The IRS DLOM Job Aid contains a lengthy section entitled “Summary of Approaches to DLOM.” As noted in the last post, this section divides the various methods (they are called approaches in the Job Aid) for determining marketability discounts into four categories. This post provides an overview of the discussion and analysis of the various methods for determining DLOMs in the four categories employed in the Job Aid.
Five categories or general methods are discussed in this section, including restricted stock studies, pre-IPO studies, restricted stock equivalent analysis, cost of flotation, and the Mandelbaum factors.
Restricted Stock Studies
The discussion of benchmark methods notes there are two basic types of benchmark analysis, those that look at restricted stock studies and those that examine pre-IPO studies. The section on restricted stock studies focuses on a group of studies that began with the SEC Institutional Investor Study (published in 1971 and analyzing transactions occurring in the 1966-1969 timeframe, and ends with two studies performed by Columbia Financial Advisors in 1997 and 1998.
All the studies considered in this section are listed in the table below excerpted from the Job Aid. Citations for each of the studies are found in the IRS DLOM Job Aid.
The strengths and weaknesses of restricted stock benchmark analysis are outlined in the Job Aid. One additional study is mentioned, the FMV Restricted Stock Database. The Job Aid is critical of this database and includes as an exhibit a study prepared by an IRS engineer in 2009. Lance Hall of FMV Opinions, Inc. has offered responses in numerous places, including here and here. I simply note the controversy here and defer any comment until we begin our analysis of all of the methods in light of prevailing business valuation standards and how each method enables appraisers to consider the factors influencing marketability.
My 1997 book, Quantifying Marketability Discounts, contains a chapter providing a detailed analysis of the majority of the studies noted above. That book is currently out of print. Its current successor is Business Valuation: An Integrated Theory Second Editionˆ(with Travis Harms). Readers who would like an to receive an excerpt from the book discussing that discussed these studies can email me (address to the left ) and I will be happy to provide it.
Three pre-IPO studies are mentioned in the Job Aid:
- Willamette Management Associates (WMA) Study. This study covered pre-IPO transactions in the 1975 to 1997 timeframe.
- Robert W. Baird & Company Pre-IPO Studies. These studies cover various time periods from 1981 through 2000 and are often referred to as the “Emory Studies” because they were published regularly by John Emory, Sr., now of Emory & Co. Exhibit B to the Job Aid provides summary information for both the Willamette Management Associates study and the Emory Studies.
- Valuation Advisors’ Lack of Marketability Discount Study. Brian Pearson of Valuation Advisors has been performing these studies for more than ten years. Mr. Pearson participated in a recent VPS STRAIGHtalk Series webinar responding to the criticisms found in the Job Aid regarding his ongoing study. Travis Harms and I also participated in that webinar to discuss my opinion of the IRS critique of the DLOM studies, databases, and models.
- Estimate the “Restricted Stock Equivalent Value” for application to the publicly traded stock
- Add an increment to the restricted stock equivalent value to account for differences in marketability of public companies versus the subject private stock.
Mr. Robak and Lance Hall (linked above) have written a number of articles describing this method.
Cost of Flotation
The brief section on cost of flotation does not really give much credence to this method. This method gets mentioned from time to time, but I do not recall seeing its use in an appraisal report for more than a decade.
Mandelbaum Factors, Judge Laro 1995
In Mandelbaum, Judge David Laro outlined a series of ten (actually nine) factors that he used to “benchmark” a marketability discount, being unsatisfied with the DLOMs developed by either of the two appraisers at trial. Mandelbaum was important in that it marked a breakaway from the “old-time” method of benchmarking.
I wrote about the original benchmarking in the first two paragraphs of Quantifying Marketability Discounts in a section titled “A Major Problem: Bold, Unsupported Adjustments in Valuations.” The book began:
The typical business appraisal requires several dozen pages of text and exhibits to arrive at a preliminary indication of value for a subject interest at the marketable minority interest level of value. From that point, the appraiser typically makes one of two bold adjustments:
1. If the subject of the appraisal is a nonmarketable minority interest in a private business, a marketability discount of some 35% (plus or minus) is subtracted from the preliminary indication of value. The appraiser will likely cite several articles and studies quoted in Shannon Pratt’s Valuing a Business, and the valuation is concluded in two or three paragraphs [citation to Pratt's 1996 Third Edition omitted] The implication is that all marketability discounts are about 35%, so the appropriate discount for the subject is therefore 35% (plus or minus).
2. The second adjustment was the control premium [discussion omitted].
In Mandelbaum, the Court was presented with two appraisals. The appraiser for the Internal Revenue Service cited three of the studies in the table above, discussed a range of discounts of 30% to 35% and concluded that the appropriate DLOM was 30%. The Court was not impressed. I can’t say more about the first appraisal because it was exactly as described in the quote above.
The appraiser for the taxpayer’s analysis included a quantitative analysis to develop his marketability discounts (there were multiple dates). They were in the range of 70% to 75%. The Court did not find his conclusion satisfying either.
Judge Laro heard the testimony of both appraisers and then conducted his own valuation. He did likewise in Estate of Noble. I know about that one because I was there.
Judge Laro’s methodology in Mandelbaum forced appraisers to begin to think about “factors influencing marketability.” He used studies cited in the taxpayer’s appraiser’s report to develop a “benchmark range” of 35% to 45%. This range was the range from the average of the cited restricted stock studies to the average of the cited pre-IPO studies. Shareholder-level factors included the company’s dividend policy, the amount of control in the block of stock, restrictions on transferability, the expected holding period for the stock, the company’s redemption policy and the costs of flotation. The three additional factors actually referred to the enterprise: financial statement analysis, the nature of the company, and the company’s management.
Judge Laro considered, based on his analysis, that five of the nine factors suggested a marketability discount below the bottom of the range of 35% to 45%. Two of the factors suggested a discount above the higher end of the range. Finally, the remaining two factors suggested a discount within the range. He concluded that the appropriate marketability discount was 30%, which was identical to the 30% conclusion of the appraiser for the IRS that was dismissed. You lose some and win some at the same time?
Mandelbaum analysis has been around since the publication of the case in 1995. It enjoys considerable use by the appraisal community in one form or another.
Mandelbaum was the subject of many reviews, including a lengthy analysis I wrote in Quantifying Marketability Discounts in 1997. Readers who would like to see this review can email me.
Wrap-up for Benchmark Method Overview
The purpose of this review of the IRS DLOM Job Aid is not to write about each and every comment, criticism or praise for each and every method. My purpose here is to lay out what is in the Job Aid. If you want to read it for your self, click here.
I mentioned three resources from the out-of-print Quantifying Marketability Discounts above:
- Chapter 2: Marketability Discount Studies — The Restricted Stock Studies
- Chapter 3: Marketability Discount Studies – The Pre-IPO Studies
- Case Review of Mandelbaum (found in Chapter 4, An Overview of Tax Court Decisions)