Is it difficult to sell a business interest in Texas as well as other states? Public stocks can be converted to cash in three days, but it often takes a year or longer to sell a private business. Minority interests in private companies can be even harder to liquidate, because they may be subject to lack control over decision-making and transfer restrictions.
Valuators attempt to quantify the costs, time, and uncertainty of selling a business interest through the discount for lack of marketability (DLOM). Here are some frequently asked questions about one of the most debated parts of a valuator’s opinion.
When is DLOM appropriate?
The term “marketability” refers to how quickly an investor can convert property to cash at minimal cost and for a relatively certain price. Experts typically arrive at a fully marketable, cash equivalent value when they use the market or income approach. The DLOM is an adjustment to the preliminary value estimate that’s typically expressed as a percentage discount.
The DLOM is typically taken when valuing minority (noncontrolling) interests. A discount also may apply when valuing controlling interests, but such interests can’t be sold and liquidated immediately. This is usually referred to as an “illiquidity” discount. It’s generally much less than the DLOM on noncontrolling interests for the same company.
What factors affect marketability?
For minority interests, the DLOM typically ranges from 25% to 50%. But it may be higher or lower than this range, depending on the specific characteristics of the interest being valued because each business interest is unique. The appropriate DLOM depends on a variety of factors.
In the landmark Mandelbaum case, Judge Laro of the U.S. Tax Court enumerated several company characteristics to consider when deciding the appropriate discount:
- Whether the stock is private or public,
- The financial condition according to financial statements,
- The dividend policy,
- The nature of the company and its history, position in the industry, and economic outlook,
- The amount of control in transferred shares,
- Management quality,
- Restrictions on transferability of stock,
- The stock holding period,
- The stock redemption policy, and
- Costs associated with making an initial public offering (IPO).
Other authorities and courts cite additional relevant factors, including the size of revenues and earnings, product and industry risk, and market volatility.
Is there external data used to support the DLOM?
Various empirical studies are used and relied on by valuators to help support DLOMs. These studies analyze real-world transaction data and try to find relationships between prices paid for stocks on and off the public markets.
Referenced in IRS Revenue Ruling 77-287, the earliest empirical studies focused on restricted stock. They compared the prices paid for registered shares of publicly traded companies to unregistered (restricted) shares of publicly traded companies. The theory is that investors discount unregistered shares that they can’t trade on the public markets for a prescribed time period.
However, restricted stock studies became less relevant when the Securities and Exchange Commission (SEC) relaxed its holding-period requirements on restricted stock in 1997. The holding period was generally two years under previous SEC rules. The current holding period is only six months, which was effective in February 2008.
Pre-IPO studies are another popular source of empirical data for the DLOM. These track transactions in stocks prior to going public and compare them to the stock’s IPO price to determine an implied DLOM. Pre-IPO studies have been widely accepted by the U.S. Tax Court, as well as courts in many other jurisdictions.
Valuation Advisors, LLC publishes the largest pre-IPO study annually. The list below, “How holding period affects the median DLOM” summarizes the results from 2015.
How do holding period affects the median DLOM?
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Holding period
0-3 months
4-6 months
7-9 months
10-12 months
1-2 years
> 2 years
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Median discount
21.5%
26.4%
38.9%
46.6%
51.8%
69.4%
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The list shows that the size of the discount increases as the timeframe from the date of the IPO increases. The longer it takes to sell an asset, the higher the presumed risk due to the illiquidity of the asset, so this is expected. As the level of illiquidity rises, so does the asset’s DLOM. When valuing shares of a privately held company, determining the likely holding period for such shares clearly impacts the value of those shares to a hypothetical investor.
In addition to the empirical studies, the DLOM may be quantified using call- and put-option modeling. Options essentially provide investors with the right, but not the obligation, to buy or sell shares at a set price for a specific period of time. Here, the value of the option is calculated to estimate the risk an investor takes that an investment’s value could deteriorate over time. In theory, the implied DLOM is the cost of the option, factoring in the time element.
Are valuation experts really needed?
In some cases, business owners mistakenly believe that they can estimate a holding period for their investment and apply the corresponding discount from a pre-IPO study to their business interest. But these studies are just a starting point.
In actuality, The IRS specifically criticizes the blind use of averages and medians from empirical studies in The DLOM Job Aid for IRS Valuation Professionals, if you’re estimating a DLOM for federal tax purposes. Fortunately, a valuator knows how to fine-tune real-world data to match the characteristics of the interest being valued.
© 2016