What Methods Do You Rely on When Calculating DLOMs?

Recent BV conference discusses DLOM for real estate LLCs

This article contains a review of a recent business valuation conference presentation on determining a discount for lack of marketability (DLOM) for real estate holding companies.

Last month, a business valuation conference, sponsored by the Minnesota Association of Business Valuation Professionals, was held in Minneapolis, MN.  This organization is an independent, nonprofit group of business valuators, members of which include certified valuation analysts (CVAs), certified business appraisers (CBAs), accredited senior appraiser (ASAs), and accredited in business valuation (ABVs).  This day-long conference covered a number of hot topics including current economic outlook, current S Corporation valuation issues, methods of computing discounts for lack of marketability (DLOMs), role of business valuators in mediation, valuing family owned small businesses, recent court cases, and exposing fraud. 

This QuickRead article will focus on methods of computing DLOMs, as presented in the session.  Specifically, the well-respected presenters, Scot Torkelson, CBA, and Joshua Johnson, ASA,, used a case study on the valuation of a Real Estate, LLC, with three members.  The attendees were provided a case study fact pattern and were then asked to answer a number of questions regarding the methodology that they would have used to arrive at the DLOM.   Since DLOMs are currently a hot topic among business valuators, this article will summarize the speakers’ brief description of the various methods now being used by the profession as a whole, in addition to what the professional business valuators attending the conference would use to arrive at the appropriate DLOM.

Citing the IRS Job Aid, issued September 25, 2009, the speakers listed the following categories of approaches used by the valuation profession:

• Benchmark approaches
• Securities-based approaches
• Analytical approaches
• Other approaches

Specific models being used for holding companies are:

• Restricted  stock studies and pre-IPO studies (see later comments regarding the latter of these studies)
• QMDM
• Long-term equity appreciation securities (LEAPS)
• Partnership profiles

Specific models being used for operating companies:

• Restricted stock studies and pre-IPO studies
• QMDM
• Management planning data
• Black-Scholes Model
• Longstaff Study
• Chaffee Study

The speakers noted that the pre-IPO studies are not applicable to businesses with which the attendees typically work; consequently, they should not be relied upon as a stand-alone measure.
The speakers also noted that a former high-ranking IRS official, Michael Gregory, (also a presenter at this conference and a Minnesota resident), stated in one of his recent books that it comes down to due diligence on the part of the valuator to determine the variable inputs, including:

• Risk of asset
• Amount of debt carried by company
• Distribution history (or lack thereof)
• Restrictions placed on owners
• Likeliness of sale of main asset in near term

The case study included the fact that, in the five years preceding the effective date of the appraisal, there were no distributions to members of the LLC.
As mentioned earlier, the presenters surveyed the attendees regarding the methodologies that they would apply to the case study facts and the results obtained from their calculations. Then, during the presentation, the attendees were provided small, portable, electronic voting devices, which they used to transmit answers to various questions about their views, methodologies, and results.  The subsequent paragraphs summarize the combined results of their pre-conference answers and their answers at the conference.

1. Which method would you use to determine a DLOM?
   • Pre-IPO and/or restricted stock studies—28 percent
   • Partnership profiles—22 percent
   • Mandelbaum 10-factor analysis—15 percent
   • Valuator’s  own judgment—11 percent
   • QMDM—4 percent
   • Other—20 percent
2. Which discounts did you select?
   • More than 35 percent— 0 percent
   • 31-35 percent—5 percent
   • 26-30 percent—31 percent
   • 21-25 percent—42 percent
   • Less than 20 percent—22 percent
   • 0 percent—0 percent
3. Which factors most influenced discounts?
   • Lack of distribution history—24 percent
   • Transfer restrictions in particular—22 percent
   • Expected holding period—11 percent
   • Earning capacity/cash flow—11 percent
   • Quality of asset held—10 percent
   • Other provisions of management control agreement—9 percent
   • Presence of debt—7 percent
   • Other factors—6 percent

Because of the limitations of the setup of electronic voting devices, only one choice was available for question 3.  Because of this limitation, there was no opportunity to take into account the fact that valuation professionals appropriately consider a multitude of factors in arriving at their decisions regarding the DLOM.

Because the statistics above represent current Minnesota valuation professionals’ opinions about the DLOM for the given real estate LLC case study facts, they provide some insight into the current state of thinking about the very subjective determination of the levels of the DLOM being used today.
Although the statistics above represent current Minnesota valuation professionals’ opinions about the DLOM for the given real estate LLC case study facts, they reflect the current state of thinking among valuation professionals across the nation about the very subjective nature of  the determination of the levels of the DLOM being used today.
It is interesting to note that BV practitioners continue to use these studies predominately, in spite of the fact that the restricted stock studies have been around a long time and include data for periods beginning as long ago as 1966, and none includes periods following 2008
The presentation also included discussion of the various option models suggested by some writers.  These models include those listed earlier, and they also included further discussion and calculations using the factors in the Black-Scholes pricing formula.
For option-based models, a list of various REITS futures contracts– sometime used in arriving at DLOMs for real estate holding entities –was provided and included the following::

• Simon Property Group
• American Tower Group
• Public Storage
• Equity Residential
• Velta Realty
• Healthcare Properties
• Healthcare REIT
• Boston Properties
• CBRE Group

Similarly, attendees were provided a list of mortgage-backed securities futures contracts, from which data is available for making decisions regarding DLOMs for real estate holding companies, as follows:

• American Capital Agency
• CYS Investments
• Armour Residential
• Annaly Capital Management
• Invesco Mortgage Capital
• Two Harbors Investment Corp.

In addition, attendees were provided with spreadsheets showing various data points using LEAPS having 14 and 26 months to expiration.
If the reader of the QuickRead Buzz article is venturing into the use of the LEAPS option based model, he or she may find the published data related to the above-listed entities helpful.
Since I have never actually used the LEAPS model in practice, I do not intend to provide the reader with a cookbook recipe for how to apply the model.  However, the reader may find helpful two Power Point graphs provided by the Conference presenters.  These graphs show levels of DLOMs indicated by use of REIT puts and also by use of mortgage securities puts.  These two graphs are included at the end of this article.
The Conference presenters emphasized that option-based models suffer from the same problems as any other methods of arriving at a level of DLOM: these models, like the QMDM, require multiple subjective inputs by the appraiser; they may have bias; there may not really be a connection to the market for the specific entity being valued.
A summary of conversations one of the speakers had with a broker included the following comments regarding the use of option-based models:

• Call options tend to be overpriced
• Put options tend to be underpriced
• Volatility seems to be forecastable in the short run, and always wrong in the long run
• Only the broker makes profits in the long run

In summary, the presentation adds useful tools for the practitioner in arriving at a rational DLOM.  For more specific details of the presentation, Scot Torkelson has consented to discuss your questions and comments by e-mail addressed to storkelson@shenehon.com

Dick Thorsen is a CPA/ABV, ABAR, CVA,   and CMEA.  He has been an active CPA since 1954 and served as chairman of the Minnesota State Board of Accountancy and president of the Minnesota Society of CPAs.  Mr. Thorsen has been elected vice president of the AICPA and has been a member of its board of directors, along with 21 of its committees, and chair of its Responsibilities in Tax Practice Committee.  He is a past member of the Institute of Business Appraisers (IBA) Board of Governors, its Professional Responsibility Board, and was one of its representatives on the NACVA/IBA Standards Unification Task Force.  He is a member of NACVA’s Standards Committee and a past member of the Examination Grading Committee.  Dick can be reached at dickthorsen@msn.com.