After reading the 15th post in my series on Understanding the Largest Valuation Discount addressing the “factors influencing marketability” as found in The IRS DLOM Job Aid, Rod Burkert of Burkert Valuation Advisers, LLC, wrote me with some helpful questions and suggestions . In that post, I provided a table breaking the factors into categories of those affecting expected cash flow, expected risk and the expected holding period. He pointed out a couple of modest inconsistencies that needed to be fixed. He also asked me how I had moved from the list of factors in the IRS Job Aid to the longer list found in the recent post. Good observations questions. Thanks, Rod!
IRS DLOM Job Aid Factors Influencing Marketability
The IRS DLOM Job Aid lists a total of 33 factors in a section titled “Factors Influencing Marketability Identified.” The factors are divided into two types, “Subject Company Factors” (25 factors) and “Subject Interest Factors” (8 factors). In the Table 1 below, I have reproduced the two types of factors and then, independently, recategorized them into three groups:
- E = Enterprise Factors. Considered in the appraisal of businesses at the (enterprise) marketable minority level of value.
- S = Shareholder Factors. Considered by investors at the shareholder level in making investment decisions in illiquid minority interests of privately owned business enterprises.
- S,E = Factors Impacting Both Enterprise and Shareholder Level Investment Decisions.
The categorizations are mine. I’m not sure how factors were categorized by the preparers of the IRS DLOM Job Aid. However, we do need to focus on factors the influence investments in illiquid minority interests. My categorization facilitates this focus.
There are a total of 33 factors listed in the IRS DLOM Job Aid. Looking at the first “subject company” factor above, which is “Value of subject corporation’s privately traded securities vs. its publicly traded securities.” I have indicated that this is an Enterprise factor, since it relates to the enterprise level, or marketable minority level of value. On the next table, we will refer to this factor as the “marketable minority level of value for a private company.” Likewise, the dividend yield is an investment of interest to shareholders (and not of direct interest in developing enterprise-level valuations), so the third subject company factor above is labelled as a Shareholder factor. And so on.
Resorted Shareholder Level Factors and Enterprise Factors
In Table 2, we see the resort based on my categorization of factors as Shareholder-related (S), Enterprise-related (E) or, perhaps, both (S,E). A glance at the Enterprise Factors at the bottom of Table 2 indicates that this sort has eliminated factors that are typically considered by appraisers in the development of value indications at the marketable minority level of value. This is important, because it is not appropriate to consider factors at both the Enterprise and Shareholder levels unless they are legitimate investment factors at both levels of value.
Note that we still have 33 factors. Other than renaming Enterprise Factor #1 as the Marketable Minority Value for Private Company, there are no changes from the IRS DLOM Job Aid other than the separation into Shareholder and Enterprise factors. Table 2 illustrates two things quite clearly:
- The Shareholder Level Factors at the top of the table are factors that, fairly obviously, can influence marketability for minority interests in private businesses.
- The Enterprise Factors at the bottom of the table pertain to the value of the business and are almost uniformly considered by business appraisers in their development of value indications at the marketable minority level, or the level from which marketability discounts are applied.
Focus on Shareholder Level Factors from IRS DLOM Job Aid
With the segregation of factors to emphasize the shareholder level factors in Table 2, we look more closely at these 21 factors in Table 3. As seen below, four of the factors relate to public companies. Since our primary interest is in the valuation of illiquid securities of private companies, we move them to the bottom of the table to focus on the private company shareholder level factors.
The shareholder level factors above are factors that investors in illiquid securities might or would consider in their decision-making processes. The table includes some general comments relating to each of the factors. These factors are generally accepted as being relevant factors that influence marketability. But the above list is not complete.
Completing the List of Shareholder Factors Influencing Marketability
We consulted two sources for additional factors that might influence the marketability of illiquid securities of private businesses. Many of the factors are in one or both of the following sources:
- Business Valuation: An Integrated Theory Second Edition. Mercer, Z. Christopher and Harms, Travis W., (John Wiley & Sons, Inc., Hoboken, New Jersey, 2007). This book is the successor to my book, Quantifying Marketability Discounts (published in 1997 and now out of print), which introduced the Quantitative Marketability Discount Model. The professionals at Mercer Capital have been developing a list of factors influencing marketability for consideration in minority interest appraisals for many years.
- (Procedural Guideline) “PG-2, Valuation of Partial Ownership Interests,” ASA Business Valuation Standards. This Procedural Guideline was developed by the Standards Subcommittee of the Business Valuation Committee of the American Society of Appraisers. It reflects the experience of all of the members of the Subcommittee who worked during its development.
The list on the left of Table 4 repeats the 17 shareholder factors from the previous Table. The list on the right, “Mercer Renames or Adds in Italics,” begins to develop a more comprehensive list. If one or both of the above sources described any of the original 17 factors from the DLOM Job Aid better than in that document, I changed the name. After considering the initial 17 factors, the additional factors, down to #36, were added based on examination of the two noted sources.
Beginning with the IRS DLOM Job Aid, we have developed a list of some 35 factors that influence marketability of nonmarketable, or illiquid, minority interests in closely held businesses. We can work with this list and bring it to a state that will enable its use in discussions regarding marketability discounts by focusing attention on specific possible factors that might influence marketability and on how the factors might be considered when using the various methods for developing marketability discounts.
Expanded List of Factors Influencing Marketability
In the fifth table in this series, we consolidate the list from Table 4. We know from the Gordon Model and the basic discounted cash flow model that there are three factors that, when considered comprehensively, determine the present value of businesses, expected risk (R), expected cash flows (and the expected growth of the cash flows) (CF). R is the discount rate that reflects the risks associated with achieving the forecasted cash flows, or the required rate of return.
The valuation of enterprises is a perpetuity concept. The expected cash flows are assumed to continue into perpetuity. Often, in a two stage DCF model, the appraiser will forecast expected cash flows for a finite period of years and then estimate a terminal value at the end of the finite forecast period.
The emphasized terms in the two preceding paragraphs were discussed at length in the fifth post in this series. Readers are referred there for a more in-depth discussion of discounted cash flow at the enterprise and shareholder levels.
Suffice it to say that the valuation of illiquid minority interests is not a perpetuity concept. Investors make illiquid investments with expected holding (or investment) periods in mind. While the expected holding periods may be uncertain and may not be determined with precision, investors nevertheless make decisions based on their expectations for expected holding periods.
The expected holding period is the period of time over which investors expect to realize their investment objectives in terms of interim cash flows and in terms of capital gains. Actual results, i.e., investment returns, will likely vary from expectations, but decisions are made based on expectations.
While the values of businesses are a function of their expected cash flows, risks and growth, the values of interests in businesses varies somewhat in functionality because of the finite nature of investment horizons. The value of an illiquid interest in a business is a function of the following:
- CF. The expected dividends or distributions (i.e., cash flows) that are attributable to the interest over the expected investment horizon, or expected holding period. This would include the expected growth in cash flows over the expected holding period. It would also include the future expectation of receiving the proceeds of selling the interest, or the terminal value of the investment at the end of the expected holding period, which is a function of the expected growth in value of the enterprise over the expected holding period. Some of the factors influencing marketability relate to expectations for the receipt of future cash flows.
- R. The expected risks of receiving the expected cash flows over the expected holding period as well as the risks associated with receipt of the terminal value upon ultimate sale of the investment at the end of the expected holding period. We used the generic R to denote the discount rate, or required rate of return for an investment in a business above. The risks associated with an investment in an interest in a business include those risks. In addition, there are incremental risks associated with such illiquid investment. For this reason, we often call the discount rate associated with illiquid investments as the required holding period return. For this discussion, we will use the conceptual R, but even a casual look at the factors influencing marketability in the lists above and below should reflect many of the incremental risks associated with investments in interests in businesses relative to the businesses themselves (in the entirety).
- HP. The third component of the discounted cash flow model applicable to interests in business enterprises is the expected holding period itself. The terminal cash flow for an illiquid investment is assumed to be received at the end of the expected holding period. The length of the expected holding period can be influenced by numerous of the factors influencing marketability. Other things being equal, the longer the expected holding period, the lower the present value of expected future benefits attributable to an interest in a business and, therefore, the higher the marketability discount. While expected holding periods can seldom be predicted with certainty, they must nevertheless be estimated by real life investors, hypothetical investors of the fair market value world, and business appraisers. A number of the factors influencing marketability relate to investors’ expectations regarding the length of the expected holding period.
- Combinations. Some of the factors influencing marketability can have an impact on more than one of CF, R, or HP.
Table 5 takes the list of 35 factors influencing marketability from Table 4 and categorizes them relative to their expected impact on expected cash flow, expected risk, and/or the expected holding period.
Conclusions of This Discussion of Factors Influencing Marketability
There is widespread acceptance that a number of factors influencing marketability should be considered when developing marketability discounts from marketable minority valuation bases when valuing illiquid minority, or nonmarketable minority interests, in closely held businesses.
Some factors like expected distributions are intuitively obvious. Other things being equal, an investment that pays a regular economic distribution (after distributing for taxes) is more attractive than one that does not. Other things being equal, an investment that has a higher expected growth in value will have a higher value than a slower-growing investment. Other things being equal, an investment with a longer expected holding period will have a lower value than one with a shorter expected holding period. These statements reflect basic present value principles.
But other things are not always equal, and numerous factors may be in place with one investment relative to another. By articulating a comprehensive list of factors influencing marketability, we have a starting point to discuss individual factors, the relationship between factors (some may be positive to value and others detrimental), and the means by which business appraisers think about and develop marketability discounts.
If we can identify specific factors influencing marketability, we can then examine how they can be considered when employing the various methods used by appraisers to develop marketability discounts, or DLOMs.
This list in Table 5 may not be entirely comprehensive. If you think of other factors influencing marketability that are not included in Table 5, please let me know. I would like to consider them for inclusion in the list.