The IRS posted the Discount for Lack of Marketability Job Aid for IRS Valuation Professionals (“the DLOM Job Aid” or “Job Aid”) on its website on Monday, August 22, 2011. The DLOM Job Aid is a manual for IRS employees to assist them when evaluating marketability discounts. One this that was important in the development of the DLOM Job Aid was to understand the basic methods employed by business appraisers including their relative strengths and weaknesses. The DLOM Job Aid is heavily researched, well written, and filled with useful content.
The DLOM Job Aid contains 112 pages of material. It is divided into seven principal sections as follows:
- A. Executive Summary
- B. Introduction
- C. General Marketability Discount Information
- D. Summary of Approaches to DLOM
- E. Evaluation and Recommendations
- F. Summary and Conclusions
- G. Bibliography
There are two tables regarding restricted stock studies and three exhibits. The exhibits are titled “Review FMV Restricted Stock Model,” “Pre-IPO Studies,” and “Analytical Approach Revisited.”
Our purpose at this point is to provide an overview of the content of the DLOM Job Aid and to identify what we will see are “factors influencing marketability” as defined in the Job Aid.
The Job Aid does an excellent job of focusing the reader’s attention on the numerous factors which can influence the marketability (and therefore the value) of securities in specific valuation situations.
Following a fairly detailed review of the Job Aid, we will begin to review each of the various methods for determining marketability discounts in light of the structure provided in the Job Aid, but also through the filters of business valuation standards (how does each method seem to comply?) and the factors influencing marketability (which specific factors does a method enable an appraiser to consider and how?).
Disclaimer Provides Mandate for Appraisers
After making the obligatory disclaimer that the opinions expressed in the Job Aid are those of the DLOM Team members and were not opinions or policies of the Internal Revenue Service, the Disclaimer actually provides a three-part mandate for IRS (and all) business appraisers. It is easy to miss or overlook, but of sufficient importance for specific focus. The Disclaimer states (with formatting liberties):
The Valuation Analyst must have:
1. a clear understanding of the facts and circumstances of each interest to be valued,
2. use professional judgement in choosing a DLOM just as is done for all other parts of a valuation,
3. and apply a reasonableness test.
1. Facts and Circumstances. Key questions regarding the first element of the mandate include: What are the “facts and circumstances” applicable to each interest being valued? What relationship do they bear to the “factors influencing marketability?” How should the appraiser express this “clear understanding?”
One thing is clear. The guidance to IRS Valuation Analysts is to understand the facts and circumstances of each case. What are the facts and circumstances of each case? Readers will have a much better idea following the discussion of “factors influencing marketability.” Note also that the guidance pertains to “each interest to be valued.” This suggests that the facts and circumstances can be different, modestly or even significantly, for different securities of the same company at the same time. But appraisers must consider facts and circumstances relevant to each appraisal situation.
2. Professional Judgment. Key questions regarding the second element of the mandate to appraisers include: Is a mere opinion an “expression of professional judgment?” What constitutes support for an opinion that reflects “professional judgment?” What is meant by the phrase “as is done in all other parts of a valuation”?
Professional judgment has been described in an accounting context as:
Professional judgment is a process used to reach a well-reasoned conclusion that is based on the relevant facts and circumstances available at the time of the conclusion. A fundamental part of the process is the involvement of individuals with sufficient knowledge and experience. Professional judgment involves the identification, without bias, of reasonable alternatives; therefore, careful and objective consideration of information that may seem contradictory to a conclusion is key to its application. In addition, both professional skepticism and objectivity are essentialto the process and to reaching an appropriate conclusion.Professional judgment is not an arbitrary decision, a substitute for professional skepticism, or a method to rationalize a particular result. Performing the process in “form” without focusing on the substance does not constitute well-reasoned professional judgment.
Professional judgment is critical to efficiently and effectively planning, performing, and concluding in an audit. Auditors use professional judgment to focus on the most important aspects of an audit; to determine the nature, timing, and extent of audit procedures; and to appropriately challenge the accounting, reporting, and other conclusions reached and financial statement assertions made by management. (emphasis added)
While this discussion applies to auditors, it is also relevant to business appraisers. The exercise of professional judgment demands an understanding of the relevant facts and circumstances of each particular valuation situation. It involves a consideration of reasonable alternatives and careful consideration of what may seem to be contradictory information. Professional judgment involves the appropriate use of skills of skepticism and objectivity. So, one cannot provide an unsupported opinion in the exercise of professional judgment.
3. Reasonableness Test. The most relevant question regarding this third element of the Disclaimer’s mandate is: With respect to a concluded marketability discount, what might constitute “reasonableness tests?”
For enterprise valuations, i.e., valuations prior to the application of marketability discounts, reasonableness tests or “sanity checks” are often employed. Reasonableness testing can include simple comparisons with relevant guideline reference points, including:
- Median or average guideline company multiples across relevant valuation parameters (sales, EBITDA, EBIT, net income, etc.)
- Transactions involving the subject company’s stock
- Comparisons with transaction multiples of sales of reasonably similar businesses
- And others…
For shareholder-level valuations where a DLOM is applied, reasonableness can be tested primarily in terms of implied rates of return over relevant expected holding periods. There is a rate of return (or range of expected returns) implied in every enterprise valuation. Similarly, there is a range of expected returns over, perhaps, a range of expected holding periods. A test of reasonableness might entail making sensitivity calculations regarding alternate holding periods and expected shareholder level returns in light of the expected returns on alternative and similar investments. In any event, appraisers need to consider reasonableness tests for nonmarketable minority valuations as well as for pre-DLOM valuations.
The three-part mandate for business appraisers in the Job Aid’s Disclaimer essentially calls for the exercise of the three “extra” factors found in Revenue Ruling 59-60 (other than the basic eight factors listed). These three factors are common sense, informed judgment and reasonableness.
Our next post will examine the “Executive Summary” and “Introduction” sections.
- IRS DLOM Job Aid
- Presentation on IRS DLOM Job Aid by Timothy R. Lee, ASA | Mercer Capital
- 3-part webcast series sponsored by Jim Hitchner’s Valuation Products and Services