After an appraiser has calculated an unadjusted indicated value for a business interest, he or she must determine which of several discounts and premiums should be applied, and for each, the appropriate amount of the discount or premium based upon the fact pattern of the valuation. If the appraiser determines that there are issues of illiquidity or marketability of the business interest being valued, he or she will then need to calculate the size of the discount for lack of marketability.

According to Shannon Pratti, there are two types of "empirical studies designed to quantify the valuation adjustments associated with the lack of marketability of non-controlling interests in closely held businesses." Those are discounts on restricted stock of publicly traded companies, often referred to as restricted stock studies, and discounts on the sale of closely held company shares compared with the price of those shares in subsequent public offerings, often referred to as Pre-IPO studies. (To read about choosing the study for a valuation, see our discussion "Pre-IPO Studies or Restricted Stock Studies—Which Will You Rely Upon?")

For the purpose of this discussion, we will focus on restricted stock studies. First, what is restricted stock, and how are discounts on restricted stock relevant for the calculation of a discount for lack of marketability? The Securities and Exchange Commission website states, "Restricted securities are securities acquired in unregistered, private sales from the issuer or from an affiliate of the issuer."ii Restricted stock may be issued through private placement offerings and employee stock benefit plans, among other methods.

Restricted stock studies have gained judicial and popular approval, as "they compare directly the price paid for restricted stock sold by a firm in a private placement with the contemporaneous market price for the otherwise identical stock traded on an exchange or over-the-counter system."iii

As an appraiser, will you use an existing restricted stock study or build your own? The courts, as in Temple, as well as numerous professional and academic discussions, have underlined the inadequacies of a DLOM drawn from the mean or median of a previously published study. Some of the problems associated with using the results from a previously published study include (a) the lack of detail on variations around the mean (for more on this topic, see our discussion "Trimmed Your Mean Lately?"), (b) the relationship between the subject interest and the interest in the published study, (c) industry specific factors, and (d) the influences of factors such as the volatility at the valuation date versus the dates covered in the published study.

It may at first be intimidating for the valuator to consider creating a custom restricted stock study for a valuation, given the data gathering and analysis work done in such classic studies as the SEC Institutional Investor Study and the Willamette Management Associates Study. However, beginning in 2001 with the publishing of the FMV Study by FMV Opinions, and continuing on to 2010 with the commercial availability of the Pluris DLOM Database,vi the valuator has a considerable volume of data on restricted stock transactions at his or her fingertips from which to select a sample. In addition to providing the necessary transaction data from which to select a restricted stock study, published databases provide the valuator with the ability to document and explain why the particular selections were made, stressing the relevance of financial characteristics, the volatility, industry particulars, and closeness to the fact pattern of the valuation.

Some thoughts to consider when creating your restricted stock studies:

  1. Explain the relationship between the restricted stock data and the business interest being valued, as the Court noted in Temple.viii Record the criteria (range of market cap, revenue, assets, etc.) used to select your sample for your restricted stock study.
  2. Explain how the typical discounts for the classification (SIC code) of the subject company differ from other industries, why, and what this implies for the discount for the subject company.
  3. Keep in mind the various challenges made to published restricted stock studies and conduct your study accordingly
    1. Size: The small sample size of published restricted stock studies has been criticized by Paglia and Harjotoviiii. This is your study, however, and like many elements in a valuation, you will need to determine an appropriate sample size for it. See adjusting your criteria in (b) below. You may or may not wish to include penny stocks or low transaction stocks in your sample, so choose a transaction database, such as the Pluris DLOM Database, that gives you control over inclusion.
    2. Relevance to subject company: You have the ability to control relevance to the subject interest through your selection of criteria and the range of values you use. Pluris DLOM Database, for example, provides the valuator with 80 data points for each transaction and the ability to select a range for the selection criteria. You will want to adjust the range of your criteria in order to obtain the sample size you determine is appropriate for your study.

The topics discussed herein are only a few of the many issues facing the valuator in determining an appropriate DLOM for a business interest. Please see the other discussions in our DLOM Discussion articles. Also, please feel free to offer comments, criticisms, and suggestions about these discussions by contacting us at marketing@valusource.com.

 

i Shannon Pratt, (2008) Valuing A Business, 5th Ed, New York: McGraw Hill, p 419

ii www.sec.gov/investor/pubs/rule144.htm

iii Robak, Espen and Hall, Lance ( 2001) "Bringing Sanity to Marketability Discounts: A New Data Source," Valuation Strategies, July/August 2001

iv ARTHUR TEMPLE, Individually, and as Independent Executor of the ESTATE OF CHARLOTTE DEAN TEMPLE, Plaintiff, v. UNITED STATES OF AMERICA, CIVIL ACTION NO. 9:03-CV-165. , Filed 3-10-2006. "Rather than taking restricted stock sale data and explaining its relation to the gifted interests, Elliot simply listed the studies and picked a discount based on the range of numbers in the studies."
CLARISSA W. LAPPO, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent, T.C. Memo. 2003-258, Docket No. 11811-01, Filed 9-3-2003. (See the Court’s discussion on the studies cited.)

v Mercer, Christopher and Harms, Travis (2001), "Marketability Discount Analysis at a Fork in the Road," Business Valuation Review, Reinemann, Annika (2008), "Lack of Marketability," Trusts and Estates

vi DLOM Database. For more information, visit www.valusource.com/pluris

vii Temple, ibid, "The better method is to analyze the data from the restricted stock studies and relate it to the gifted interests in some manner…"

viii Paglia, John K. and Harjoto, Maretno (2010), "The Discount for Lack of Marketability in Privately Owned Companies: A Multiples Approach," Journal of Business Valuation and Economic Loss Analysis, Vol. 5, Issue 1