In the last two posts in this series, we have addressed two of at least three issues that are not easily addressed in the context of the traditional levels of value concepts in statutory fair value determinations.
- Determining the proportionate interest in a going concern
- The applicability of “implicit minority discounts” in Delaware fair value determinations
This post begins to address a third issue, that of the applicability of marketability discounts in statutory fair value determinations in New York.
The rules for the two most important valuation discounts in New York statutory “fair value” (FV) proceedings, such as shareholder oppression and dissenting shareholder cases, are well established: the discount for lack of marketability (DLOM) is in; the minority discount a/k/a discount for lack of control (DLOC) is out. DLOM applies because it reflects the additional time and risk of selling even a controlling, nonmarketable interest in a closely held business as compared to publicly traded shares. In contrast, the reasoning goes, if DLOC were applied in FV proceedings the majority shareholders would receive a windfall that would encourage squeeze-out and unfairly deprive minority shareholders of their proportionate interest in the venture as a going concern.
As I’ve previously written here and here, the exclusion of DLOC in FV appraisals is the principal distinguishing feature from the “fair market value” (FMV) standard used in matrimonial, gift and estate tax matters where, premised on a hypothetical arm’s-length transaction under which neither buyer nor seller is under any compulsion to buy or sell, both discounts generally apply. The two discounts, individually and certainly when combined, can substantially reduce the value of an interest in a closely held business entity. (Links in original post)
Having stated this current overview of New York statutory fair value law, Mr. Mahler then goes on to discuss Cole v. Macklowe, an apparent exception (and subject to appeal) to the rote applicability of a marketability discount in an otherwise controlling interest valuation.
Once again, we look at the traditional, three-level levels of value chart that gives rise to much confusion in the statutory fair value world.
At its simplest, the marketability discount is applicable to the marketable minority level of value. It is that conceptual valuation discount that accounts for the additional risks and (likely) lower expected cash flows attributable to illiquid minority interests rather than to an enterprise. Two observations are appropriate here:
- The marketable minority level of value is an enterprise level of value. Value indications are developed based on the capitalization (or discounting) of 100% of enterprise cash flows. Some say that the level is, nevertheless, minority. However, since 100% of the enterprise cash flows are capitalized into the current price for public (and, as-if for private) companies, no discounting from that level for lack of marketability or otherwise is appropriate in fair market value (or fair value) determinations at that level. See the further discussion below.
- The control level of value on the chart also represents the capitalization (or discounting) o 100% of the cash flows of an enterprise. However, the control level cash flows may be different than at the marketable minority level if others think they can run the company better (and adjust existing cash flows) or differently (and adjust existing or synergistic cash flows).
Looking back at the chart, it is clear that the marketability discount relates to the marketable minority level of value. Market evidence of the lower typical pricing of public securities whose liquidity is impaired is found in numerous restricted stock studies. In the third post in this series, we learned:
It has long been accepted that minority interests in private companies are worth less, perhaps even substantially less, than controlling interests. What have not been clearly understood are the reasons for differences in value between minority and controlling interests of businesses.
Appraisers have typically moved from the marketable minority level of value to the nonmarketable minority level of value through the application of a conceptual discount called the marketability discount. That has been my term of preference for many years, but others refer to the same discount as the discount for lack of marketability (DLOM).
If, as in our example above, the marketable minority level of value is $10 per share for a company, and a transaction in a minority block occurs at $7.50 per share, then the marketability discount is 25% (1 – ($7.50/$10)).
The concept of valuation discounts related to lack of marketability has been studied in the public securities markets since the 1960s. A good overview of available market evidence (i.e., restricted stock studies and pre-IPO studies) is found in my book, Business Valuation: An Integrated Theory Second Edition (with Travis Harms). These studies of market evidence fall into two categories, restricted stock studies and pre-IPO studies.
In the remainder of this post, we will address the issue in light of levels of value charts. In future posts, we will refine our discussion of expected cash flow, risk, and growth to further elaborate on this question and the proportionate interest in a going concern and the implicit minority discount questions as well.
The logic for the application of a marketability discount to an otherwise controlling interest is repeated from above:
DLOM applies because it reflects the additional time and risk of selling even a controlling, nonmarketable interest in a closely held business as compared to publicly traded shares.
This is the stated logic (as summarized by Mr. Mahler) and it is consistent with what I have seen in my experience in statutory fair value matters in New York, as well. While the issue may be well-settled, it is also well-debated in New York statutory fair value cases because the logic is simply incorrect. In light of the three-level chart above, it should be clear that there is no marketability discount applicable at the controlling interest level of value.
No valuation discount or premium has any meaning unless the base from which it is taken or to which it is applied is defined. The marketability discount has meaning because it applies to the marketable minority level of value and reduces value for lower expected cash flows and greater risk normally associated with holding illiquid minority interests.
It is incorrect, both theoretically and practically, to apply a marketability discount to a controlling interest in a business. The market information (i.e., restricted stock studies) has no bearing on controlling interests. Yet, it is the restricted stock studies (and pre-IPO studies) that have been cited to justify marketability discounts to controlling interests in New York fair value determinations.
There are no studies that provide market evidence of the lack of marketability for controlling interests in companies. It is true that public securities can be sold and cash received in settlement three days later. That is the institutional framework in which interests in public companies are sold.
It is also true that it generally takes considerable time to sell entire companies. However, it is appropriate to compare this time with the three day settlement period for public security transactions. I first wrote an article on this topic in June 1994 in the Business Valuation Review. The logic was developed further as we developed the integrated theory of business valuation.
Thanks to the magic of Google, readers can look inside the overs of Business Valuation: An Integrated Theory Second Edition on this topic.
A New York Hypothetical Example
In New York, the application of a marketability discount to otherwise controlling interests is particularly interesting. A number of the cases in which the issue has arisen have related to asset holding companies. Many of the thousands of apartment buildings, office buildings and other rental properties in New York City have been placed into corporate or partnership form. A number of those corporate entities have been involved in statutory fair value or shareholder oppression disputes.
Consider that a corporation whose primary assets, other than cash, are apartment buildings in New York City. In a statutory fair value matter, the apartment buildings would normally be appraised individually by qualified real estate appraisers. Assume for purposes of this example that two qualified real estate appraisers reached conclusions within three percent of each other, an immaterial amount that is resolvable between the parties or certainly by a court.
Now consider that two business appraisers are retained by the company and the dissenting shareholders, respectively, to value the stock in the company, and that the real estate values are stipulated by the parties.
- Both appraisers have an identical net asset value. There is no dispute over the value of cash, any other assets and the few liabilities on the balance sheet.
- No other valuation issues relating to the valuation of the company, e.g., embedded capital gains or other off-balance sheet liabilities, were identified by either appraiser.
- Both business appraisers conclude that net asset value is $20.0 million
- One appraiser applied no marketability discount, so her conclusion of the fair value of the company was $20 million.
- The other business appraiser applied a discount for lack of marketability of 30%, consistent with case law, citing restricted stock studies as the basis, so his conclusion of fair value was $14 million.
What is a judge to do? In a similar case that has not yet been decided (and where there were also other valuation issues), I made arguments like above regarding the inapplicability of the DLOM, or marketability discount to an otherwise control valuation. I also pointed out, after reading the appraisal reports of two groups of real estate appraisers, that “time to market” was an integral assumption in both groups of appraisals.
“Time to market” was the expected exposure time that preceded the valuation date of the reports that was assumed to have already occurred prior to the valuation date.
If the time to market had already been considered, how then would it make sense to apply an additional and arbitrary DLOM to the corporation’s fair value for, effectively, the time to market the corporation (which consisted almost entirely of the properties) which had already been considered by the real estate appraiser.
The Real New York Case at Hand
Mr. Mahler reports the following about Cole v. Macklowe:
The application of discounts, Justice Diamond therefore concludes, does not turn on statutory constraints. ”Rather, the issue turns on whether the policy concerns underlying the ban on the use of discounts are present in this case.” Those concerns are present in Cole, Justice Diamond finds, based on four factors:
- Macklowe’s repudiation of Cole’s equity interests “is clearly analogous” to oppressive majority shareholder conduct intended to limit or preclude minority ownership rights, thereby implicating the statutory objective in oppression cases of obtaining a “fair appraisal remedy.”
- The use of discounts would “reward” Macklowe by limiting the damages payable by him arising from his own misconduct.
- As in Vick, the unavailability of discounts is “particularly apt” since the business assets consist of real estate, and their application would deprive Cole of what the value of his interests would have been had each of the designated properties been sold on the open market.
- The use of discounts would result in a “windfall” to Macklowe by virtue of his “consolidating or increasing his ownership and control of the properties,” as opposed to a sale to a third party who gains no right to control or manage the entity.
“Accordingly,” Justice Diamond decrees, “Macklowe’s request for leave to present expert testimony regarding the applicability of minority and marketability discounts is hereby denied.”
In correspondence with Mr. Mahler, he noted that to date, there is little case authority in New York to justify the use of DLOM in statutory fair value cases. That guidance came in Matter of Blake (1985), in which we find the following:
With regard to the discount applied by the referee and approved by Special Term, we believe that that discount should be reduced from 40% to 25%. Said discount should only reflect the lack of marketability of petitioner’s shares in the closely held corporation. No discount should be applied simply because the interest to be valued represents a minority interest in the corporation.
Business Corporation Law § 1104-a was enacted for the protection of minority shareholders, and the corporation should therefore not receive a windfall in the form of a discount because it elected to purchase the minority interest pursuant to Business Corporation Law § 1118. Thus, a minority interest in closely held corporate stock should not be discounted solely because it is a minority interest (see, Brown v Allied Corrugated Box Co., 91 Cal App 3d 477, 154 Cal Rptr 170; Woodward v Quigley, 257 Iowa 1077, 133 NW2d 38; but see, Perlman v Permonite Mfg. Co., 568 F Supp 222, 230-232, affd 734 F.2d 1283; Moore v New Ammest, 6 Kan App 2d 461, 474-475, 630 P2d 167, 177).
However, a discount recognizing the lack of marketability of the shares of Blake Agency, Inc., is appropriate, and, under the circumstances of this case, the amount of the discount should be 25%. A discount for lack of marketability is properly factored into the equation because the shares of a closely held corporation cannot be readily sold on a public market. Such a discount bears no relation to the fact that the petitioner’s shares in the corporation represent a minority interest (see, e.g., Haynsworth, Valuation of Business Interests, 33 Mercer L Rev 457, 489-90; Lyons & Whitman, Valuing Closely Held Corporations and Publicly Traded Securities with Limited Marketability: Approaches to Allowable Discounts from Gross Values, 33 Bus Law 2213; cf. Ford v Courier-Journal Job Print. Co., 639 SW2d 553 [Ky App])
There is not much guidance here. Looking at the Ford v. Courier-Journal case cited above, though, the evidence cited to justify a 25% marketability discount is definitely based on restricted stock (minority) transactions of public companies:
After a careful examination of the total assets, and even a consideration of the Stevens sale, which occurred after the statutory date of December 20, 1978, the appraisers arrived at a net asset value of $165.00 a share. They then applied what they termed a “marketability discount” in the following language:
*556 The final step is to address the question of marketability. C-J Job Printing is not a public company and a closely held stock is considerably less attractive to an investor than a similar stock with access to the public marketplace. This difference is normally expressed in terms of a marketability discount applied to its “if-public” price. These discounts, in general, range between 20 and 50 per cent and reflect both the nature of the public market (which was generally unreceptive to new issues at the valuation date) and the characteristics of the subject company (in this case a small regional business with no express desire to go public). (Emphasis added)
The evidence cited pertained to restricted stock studies in existence in the late 1970s or early l1980s. The valuation date above was in 1978 and the opinion was rendered in 1982. A great deal has happened in the world of valuation since then that is not reflected in the current application of a marketability discount in statutory fair value determinations in New York.
As stated in the first post in this series, I am agnostic with respect to what courts in any jurisdiction call fair value. The various courts are called upon to make equitable determinations and this can be a difficult process.
What I am concerned about, however, is the fact that courts provide valuation guidance in the process of making their statutory fair value determinations. If that valuation guidance is unclear, or if it is based on inadequate or inappropriate market evidence, then the stage is set for future disputes in fair value determinations.