Discount for Lack of Marketability Guide and Toolkit

Authored by: James R. Hitchner; R. James Alerding; Joshua B. Angell; and Katherine E. Morris

The author provides a review of Discount for Lack of Marketability Guide and Toolkit, authored by James Hitchner; R. James Alerding; Joshua B. Angell; and Katherine E. Morris.

[su_pullquote align=”right”]Resources:

Discounts for Lack of Marketability (DLOM) Workshop

How to Objectively Support Discounts for Lack of Marketability—The Empirical Method

Review of Option-based Models for Discount for Lack of Marketability

Working Your Way Through the DLOM Minefield

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I would like to share with you some very exciting news regarding the most current, up-to-date commentary on discounts for lack of marketability (DLOM) and the associated tool kit to help you in determining a DLOM.  This is the Discount for Lack of Marketability Guide and Toolkit, authored by: James R. Hitchner; R. James Alerding; Joshua B. Angell; and Katherine E. Morris.

The text includes over 800 pages that may be obtained in either hard copy or PDF formats.  Before presenting highlights of various chapters (some of which are the best I have ever read on certain subtopics), I want to provide just a brief overview.  The authors went to great pains to provide a detailed analysis of the various restricted stock transaction databases, a summary of all the various option methods, and excellent case studies to help the reader fully understand and be able to apply the different methodologies and commentary on relevant court cases.

Besides the actual text, the authors also offer the VPS DLOM Toolkit which includes 10 Excel models with user model manuals to assist the valuer in application.  These include:

• The Restricted Stock Calculator that allows the valuer to develop detailed comparisons of the subject entity company characteristics to the restricted stock transactions, adjust the data for difference in holding periods and volatility, and incorporate option methodologies and include qualitative factors.
• The Toolkit also includes the most frequently used option models for the calculation of the subject company specifications.
• The Toolkit provides the Valuation Products and Services (VPS) version of the Quantitative Marketability Discount Model (QMDM) calculator.
• Upon application of the approaches above, each model provides the valuer with report-ready exhibits saving the valuer time.
• It should be noted, however, that the Toolkit requires the use of the FMV Restricted Stock Database (now Stout) that needs to be purchased separately.

My overall perspective is: what a well-done book and accompanying toolkit!  Last year I was asked to be a reviewer of the text.  I intended to review the book over a several week period to provide comments back to the authors, but once I started reading the book, I decided to take a couple of hours over several days to read it and to provide commentary to the authors on their most recent draft.  I did not want to put it down.  I really enjoyed reading this work.  What an excellent contribution to the literature and field.  I believe this book is the most up to date published book on DLOMs.  The text is a must for any business valuer’s library

The Toolkit offers a practical way to implement the text.  I received a copy of the Toolkit to conduct this review, but I have not fully analyzed its many alternatives.  I think serious consideration should be made regarding the application of this tool as part of a valuer’s toolbox.

As the champion of the IRS Job Aid on Discount for Lack of Marketability, I had a real interest in this topic.  The IRS Job Aid was written in 2009 (eight years ago and was released to the public in 2011).  When I championed that document, we at the IRS wanted to reach out to the authors of the 20 models (18 including two in the appendices) but IRS council would not allow IRS employees to reach out to the authors as the public may perceive the IRS preferring one approach to another.

However, two years later, I could reach out to authors of various approaches with the approval of the Office of Government ethics and that resulted in my book, Discount for Lack of Marketability and the IRS.  I followed up and personally spoke to most of the modelers, including their insights in the text.  The Job Aid and my book are used by IRS employees.  I have since recommended to the IRS that the IRS take down the Job Aid as it is not consistent with current theory or practice.  What is?  I believe the Discount for Lack of Marketability Guide and Toolkit are the most current publication addressing both theory and practice, and I am especially impressed with the research associated with restricted stock studies.

To assist the reader, the authors have conducted an extremely thorough search of the literature.  The figures, charts, graphs, and tables are all very well presented in an easy to read and research format.  To assist readers, the authors have also inserted “VALTIPs” throughout the text with very practical commentary for the reader.  The VALTIPs work as if you have the authors working with you and providing the commentary and insight you need to really understand the hidden practical commentary you wish you had in other texts.

Chapters 1 to 4 set the stage for understanding DLOM, DLOL, marketability, the conceptual framework regarding levels of value, and entity level versus shareholder level discounts.  Chapter 5 introduces various qualitative and quantitative approaches, including the most current models in the literature.

The overview of restricted stock in Chapter 6 is the best concise, clear commentary I have ever read on this topic.  It is outstanding!  This comprehensive commentary introduces some comparisons between the FMV RSS Database and the Pluris DLOM Database that are elaborated on in great detail later in Appendices G and H.

Chapters 7 to 9 address characteristics of issuing restricted stock studies, discount analysis of restricted stock studies, and hypothesis explaining discounts on restricted stock.

Chapter 10 provides a detailed analysis of factors affecting restricted stock discounts.  Having reviewed many appraisers’ reports, it is common for the appraiser to list factors, but not to necessarily analyze the factors and comment on the facts of the subject related to these factors.  This chapter provides the reader with not only the factors to consider, but data, analysis, and VALTIPs to assist the appraiser in the analysis of each factor.  Explaining why the factor is important in light of the facts of your subject is critical in application to determining a DLOM.

Chapter 11 provides an overview of the broad categories as benchmark studies, specific transaction methods, and quintile based methods.

Chapter 12 presents a review of large block data.  This chapter presents the problems with large blocks and a case example to help the reader understand the concepts and how and when to consider concerns raised by a large block.  The case study brings this home.

Chapter 13 points out that restricted stock studies are not a panacea and, as such, the chapter presents the criticisms of the restricted stock studies.  A valuable tool is presented in this text and with the Toolkit, but be assured, your professional judgment is still required.

Chapter 14 summarizes 21 restricted stock studies with figures, strengths, weaknesses, and VALTIPs.  This is the best analysis of restricted stock studies I have ever read.  What an excellent source!  The chapter provides a summary of each of the restricted stock studies.  Understanding the actual study, the time period under study given the holding period of the underlying data, and the subject’s expecting holding period are critical.

My background is only in the federal tax arena, so I admit to having a skewed perspective.  The IRS and the U.S. Tax Court historically have taken a very dim view in the application of pre-IPO studies unless the subject is either currently undergoing an IPO or intends to in the immediate future, but that does not mean other jurisdictions share that same perspective.  IPOs are unique and risk-laden events where both the pre- and post-values are subject to speculators, inside information, stock market biases, outside events, changing investment opportunities and several other factors that, in general, make them poor choices to determine DLOMs in the federal arena.  To see the author’s commentary on this topic, see chapter 15.

Chapter 16 addresses the issue associated with the impact of controlling interests on DLOM and DLOL and summarizes the view of Hitchner, Pratt, and Fishman on this topic.

I have found that considering the impacts of the Mandelbaum court case and the factors from the IRS Job Aid to be instrumental in determining a DLOM.  So do the authors and these are very well presented in chapter 17.

Chapter 18 discusses four acquisition methods for calculating a DLOM and then presents criticisms and conclusions for your consideration.

Seven option methods are presented in chapter 19 with insightful VALTIPs, analysis of the models, charts, examples, and figures to give you excellent insight into each.

Chapter 20 provides a practical view on how the market prices restricted stock studies considering the Income Approach, the secondary market for private equity and then critiques the Income Approach and provides conclusions.

Chapter 21 focuses on cash flow adjustment models with an emphasis on the Quantitative Marketability Discount Model (QMDM) with criticism, responses to criticisms, and commentary from various sources.

Chapter 22 provides insights on the LEAPS model and the bid-ask spread method.

At this point, the chapters are concluded, the book is just under 50% completed, but the reader is provided with over 400 pages of nine insightful appendices before concluding with the 10 page bibliography and an index.

I would encourage the reader to take the time to explore each of these appendices.  They were provided to help you and they do provide great information.

Appendix A provides a very well done case study with sample report language on a non-dividend paying company.

Appendix B provides a very well done case study with sample report language for a dividend paying company.  It is important to note the differences and similarities between appendix A and B.

Appendix C presents the IRS Job Aid originally completed September 25, 2009.

Appendix D is the article entitled, Do Put Option Models Overstate Discounts for Lack of Marketability, authored by Jay Fishman and Lester Barenbaum reprinted by Financial Valuation and Litigation Expert, Issue 42, April/May 2013, Valuation Products and Services.

Appendix E simply presents the definition of the coefficient of determination r².  This is important given how many of us need assistance and a reminder on what this means and how it should be interpreted.

Appendix F is the summary user manual for the DLOM Toolkit.  This is version 1.0 beta dated January 2015.  As time goes on, the user of the Toolkit will want to look to the most current version on line.

Appendix G is a reprint of FMV Opinions Restricted Stock Database: Before You Rely on Restricted Stock Block Size to Determine an Incremental DLOM Application to Private Equity, Know the Facts, by James R. Hitchner, Financial Valuation and Litigation Expert, Issue 34, December 2011/January 2012, Valuation Products and Services.  I cannot emphasize enough and the authors articulate how important it is to conduct proper due diligence and determine the facts in your case.  The text states, “This article is based on the database and methodologies employed in 2012.  Some changes have been made.  However, the overall discussion is still valid.”  I concur.

Appendix H presents the Pluris DLOM database and exhibits with excellent charts, figures, and graphs to allow you, the reader, to gain insights into the data.

Similarly, Appendix I presents the FMV database and exhibits with excellent charts, figures, and graphs to allow you, the reader, to gain insights into the data.

Providing both Appendix H and I in this manner gives the reader the opportunity to truly compare these two sources with one another and to understand the strengths and weaknesses of each.

Appendix J provides a series of court cases.  The citation, a summary of the case, key takeaway information, details, and discussion provide the reader with excellent insight on each case.  The work on this section was written by various authors with you in mind.  In some instances, there are insights from those that were actually involved with the cases.  This is very helpful.  I would have preferred a table of contents to these 229 pages, but taking the time to peruse these and identify those most relevant to your concerns would be a worthwhile endeavor.

Often readers do not spend time in the bibliography, but in this case, the authors were kind enough to segregate the material into articles, books, websites and blogs, other, and referenced court cases in the text.  I would especially encourage readers to check out the websites and blogs.

Finally, an index is provided to assist the reader in finding a particular topic quickly and easily.

In short, this text is the most comprehensive, up-to-date commentary on discounts for lack of marketability and should be obtained not only as a reference, but since it has an accompanying toolkit, this product really provides a tool to assist the valuer in determining a DLOM.  It was a pleasure to be a reviewer of the text and to provide you my review for your consideration.

Michael Gregory, CVA, ASA, MBA, worked for the IRS for 28 years as a specialist through executive level. Twice he was nominated by his employees and received the honor of IRS civil servant of the year in his career; both as a front line manager and a territory manager. In 2011, he founded Michael Gregory Consulting, LLC. His web page is www.mikegreg.com offering his videos and books.

Mr. Gregory can be contacted at (651) 633-5311 or by e-mail to www.mikegreg.com.