VALUATION DISCOUNTS AND PREMIUMS

VALUATION DISCOUNTS AND PREMIUMSFundamentals, Techniques & Theory3. Factors That May Increase or Decrease the Discounta) Size of block – depending on size and circumstancesb) Buy-sell agreement – depending on provisionsA significant number of studies have been undertaken in an attempt to understand the impact ofmarketability as a characteristic of equity ownership. The studies themselves are varied andcomplex. However, they can be generally classified into four categories:1. Comparison of private placements of restricted shares of public company stocks with publiclytraded unrestricted shares of the same company. The restrictions imposed on the privateplacement shares are generally imposed by Securities and Exchange Commission rules. Theseare commonly referred to as Restricted Stock Studies.2. Comparisons of pre-initial public offering stock transaction values with post-initial public offeringtransactions and stock value of the same company. These are commonly referred to as pre-IPOStudies.3. Comparisons of public companies price/earnings ratios with price earnings multiples onacquisitions of privately held companies.4. Measurement of flotation costs as a means of measuring the effects of marketability on controlinterest value. This method is not commonly used due to numerous practical limitations.B. A CRITICAL LOOK AT EMPIRICAL STUDIES TO SUPPORT A DISCOUNT FORLACK OF MARKETABILITYPractice PointerIn recent years, the U.S. Tax Court has been critical of inadequate justification provided byvaluation analysts for both the DLOM and DLC. For example, in Estate of Josephine T.Thompson, T.C. Memo 2004-174 (July 26, 2004) the U.S. Tax Court criticized both experts; theestate experts were criticized since they “based their minority and lack of marketability discountson general studies and not on the facts of the case. The experts for the estate selected discountrates that were extremely and highly favorable for the estate, without any credible substantivediscussion of how the facts of this case support such particular discount”; respondent expert didnot apply a minority discount, no explanation was provided. As a result of these deficiencies, theU.S. Tax Court devised its own discount minority and marketability discounts.It is critically important that valuation analyst focus on the reasons underlying the discount(s)and that the studies cited hereunder not merely be regurgitated or cited.Lack of marketability is defined as the absence of a ready or existing market for the sale orpurchase of the securities being valued. Tax cases are not determinative of discounts in non-taxrelated valuations, but the valuator must be aware of these cases when performing a valuationfor a tax-related purpose. The courts have repeatedly indicated that prior decisions are animportant element for the valuator to consider when determining the level of discount and themethod of determining those discounts. The courts have tended to be conservative in the levelof lack of marketability discounts they have allowed.The studies discussed in this chapter give some support to the level of discount to apply in lackof marketability situations. The key to the successful application of discounts in a valuationsituation (whether tax related or not) is to properly support and explain the basis for thediscount. Traditionally, this is an area where valuators have failed the most.20 – Chapter Seven © 1995–2011 by National Association of Certified Valuators and Analysts (NACVA). All rights reserved.2012.v1 Used by Institute of Business Appraisers with permission of NACVA for limited purpose of collaborative training.