Does the DLOM apply? What level of discount is justifiable? Which method?

A review of BVR’s Guide to Discounts for Lack of Marketability.

If you are looking for a comprehensive source of information about the DLOM and the cases that business appraisers consider for confirmation of a method, look no further than BVR’s Guide to Discounts for Lack of Marketability, Fifth Edition by John Stockdale, Sr.

DLOM

As part of your work, have you asked yourself whether a discount for lack of marketability (DLOM) is  applicable to a controlling interest based on unique facts and circumstances and wondered where to look for authority?  If you are unsure about the magnitude of the discount, you will need to research multiple resources to gain a sense of comfort.  Time is money, and conducting extensive research–whether to examine periodicals, search on-line U.S. Tax Court cases, consulting other reference material or discussing the issue with other business valuators–takes time.  Assessing the merits and lack thereof of the various methods is also time consuming and somewhat tedious.

Accordingly, where does a business appraiser go to find all of the current approaches to determine the DLOM for a controlling interest on a theoretical level, calculation example(s), and the current view(s) of the U.S. Tax Court as they pertain to the nature of the business or investment entity that is being appraised?  Historical books by Shannon Pratt, Jay Fishman, John Stockdale, and others generally have been printed in the mid-2000s with some updates; these are dated.  However, there is a new edition of a book that contains a compendium of the various approaches.  This book is entitled BVR’s Guide to Discounts for Lack of Marketability by John Stockdale, Sr.  It is a two-volume set.  The first volume discusses the technical and background aspects of dealing with the issue of DLOM, and the second volume contains the cases dealing with the issue of DLOM and the subsequent court rulings.    

The various computational methods that appear to have some growing traction in the business valuation community to estimate the DLOM for controlling interest are the Chaffe Put Option, the Finnerty Average Strike Put, the Meulbroek CAPM, the Stockdale Time Model, the Economic Components Model, the NICE, and the Masten-Webb Tiered Income methods.  With each of these options available, there continues to be a level of uncertainty that the appraiser needs to consider and determine its applicability to the specific valuation case.

The need to estimate volatility or risk under a normal distribution assumption, in the first three methods, does decrease the level of credibility of the outcome from the computation.  How can appraisers have any certainty of the degree of risk a business has over a period of time, particularly  when we are trying to estimate the specific risk of a company compared to the industry risk that is presented in the Ibbotson SBBI Valuation Yearbook published by Morningstar?  Any computation that requires an appraiser to add into the calculation a factor for risk that is not supported by an outside reference is an opportunity for the results to be questioned, especially if the business valuation report is reviewed by the IRS.      

One of the most significant features of the books is the detailed example of how an appraiser can apply any of the various approaches to calculating the DLOM given the set of facts of the specific engagement.  The book also provides a keen insight by Mr. Stockdale of the strengths and weaknesses from applying any one approach unless an appraiser understands the nature of the business entity or a profile of an investment entity and how it relates to the spreading of risk for the entity.  There is also a discussion of how to develop various approaches to estimate the DLOM for real-estate investment vehicles and entities utilizing the data provided by the real estate appraiser by applying both the long-term period to sell off the assets and the shortest term to sell off the assets.

The summary of the U.S. Tax Court cases on DLOM presented in the books focus on controlling interest discounts. These discounts vary significantly.  The allowed discounts range from a low of 15 percent to a high of 40 percent.  The U.S. Tax Court cases cited in the books present a significant ready reference source to determine the appropriateness of a discount in a given engagement.  It is not often that an appraiser has the ability to test the probability of their estimated discount to determine its similarity to what has been allowed in other tax court settled cases.

This two-volume set of books is an excellent source of theoretical, historical, and current approaches to estimate the DLOM for a given engagement.  The U.S. Tax Court cases and their detail enable appraisers to test their conclusion based on situations that have been brought to trial for estate and tax planning opportunities. 

When doing a controlling position engagement, an appraiser should definitely review the information provided in Chapter 16 of the two-volume reference.  In the next edition, it would be great to include Excel models of each of the methods covered, samples and a comparison chart, too!

Ed Wandtke, CPA, CVA, MBA, is principal of Wandtke & Associates and Executive Staffing Solutions, Inc., both are based in Columbus, OH.  The firm provides valuation services for service companies, intellectual property, and intangible assets, as well as business brokerage services. For further information, visit www.wandtke.com