Using the The FMV Restricted Stock Study in ... - BVMarketData

Latest twelve-month (LTM) revenues of $50 million. LTM net income of $1 million. Total assets of $15 million as of December 31, 2008.Book value of shareholders’ equity of $5 milion as of December 31, 2008. Distributions to shareholders have historically been made in amounts necessary to covershareholders’ tax liabilities, but have never been in exces of such amounts in favor ofretaining income for expansion. The majority owners intend to pursue a similar strategyin the foreseeable future.Economic InformationAnnualized economic growth, as measured by gross domestic product (GDP), was negative 6.3percent in Q4 2008, compared with negative 0.5 percent in Q3 2008 and negative 0.2 percent inQ4 2007. 1 UCLA’s Anderson Forecast projects that real GDP will decline at annualized rates of6.8 percent in Q1 2009, 4.5 percent in Q2 2009, and 1.7 percent in Q3 2009. Nationalunemployment rose to 6.7 percent in November 2008 from 4.5 percent a year earlier 2 andwas expected to reach 10 percent in 2010. 3U.S. equity markets experienced significant turbulence in 2008. The first significant decrease inthe Dow occurred on July 15, 2008 when the blue chip index fell below 11,000 on fears of bankfailures. The Dow then increased substantially the following day due to a combination of risingoil prices and U.S. government market intervention, through which short-selling of shares wasprohibited for 799 financial stocks. The Dow decreased again on September 17, 2008, whenAIG received a loan from the U.S. government, and again on September 29, when the U.S.Treasury Department’s bailout bil failedto gain approval in the House of Representatives. Forthe full year, the Dow declined 4,268 points to 8,776, the S&P 500 decreased 544 points to 903,and the NASDAQ decreased 1,033 points to 1,557. Highlighting the extreme level of marketvolatility observed in fall 2008, on October 24, 2008, the CBOE VIX indicator 4 reached its alltimeintraday high of 89.53, 5 and on November 20, 2008, the indicator experienced its highestdaily closing of 80.86. On December 31, 2008, VIX closed at 40.Problem: DLOM DeterminationReview the data provided regarding ABC Corp., the Subject Interest and the state of theeconomy as of the Valuation Date. Your assignment is to determine an appropriate DLOM forthe Subject Interest as of the Valuation Date.1 http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm2 http://www.bls.gov/news.release/jec.nr0.htm3 http://uclaforecast.com/contents/archive/2009/media_32509_1.asp4 Measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Seehttp://www.cboe.com/micro/vix/introduction.aspx5 http://cboenews.com/10-29-2009/VIX_milestones.php2

alowed the purchaser to “tack” the holding period of previous owners to his/her ownholding period, as long as the previous owners were not affiliates of the issuer.- 1997. The initial holding period was shortened from two years to one year, and the ultimateholding period for non-affiliates under Rule 144 (k) was shortened from three years to twoyears.- 2008. The initial holding period applicable to the resale of restricted securities of reportingissuers was reduced from one year to six months (the holding period for sales of restrictedsecurities of non-reporting issuers remained at one year). The ultimate holding period fornon-affiliates was reduced to six months for reporting issuers, and to one year for nonreportingissuers.In addition to the above-mentioned regulatory changes that have improved the liquidity ofrestricted stock, the development of new financial derivatives and trading techniques hassimilarly impacted the “market” for restricted stock.Valuation GuidelinesIRS Revenue Ruling 77-287 establishes valuation guidelines in the determination of DLOMs forsecurities restricted under Rule 144. The basis for Revenue Ruling 77-287 was the InstitutionalInvestor Study Report 7 (SEC Study), which empirically examined discounts in more than 300transactions involving securities that were restricted under provisions similar to Rule 144, andwhich found an overall average discount of 24 percent. Importantly, the SEC Study also foundthat the discount is correlated with certain key financial metrics of the issuing company. Basedon the SEC Study findings, Revenue Ruling 77-287 provides certain guidelines for determiningDLOMs for restricted securities, including but not limited to the following:1. No automatic formulas should be used.2. The discount is a function of the earnings, net assets and sales of the issuing entity.3. The discount is a function of the resale constraints applicable to the restrictedsecurity.In summary, the appropriate DLOM for illiquid securities is not the result of applying anautomatic formula, but will vary depending on the specific facts and circumstances in any case.[Take-Home Point =>] In selecting a DLOM, consideration should be given to (1) the financialcondition and performance of the issuing company, and (2) the degree of illiquidity of thesecurities being valued.7 Institutional Investor Study Report of the Securities and Exchange Commission, H.R. Doc. No. 64, Part 5, 92ndCongress, 1st Session, 1971, pp. 2444-2456.5

The FMV Restricted Stock Study TMThe FMV Study is the largest, most detailed of the available restricted stock studies, andprovides specific information on how to determine DLOMs for minority interests in privatefirms. The FMV Study 8 includes 597 actual transactions involving restricted securities of publiccompanies from July 1980 through December 2008. The overall average discount for all 597transactions in the FMV Study is 20.5 percent and the median discount is 17.0 percent. Thesample distribution is shown in the histogram below:Histogram: The FMV Restricted Stock Study (1980-2008)Frequency1009080706050403020100< -10%-10% to -5%-5% to 0%0% to 5%5% to 10%10% to 15%15% to 20%20% to 25%25%to 30%30% to 35%35% to 40%40% to 45%Restricted Stock Discount45% to 50%50% to 55%55% to 60%60% to 65%65% to 70%70% to 75%75% to 100%The impact of financial risk and stock price volatility on the DLOM is significant. Thefollowing table provides a comparison of company characteristics between high-discounttransactions and low-discount transactions. The sample is divided into five percentile groups, orquintiles, based on the distribution of the restricted stock discount, and medians are computed foreach quintile group across all parameters. 98 The FMV Restricted Stock Study is presented in “Determining Lack of Marketability Discounts” and al of thedata therein is available through www.BVMarketdata.com.9 Due to the long time period over which the FMV Study transactions take place, company financial characteristicshave been adjusted for inflation for better comparability.6

The FMV Study also provides data on variables that are directly associated with the particulardegree of liquidity of a block of restricted stock. As discussed previously, Rule 144 requires thatin order to sell through public trading, restricted stock has to be held for an initial holding periodof between six months and two years, depending on the date the stock was issued, and thenslowly “dribbled out” in public markets according to Rule 144’s volume limit provisions. Underthe dribble-out provisions, large blocks of restricted stock can take many years to dribble-out inpublic trading and are therefore significantly more illiquid than small blocks. Not surprisingly,the DLOM is strongly correlated with block size, as shown in the table below:Median StatisticsMarket Total% Shares Value Assets MTB IssuerPlaced ($mm) ($mm) Ratio Volatility VIX Discount0 - 10% $129.7 $33.2 5.6 75.7% 22.2 16.2%10 - 20% 99.2 41.6 3.5 68.5% 17.9 16.5%20 - 30% 62.2 32.9 2.9 75.3% 15.1 17.6%30 - 40% 37.0 22.9 2.6 79.8% 15.7 33.1%> 40% 15.8 23.0 1.3 80.8% 17.6 40.2%The data shows that the discount increases due to a greater degree of illiquidity (i.e., larger blocksize), and the magnitude of this relationship is most significant among block sizes greater than 30percent.[Take-Home Point =>] These very large blocks, which may require many years to liquidatethrough public sales, are so illiquid that they resemble private equity. Stated differently, thedribble-out provisions of Rule 144 make it so difficult to sell such blocks in public markettrading that the most attractive solution, in most cases, would be a private sale.We note that the large-block transactions are, on average, accompanied by weaker companyfinancial characteristics as indicated by lower market value and total assets. Accordingly, inorder to better isolate the impact of liquidity on the discount, we have eliminated companies inthe FMV Study with market values greater than $100 million. Additionally, we have eliminatedtransactions that were known to include registration rights. 11 The table below provides acomparison of large-block versus small-block transactions within this transaction sample.11 Because the terms of registration rights are often either unknown or are sufficiently complex such that estimatingtheir impact is difficult, we have removed this uncertainty from our analysis.8

Median StatisticsMarket Total% Shares Value Assets MTB IssuerPlaced ($mm) ($mm) Ratio Volatility VIX Discount< 20% $39.9 $11.9 4.2 81.7% 22.2 23.9%> 20% 37.4 16.8 3.1 85.7% 15.1 34.5%> 25% 35.0 18.1 2.8 68.6% 15.1 37.9%> 30% 33.4 20.3 2.7 78.5% 16.6 47.7%> 35% 23.9 8.3 6.7 80.8% 17.5 52.6%MTB 35% 38.6 60.7 3.3 80.8% 21.2 52.6%Increasing block size from less than 20 percent to greater than 35 percent results in an increase tothe discount of 28.7 percentage points (52.6% - 23.9% = 28.7%), or approximately 2.2 times(52.6% / 23.9% = 2.2). We note that given the particular sample selected, as described above,the key financial characteristics are generally similar between the various groups analyzed.However, because the MTB ratio increases somewhat for blocks greater than 35 percent, wehave removed companies that have MTB ratios above 10.0, as shown above, and we find similarresults. We conclude that, given a particular level of company-specific risk, more illiquidsecurities require substantially higher discounts.We have stated previously that private equity should generally be considered more illiquid thantypical restricted stock in public entities, and that the largest blocks of restricted stock in publiccompanies are the most comparable to private equity. The table below provides the indicateddiscount adjustment factors that result from the greater illiquidity associated with large blocks ofrestricted shares, which should also be considered appropriate adjustment factors to derive thediscount applicable to private equity (which is most similar to the largest blocks of restrictedshares).9

Based on our analysis, we have determined two adjustment factors: additive (determined as thedifference in the median discount between the large-block and small-block transaction samples)and multiplicative (determined as the fraction of the median discount of the large-blocktransactions divided by the median discount of the small-block transactions). For example, the28.7% additive adjustment for greater-than-35% blocks is calculated as 52.6% - 23.9%, and the2.20 multiplicative adjustment is calculated as 52.6% / 23.9%. As shown, the additiveadjustment factors range from 11.0 percent to 29.0 percent and the multiplicative adjustmentfactors range from 1.45 to 2.2 times.[Take-Home Point =>] Using the degree of liquidity of large blocks of restricted stock inpublic companies as a proxy for the degree of liquidity of private equity, these adjustment factorsmay be applied to the restricted stock equivalent discount to derive the discount appropriate forprivate equity.Typically, the multiplicative adjustment factor should be considered more appropriate than theadditive adjustment factor, especially in cases where the selected restricted stock equivalentdiscount is significantly above or below the 23.9% median discount for the control group. Forexample, adding 28.7% to a 15% restricted stock equivalent discount may be excessive (providesa private equity discount indication of 43.7%), whereas a 2.2 times multiplicative adjustmentprovides a private equity discount indication of 33%.The variables discussed so far are indicators of company-specific financial and market risk andthe degree of liquidity of a particular security. The FMV Study also provides data regarding theimpact of broader market risk, measured by volatility in equity markets. In order to assess theimpact of broader market risk on restricted stock discounts, each transaction in the FMV Study isassigneda “market volatility” variable. For this analysis, we utilized the CBOE Volatility Index(VIX), a widely used measure of market risk. 12 To control for short-term fluctuations in VIXvalues (which can be highly volatile) during the typical time period required to complete privateplacement transactions, the trailing 6-month average daily VIX closing value. 13 The table belowdemonstrates that transactions occurring during times of high VIX values have higher-thannormaldiscounts.12 VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, which is constructed usingthe implied volatilities of a wide range of S&P index options (both calls and puts) and indicates the market’sexpectation of 30-day forward-looking volatility. See http://www.investopedia.com/terms/v/vix.asp.13 Since only the transaction month and not the exact day is known for many of the FMV Study transactions, themarket volatility variable is the maximum trailing 6-month average daily VIX closing value for the transactionmonth.10

Median StatisticsMarket TotalVIX % Shares Value Assets MTBPercentile Group Low High Placed ($mm) ($mm) Ratio VIX DiscountTop Quintile 25.3 - 32.9 8.2% 64.8 23.0 2.9 28.4 20.4%Second Quintile 23.2 - 25.3 6.8% 131.9 34.5 5.7 23.9 17.1%Third Quintile 17.4 - 23.2 7.6% 126.6 34.0 5.2 21.5 15.2%In order to isolate market risk and control for the degree of liquidity, for the above analysis wehave excluded transactions in the FMV Study with block sizes greater than 20 percent. Asillustrated, the top-quintile and second-quintile groups possess median discounts of 20.4 percentand 17.1 percent, respectively, versus discount for the middle (third) quintile of 15.2 percent.We note that the companies in the top quintile, on average, possess greater financial risk than thecompanies in the second and third quintiles, as shown by lower market value and total assets.Accordingly, in order to better isolate the impact of stock market volatility on the discount, wehave eliminated companies in the FMV Study with market values greater than $100 million. Thesample analyzed in the below table includes all FMV Study transactions with block sizes lessthan 20 percent and market values below $100 million.Median StatisticsMarket TotalVIX % Shares Value Assets MTBLow High Placed ($mm) ($mm) Ratio VIX DiscountTop Decile 28.5 - 32.9 6.9% 43.6 11.8 2.9 29.7 32.1%Top Quintile 26.1 - 32.9 7.7% 43.6 12.0 2.9 28.5 26.9%Second Quintile 23.9 - 26.1 7.8% 48.6 16.7 3.1 24.6 24.4%Sample Median 11.7 - 32.9 9.0% 44.3 15.0 3.2 22.5 21.8%As shown, the various percentile groups possess similar company-specific financial risk andliquidity characteristics, suggesting that the observed differences in discounts are primarily afunction of differences in market volatility. The table below provides the indicatedmultiplicative adjustment factors based on the VIX value as of a valuation date.VIX Median Median MultiplicativeLow High VIX Discount Adj. FactorTop Decile 28.5 - 32.9 29.7 32.1% 1.47Top Quintile 26.1 - 32.9 28.5 26.9% 1.23Second Quintile 23.9 - 26.1 24.6 24.4% 1.12Sample Median 11.7 - 32.9 22.5 21.8% 0.00The above table indicates that moving from a VIX value of 22.5 to 29.7 results in an increase inthe discount of 10.3 percentage points, or 1.47 times the median discount for the overall sample.Accordingly, in the event that a valuation date falls within a period of unusually high market11

volatility, it is appropriate to apply an adjustment factor to the discount arrived at by comparisonof company-specific financial and market risk and security liquidity characteristics. Theappropriate adjustment factor is selected considering the median discount from thequintile/decile group in which a particular valuation date falls based on the trailing 6-monthaverage VIX value as of such date. However, consideration may also be given to VIX valuescloser to the valuation date (e.g., trailing 3-month, 1-month, and valuation date values). In theevent the VIX value on a given valuation date is significantly above historical levels, such asduring fall 2008, valuation date VIX values may better capture investor sentiment than trailing 6-month averages.DLOM Determination MethodologyThe methodology to determine the DLOM, based on the above data and analyses, involves athree-step analysis:1. Restricted Stock Equivalent Discount. The determination of the discountapplicable to the shares (or other equity interest) in a private company, as if theywere restricted shares in a public company. The determination of the restrictedstock equivalent discount is based on a comparative analysis of the subjectcompany and the FMV Study companies issuing small blocks of restricted stock.2. Private Equity Discount. An analysis of the incremental discount required forprivate equity, which reflects the fact that interests in private companies aresignificantly less liquid than all but the most illiquid issues (i.e., the largestblocks) of restricted stock in public companies. The adjustment to go from therestricted stock equivalent discount to the private equity discount is based on theadditive and multiplicative adjustment factors derived from the comparison ofdiscounts associated with small-block versus large-block transactions.3. Market Volatility Adjustment. An analysis of the incremental discount required inthe event that equity markets demonstrate unusually high volatility around a givenvaluation date. This adjustment reflects the fact that restricted stock transactionsgenerally occur at higher discounts during periods of abnormally high marketvolatility. The adjustment factor is derived from a comparison of FMV Studytransactions occurring during months with normal trailing 6-month average VIXvalues versus those occurring during months with very high trailing 6-monthaverage VIX values.The three steps outlined above relate to the alternative levels of value framework,discussed previously, as shown in the following diagram.12

Level of Value Adjustment Supporting Data / MethodologyMarketable Minority(Publicly Traded Equivalent) Restricted Stock Comparative Analysis with Small-BlockEquivalent Discount Restricted Stock TransactionsRestricted Stock EquivalentPrivate EquityLarge-Block vs. Small-BlockNon-Marketable Minority Discount Adjustment Restricted Stock Transactions(Private Equity)Normal Time FrameMarket Volatility Restricted Stock TransactionsNon-Marketable Minority Adjustment During Volatile Months(Private Equity)vs. Normal MonthsHighly Volatile Time Frame[Take-Home Point =>] FMV does not advocate estimating the DLOM based on a directcomparison of the subject company with large-block transactions (or with large-blocktransactions occurring during highly volatile periods), which would necessitate a single step toderive the private equity discount (or the total discount in the event a valuation date falls within ahighly volatile period), because there is not a sufficient sample of large-block transactions toprovide a reliable discount indication in most cases. It is our opinion that the two-step analysisto derive the private equity discount (and the three-step analysis to derive the total discount)generates more accurate results.Application of DLOM Determination MethodologyThis section illustrates how the above three-step method may be applied to determine anappropriate DLOM for the Subject Interest in ABC Corp.Restricted Stock Equivalent DiscountThis analysis is based on a comparison of the following financial characteristics of the subjectprivate company to those of issuers of small-block transactions (less than 20 percent sharesplaced) in the FMV Study: market value, revenues, total assets, book value of equity, MTB ratio,net income, net profit margin, and whether or not the company pays regular dividends. Theseeight valuation parameters are grouped into four broad categories: size, balance sheet risk,profitability, and dividends. [Note - for private entities which are pass-through entities for taxpurposes (e.g., subchapter S corporations, limited partnerships, and limited liability companies),we typically consider such entities to be dividend-paying only if distributions are made above thelevel required to satisfy owners’individual income tax liabilities.] Although stock pricevolatility demonstrates a strong positive correlation with the DLOM, it is not a measurablevariable for the stock of private companies, and it is therefore not used in the determination ofDLOM’s for private companies. Stock price volatility, however, should be considered indetermining discounts for restricted stock in publicly traded companies.The data in the FMV Study is sorted into various percentile groups (five quintiles as well as a topand bottom decile) for each of the above parameters, and the median discount for each group iscomputed. The subject entity is then compared with the data for each parameter to see in which13

quintile/decile group it belongs. The median discount for the quintile/decile group in which thesubject entity falls provides one indication of the appropriate restricted stock equivalentdiscount. The table below provides an example of this analysis with respect to the total assetsvariable.As shown in the schedule below, the weighted average of the discount indications for all of thevaluation parameters is then computed, where the selection of weights is based on which factorstend to be the most important determinants of the DLOM. As mentioned previously, in mostcases the key variables are considered to be market value, total assets, MTB ratio and netprofit margin. However the weights applied in any particular case may vary based on thespecific facts and circumstances surrounding the subject company and the subject interest beingvalued. This analysis is presented as follows:In addition to the discount indication provided by the above analysis, we perform an additionalanalysis which involves identifying companies in the FMV Study that are comparable to thesubject private company across a number of the key variables. Again, we base this analysis onsmall-block transactions only. Sub-samples of FMV Study transactions are created using thefollowing methodology:14

• Each transaction in the FMV Study is analyzed to see if the issuing entity is a matchwith the subject company across the four key variables: market value, total assets,MTB ratio, and net profit margin. An “exact match” on any particular variable isdefined as the issuing entity in the FMV Study being in the same quintile group as thesubject company for that variable. A “close match” on any particular variable isdefined as the issuing entity in the FMV Study being in the same, or an adjacent,quintile group as the subject company for that variable.• Four sub-samples of companies are then constructed, two with companies that arematches (exact matches for one sub-sample and close matches for the second) on allfour key variables and two with companies that are matches (again, exact matches forone sub-sample and close matches for the second) on any three of the four keyvariables.The median discounts for each of the sub-samples are computed, which provide additionalindications for the appropriate restricted stock equivalent discount for the subject company. Inthis analysis, particular attention should be given to the number of transactions included in eachsample. Generally, depending on the sufficiency of the number of transactions, greatest weightshould given to the discount indications from the “4-Exact” matches sub-sample, and lesserweight should be given to the “3-Exact” matches and the two “Close” matches sub-samples. Theresults of this analysis when performed of ABC Corp. are presented as follows:The restricted stock equivalent discount for the subject entity is selected giving consideration toeach of the indications from the two analyses described above. In the case of ABC Corp., aconservative estimate of the restricted stock equivalent discount would be 20 percent.Private Equity DiscountThe restricted stock equivalent discount represents the discount appropriate for a public companyissuing a small block of restricted stock that will ultimately have access to a public tradingmarket. Interests in privately held entities are generally subject to a greater level of illiquidity,more similar to that associated with the largest blocks of restricted stock in public companies.The next step then is to determine the appropriate total discount for lack of marketability for aninterest in a private company by applying the aforementioned range of private equity adjustmentfactors (see“Indicated Private Equity Adjustment Factor Range” on p. 9) to the restricted stockequivalent discount, which yields a range for the total marketability discount applicable toprivate equity (before consideration of broader market risks and any other applicable specialfactors). The appropriate private equity discount is selected from this range, giving15

consideration to all of the available data. For most valuations, absent strong arguments to thecontrary, the private equity discount for the subject entity is likely to be drawn from the middleof this range. The following illustrates the application of this analysis to the Subject Interest inABC Corp.Applying the range of additive and multiplicative private equity adjustment factors to the 20percent restricted stock equivalent discount provides an indicated private equity discount rangeof between 30 and 47 percent. Given that there are no unusual circumstances surrounding aninvestment in the Subject Interest, such as contractual restrictions on resale, in this case we selecta private equity discount of 40 percent, or approximately the mid-point of the indicated range.Market Volatility AdjustmentHaving determined the private equity discount, which is based on the specific risk and liquiditycharacteristics of ABC Corp. and the Subject Interest, the next step is to determine theappropriate market volatility adjustment. In order to make an appropriate comparison with themarket volatility variable included for each transaction in the FMV Study, the trailing 6-monthaverage daily VIX closing value as of a given valuation date is compared to the VIX values fortransactions within the FMV Study. If the calculated VIX value falls within the top decile, topquintile, or second quintile of transactions in the FMV Study, the indicated adjustment factorsmay be applied to the private equity discount to calculate the market volatility adjustment. Theapplication of the market volatility adjustment for the Subject Interest in ABC Corp. is illustratedas follows:16

VIX 6-Month AverageMultiplicativeMedian AdjustmentLow Median High Discount FactorTop Decile 28.5 29.7 32.9 32.1% 1.47Top Quintile 26.1 28.5 32.9 26.9% 1.23Second Quintile 23.9 24.6 26.1 24.4% 1.12Sample Median 11.7 22.5 32.9 21.8% 0.00Selected Market Volatility Adjustment FactorTrailing 6-Month Average VIX as of Valuation Date 41.83Indicated Multiplicative Adjustment Factor 1.47Selected Market Volatility Adjustment Factor 1.50The trailing 6-month average daily VIX closing value is 41.83, which lies above the high end ofthe data in the FMV Study. In this case, we conservatively select a 1.5 times multiplicativeadjustment factor based on the top decile indication. However, arguments could reasonably bemade to select a greater adjustment factor. Given the empirically observed relationship betweenrestricted stock discounts and market volatility, during certain time periods when extremevolatility is present, it may be appropriate to apply adjustment factors in excess of thoseindicated by the top decile. For example, due to the collapse of credit markets stemming fromthe mortgage crisis, and compounded by rapidly declining economic conditions in the U.S. andabroad, on October 24, 2008 the VIX reached a record level of nearly 90, reflectingunprecedented expectations of future volatility. Given that the median VIX value in the topdecile of the FMV Study is 29.7, the indicated adjustment factors would not appropriately takeinto consideration this unique period in history. Applying the 1.5 times adjustment factor to theprivate equity discount of 40 percent results in a total discount indication of 60 percent.Selected Private Equity Discount 40.0%Times: Market Volatility Adjustment Factor 1.50Indicated Total Discount for Lack of Marketability 60.0%Discount ConclusionFinally, any specific facts or circumstances surrounding the interest being valued must beconsidered in reaching a conclusion for the discount for lack of marketability. These mayinclude attributes such as contractual restrictions on transfer, right of first refusal, high levels ofcash distributions, or the probability of a sale of the subject entity. In the case of ABC Corp. andthe Subject Interest, there are no significant additional factors that would warrant an adjustmentto the 60 percent total discount arrived at above.17