of the Revenue Ruling states that, â€śPrimary consideration should be given to the dividend-paying capacity of the company rather than to actual dividends paid in the past.â€ť
This discussion will examine studies and judicial decisions addressing the use of DLOMs where there are controlling, 100% ownership interests, followed by a review of a recent client assignment that illustrates the importance of being well versed with the valuation theory in this area.
Background on Marketability Discounts
The IRS recognized the need for discounts to be applied to securities that were not freely tradable when it issues Rev. Rul. 77-287.4 Â The Revenue Ruling states:
It frequently becomes necessary to establish the fair market value of stock that has not been registered for public training when the issuing company has stock of the same class that is actively traded in one or more securities markets. Â The problem is to determine the fair market value between the registered shares that are actively traded and the unregistered shares. Â This problem is often encountered in estate and gift cases.
The Service is acknowledging in the Revenue Ruling that ownership interests in privately held corporations, that cannot be immediately converted into case, do not hold the same value as those that can be via an active stock exchange Rev. Rul. 77-287 goes on to discuss the institutional Investor Study.5
Pursuant to Congressional direction, the SEC undertook an analysis of the purchases, sales, and holding of securities by financial institutions, to determine the effect of institutional activity upon the securities market. Â The study report was published in eight volumes in March 1971. Â The fifth volume provides an analysis of restricted securities and deals with such items as the characteristics of the restricted securities purchasers and issuers, the size of transactions (dollars and shares), the marketability discounts on different trading markets, and the resale provisions.
The study found that discounts tended to be higher for transactions involving non-reporting companies traded in the over-the-counter market than for companies whose shares are freely tradable on established stock exchanges averaging 32.6% vs. 25.8%).
Issues of Time and Risk. Â Discounts for lack of marketability arise when a state price is not immediately realizable in cash, and there is uncertainty about the eventual receipt of the state price. Â Numerous analyses of restricted stocks have found that risk, in the form of volatility, is highly correlated with the discount. Â Such issues of time and risk are clearly an inherent factor in transactions involving sales of controlling interests in privately held companies. Â The time between listing a business and closing a transaction, for companies contained in the Bizcomps and Prattâ€™s Stats database, averaged 193â€“197 days. Â Further, in the Bizcomps database, transactions are only tracked for 999 days, and there are deals that take longer than that to complete. Â In addition, business brokers advise that only a small number of companies that are listed are eventually sold, perhaps only 20%.6
Studies that have been performed in order to examine the application of marketability discounts to valuations of privately owned companies include:
- The Existence of, and Earnings Quality Explanations for, the Private Company Discount, by Gus De Franco Illait Gavious, Justing Tin, and Gordon D. Richardson. This 2006 study compared private acquisitions of 100% ownership interests in privately held U.S. companies to acquisitions in public companies. Â The sample consisted of 673 private companies and 2,249 public companies. Â The study found that marketability discounts for the acquisition of private companies were between 21% and 37%.
- The Private Company Discount, by John Koeplin, Atulya Sarin, and Alan C. Shapiro. 7 This study published in 2000 concluded that domestic private companies are acquired at a 20â€“30% discount relative to similar public companies.
- A New Examination of The Private Company Discount: The Acquisition Approach, by Maher Kooli, Mohamed Kortas, and Jean-Francois Lâ€™Her.8 Â This 2003 study concluded that the private company marketability discount is 34%.
Studies such as the ones cited above give weight to the argument that privately held companies are less liquid than public companies. Â However, the use of these studies alone can be somewhat problematic as each study makes certain assumptions that may be open to challenge. Â In addition, such studies do not rise to the level of adjudicated judicial cases. Â However, it was almost certainly the similarities of the companies in the studies to the ones in a client engagement, discussed below, that caused the government to issue a refund.
Discounts Applied in Tax Court Decisions
DLOMs are a product of economic and theoretical considerations as well as legal requirements. Â A review of Tax Court cases shows that they are not limited to minority holdings in business entities, but rather have been allowed for controlling interests on several occasions. Â Some cases where courts allowed marketability discounts under such circumstances are discussed below.
The first case reviewed contains very similar facts to the holding company valued in the client engagement discussed below. Â In Estate of Dougherty,9 the decedent had a 100% interest in a trust that owned all the common stock of A.L. Dougherty Co., Inc., a corporation whose assets included securities, notes receivable, and parcels of real estate. Â The IRS contended that because the trust held 100% of the A.L. Dougherty Co., Inc. stock, no DLOM was warranted. Â The IRS bases its position on Estate of Jephson.10 Â However, the court disagreed, finding that Estate of Jephson supported the position that a DLOM was applicable. Â The court found a 25% DLOM to be appropriate, as well as 10% discount for incremental management costs.11
Another case involving a 100% ownership interest is Estate of Bennett.12 Â In this case, the issue was the valuation of a 100% ownership interest in the common stock of Fairlawn Plaza Development, Inc. Â Here, the court allowed a 15% DLOM, stating:
So too, in this case, our holding that a lack of marketability discount is warranted is based on the totality of facts presented. Â Here we have a real estate management company whose assets are varied and non-liquid. Â We think that the corporate form is a quite important consideration here: there is a difference in owning the assets and liabilities of Fairlawn directly and in owning the stock of Fairlawn, albeit 100% of the stock. Â We think some discounting is necessary to buy Fairlawnâ€™s package of desirable and less desirable properties. Â Thus, the line of cases in which we have recognized that difficulties arise in holding non-liquid assets in the corporate form, even in the 100% ownership situation, is applicable in this case.
Overvaluations in Illustrative Estate Return
The case discussed below illustrates just how important it is that the business valuator not just â€śgo through the motionsâ€ť in preparing a business valuation. Â In 2010, the present authorâ€™s firm was asked to review an estate return. Â The return contained two valuations in which businesses appeared to have been materially overvalued. Â The overvaluations were due to the fact that in preparing the return:
- The valuation professionals had taken, no marketability discount on the value of the decedentâ€™s 100% ownership interest in a consolidated corporation, and
- The valuators had taken an inadequate discount on the value of the decedents 100% ownership interest in a second corporation.
First Valuation. Â The estateâ€™s first business valuation was for a tiered C corporation which owned 100% of the following entities:
- A C corporation that was listed as a â€śland development company.â€ť The corporation owned approximately 36 real estate parcels that had been appraised at no value.Â In addition, the company owned six real estate lots located along a golf course, an interior lot, a single-family house which was being used as an office, two residential real estate condominiums, and two additional single-family houses.Â The company also owned a golf course and a clubhouse at the course.
- A C corporation that operated that golf course and clubhouse.
- A C corporation that owned and operated a tree and plant nursery, and also performed contract mowing, landscape maintenance, irrigation repair, and other related services.
- A C corporation formed to develop cellular telephone equipment.
In valuing the decedentâ€™s 100% ownership interest in the stock of the holding company that owned the above mix of entities, the valuator used what he called the â€śunderlying asset method,â€ť and did not apply a lack of marketability or lack of liquidity discount.
Second Valuation.Â The second business valuation in question was for a 100% interest in a C corporation which had approximately $25 million in annual sales, most of which were to one customer.Â The company did not operate under a contract with that customer.Â Rather, all work was performed in response to contemporaneous purchase orders.Â The valuator made the following (redacted) comments as to the industry and the entity being valued:
The industry is facing significant challenges that are creating a difficult climate for other companies affiliated with this industry, such as [the subject company].
With contracting domestic market share and relatively high fixed costs, [the customer] has experienced considerable financial difficulties and this trend is not expected to reverse in the near term, thus affecting the growth and profitability of [the subject company].
Unlike publicly traded companies, the subject interest cannot be converted to cash in a relatively short time.Â In fact, the likely time horizon to complete a sale of the subject interest is nine to eighteen months.
Since restricted stock studies compare the prices that investors are willing to pay, at the exact point in time, for two otherwise identical securities, with one being fully liquid and the other having liquidity related restrictions, the discounts associated with restricted stock transactions serve as a useful starting point for estimating the DLOM applicable to the subject interest.Â In doing so, it may be most appropriate to consider restricted stock discounts associated with relatively shorter holding periods.Â Restricted stock discounts with shorter holding periods generally average 15% to 20%.
We referred to the cost of floatation of registered issues published by the SEC, which analyzed the costs of various types of debt and equity public offerings.Â The study on common stock showed floatation costs, as a percentage of total proceeds, ranging from 3.0% for issues over $100,000,000 to over 23% for issues under $500,000.Â As the value of the business enterprise increases from $500,000, the cost of floatation as a percentage of total proceeds drops rapidly.Â This study illustrates that there is a cost associated with converting a nonmarketable security into a marketable one.
The valuator found that overall, the subject interest was not as liquid as interests in publicly traded companies.Â To obtain liquidity, the owner of the subject interest would likely incur material time and expense to locate a buyer and structure a transaction.Â Based on these factors, a 10% discount for lack of marketability was estimated to apply.
Review of Original Valuations
When the estate was brought to the attention of the current authorâ€™s firm by an advisor to the decedentâ€™s widow, the returns had been filed and all related federal estate taxes paid.Â In fact, the decedentâ€™s widow had mortgaged the family home in order to pay the estateâ€™s federal estate tax.Â Her advisor became concerned that the companies in the estate had been overvalued, and the estate taxes materially overpaid.
The holding company had been valued at approximately $18 million, based on its net assets at market value, with no discounting of any kind.Â The other corporations, for which one customer provided for almost 100% its revenue, had been valued at close to $8 million after taking a 10% DLOM.
As noted above, Rev. Rul. 59-60 contains the following statement:
A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment, and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.
In the case of the holding company, it made â€ścommon senseâ€ť that it would be quite difficult to find a buyer for a C corporation which owed interests in such diverse entities.Â And unlike shares of stock that are freely tradable on established exchanges, no exchange would have enabled the subject estate to sell its ownership interest.Â In addition, at the time of the decedentâ€™s demise, the corporation was illiquid as it only had approximately $3,800 in current assets to satisfy approximately $22 million in current liabilities.Â A search of transaction databases revealed no sales or similar organizations.Â Also, due to its large negative working capital position and lack of cash, the company was not able to pay dividends.Â The company was thus revalued based on the Dougherty case discussed above, with a 35% discount (25% lack of marketability discount, and a 10% discount due to increased management costs arising from the varied nature of the companyâ€™s assets) applied to the net asset value determined by the valuator.Â The total discount exceeded $6.2 million.
As to the second company, it was not possible to determine how the valuator had computed a 10% lack of marketability discount, so the numbers from the referenced SEC studies were interpolated and a 21.01% discount was calculated.Â The revised valuations for the two companies were included on an amended Form 706 (Federal Estate Tax Return).Â The IRS Appeals Office approved the amended returnâ€”and a refund check was issued in the amount of almost $2.7 million (which included interest).
Business valuation professionals should do more than just â€śgo through the motions.â€ť Â It is necessary to look behind the financials, follow the steps in Rev. Rul. 59-60 and subsequent Revenue Rulings, draw from past experience, and use common sense when correlating all factors.
Do not be the trustee of an estate, or the preparer of an estate tax return, that is responsible for a return containing overvaluations.Â When someone not well versed in valuation theory is handling the preparation of an estate tax return, any material business valuations should be reviewed by another trusted professional.Â Otherwise, millions of dollars may be left on the table, as was almost the result in the case discussed.
1 Job Aid for IRS Valuation Professionals â€śDiscount for lack of Marketability.â€ť 9/25/2009
2 Hitchner, Financial Valuation: Applications and Models, 2nd ed. (Wiley and Sons, 2006)
3 1959-1 CB 237
4 1977-2 CB 319
5 Institutional Investor Study Report, H.R. Doc. No. 64, Part 5, 92d Cong., 1st Sess, (1971)
6 DiMattia, â€śControlling Interestsâ€”Discount for Lack of Marketability. The Empirical Evidenceâ€ť CPA Expert (Summer 2008)
7 12 J of Applied Corporate Finance 94 (Winter 2000)
8 6 J of Private Equity 48 (Summer 2003)
9 TCM 1990-274
10 87 TC 297 (1986)
11 â€śThe assets of A.L. Dougherty Co., Inc. are varied and there would be management costs that should be taken into account when valuing the stockâ€ť
12 TCM 1993-34
This article was originally published in Valuation Strategies, July/August 2014 issue. Â© 2014 Thomson Reuters/Tax & Accounting. Â Reprinted with permission.
Edward Bortnick began his career in public accounting in 1971. He has served as Principal since 1977, including eighteen years in his own practice prior to merging with Simon Krowitz Bolin & Associates, P.A. in 1998. Over the years, Mr. Bortnick has acquired a unique and varied background of skills in accounting, taxation, business matters, and valuation services. His primary focus is on litigation services, specializing in valuations and bankruptcy and divorce support. He has appeared in Circuit, U.S. Bankruptcy, and Federal courts to serve as an expert in business disputes, divorce, and tax matters.
Mr. Bortnick can be contacted at (301) 468-7700 or by e-mail to firstname.lastname@example.org.