This post reviews and discusses pages 5-11, or Section C, of the IRS DLOM Job Aid. The Section is titled “General Marketability Discount Information” and has five sections. We will discuss each section, but the focal point is the second section, “Factors Influencing Marketability Identified.”
1. Marketability Defined
The first section begins with definitions of marketability and the discount for lack of marketability (DLOM) from the International Glossary:
Marketability. The ability to convert property to cash at minimal cost.
Discount for Lack of Marketability. An amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability
There is a brief but important discussion in two paragraphs, which are quoted below. These two short paragraphs highlight the reasons that investors demand a price concession for an unmarketable asset relative to one (the example is a publicly traded stock) that is readily marketable and for which cash can be obtained quickly and without discounting.
Given two identical business interests, a higher price will be paid by investors in the market for the business interest that can be converted to cash most rapidly, without risk of loss in value. An example is publicly-traded stock on the New York Stock Ecxchange, where the owner can order the sale and the proceeds are deposited in bank account in three days.
In the alternative, a lesser price is expected for the business that cannot be quickly sold and converted to cash. A primary concern driving this price reduction is that, over the uncertain time frame required to complete the sale, the final sale price becomes less certain and with it a decline in value is quite possible Accordingly, a prudent buyer would want a discount for acquiring such an interest to protect against the value loss in a future sale scenario. [emphasis added]
The IRS DLOM Job Aid recognizes, as can be seen by the italicized portion above, that a marketability discount is appropriate when the risks of holding an asset over an uncertain timeframe prior to realizing the expected benefit or cash flow exceed the risks of holding an otherwise similar but marketable asset.
Readers of this blog have heard me say before that value of an enterprise is a function of its expected cash flows (and their growth) and the risks associated with achieving them. The value of an interest in an enterprise is also a function of the expected cash flows – to the interest – and the risks associated with achieving them. The expected cash flows for an enterprise are all of its expected future benefits, into perpetuity. The expected cash flows to an interest are those that can reasonably be expected to be received – in the form of dividends or distributions and in a sale at the end of an uncertain holding period.
The IRS Job Aid uses different language to describe these relationships between marketable and nonmarketable interests.
2. Factors Influencing Marketability Defined
Mandelbaum v. Commissioner outlined a number of factors that potentially influence marketability. The case fostered a widespread discussion of how these factors could be assessed in specific valuation situations in relationship to certain “benchmarks” pertaining to restricted stock studies and pre-IPO studies.
Nine factors were mentioned in Mandelbaum. The case actually mentions ten factors, but the first one is an appraiser’s previously determined value of the enterprise at the marketable minority level of value.
The IRS DLOM Job Aid provides a more extensive list of factors influencing marketability, divided into two categories relating to the subject company and to the subject interest. The factors were “modeled after the Mandelbaum factors.” There are 25 subject company factors and an additional nine subject interest factors. The relevant factors all relate to a subject interest and can be termed “shareholder-level factors.”
Upon examination, the factors can be organized differently, and, like in Mandelbaum some of the subject company factors are, in reality factors that do indeed relate to the company and not directly to the marketability discount. With a bit of reorganization, the factors can be related to whether they relate to the expected cash flow of a subject interest (or the growth of the cash flows to the interest), the expected holding period, or to the risks associated with achieving the expected cash flows.
The adjusted list is shown below, where the factors are highlighted if they impact the risks (R), the expected holding period (HP) or the expected cash flows to an interest (CF). Some factors can influence more than one of the value drivers. The list is marked to facilitate a visual separation between the categories of factors. In developing this list based on the review of the IRS DLOM Job Aid, we also examined PG-2 (Procedural Guideline), Valuation of Partial Ownership Interests in the ASA Business Valuation Standards as a cross-reference.
What is important about the list of factors influencing marketability in the IRS DLOM Job Aid is the focus on specific factors. These factors are the same factors that are considered by hypothetical and real buyers of illiquid minority interests.
As the series on Understanding the Largest Valuation Discount continues, we will return to the above list of factors influencing marketability and ask how the various methods for developing marketability discounts are or can be considered when using them.
3. Willing Seller Consideration
The short (about one page) discussion of hypothetical willing sellers in the IRS DLOM Job Aid is not very satisfying. Several fairly dated cases are noted that provide various glimpses of buyers and sellers in specific fact situations. Several of the cases seemed to imply either family attribution or focusing on specific sellers and buyers, rather than hypothetical willing sellers and buyers.
Quoting Cousins v. CIR, we do find the following:
…we do not construe a fair market as meaning that the whole world must be a potential buyer, but only that thee are sufficient available persons able to buy to assure a fair and reasonable price in light of the circumstances affecting value.”
For a deeper treatment of the hypothetical willing seller, see my article titled ”Fair Market Value vs. the Real World.“
4. Marketability of Minority vs. Controlling Interests
This discussion mentions that the application of marketability discounts to controlling interests is a “controversial issue amongst appraisers.” The two paragraph section mentions the controversy and then notes that appraisers who believe in such a discount also believe that they should be smaller than marketability discounts applied to minority interests.
I have written about this controversy in the past. For a discussion of this issue, see Chapter 3 of Business Valuation: An Integrated Theory Second Edition (with Travis W. Harms).
A discount [or premium] has no meaning until the conceptual basis underlying the base value to which it is applied is defined.
Those who advocate the application of marketability discounts to controlling interests have yet to define the base value, i.e., placement on the levels of value charts, from which it is to be taken. Nor have they described how this discount might be developed or what relevant market evidence of its existence there might be. Anyhow, we will save this discussion for treatment in a full post later in the series.
5. Sample Initial IDR Items on Marketability
This section provides a list of 17 items that the IRS might request in an Information Document Request to enable analysis of the appropriate marketability discount in specific fact situations.
There is parenthetical commentary discussing the relevance of the requested items regarding their contribution to lack of marketability.
What’s Coming Next?
The next few posts will examine the section ”Summary of Approaches to DLOM” (pages 12-73 of the Job Aid). This section considers the various methods employed by business appraisers to determine marketability discounts, dividing them into four categories:
- Benchmark study
- Analytical methods
- Other methods
We will do a bit of organizational work with the discussion and will ultimately categorize the methods as to whether they should properly fall under the income approach or the market approach to valuation. It will be an interesting and informative segment to this ongoing series, Understanding the Largest Valuation Discount.