Business Valuation Discounts and Premiums, 2nd Edition

List of Exhibits xv

About the Author xix

About the Contributing Authors xxi

Foreword xxv

Preface xxvii

Acknowledgments xxix

1 Overview of Business Valuation Discounts and Premiums and the Bases to Which They Are Applied 1

Discounts and Premiums Are Big-Money Issues 2

‘‘Entity Level’’ versus ‘‘Shareholder Level’’ Discounts and Premiums 3

How the Valuation Approaches Used Affect the Level of Value 8

Use of Public Company Data to Quantify Discounts and Premiums 9

How the Standard of Value Affects Discounts and Premiums 10

American Society of Appraisers Business Valuation Standard VII:Valuation Discounts and Premiums 12

Summary 13

2 Minority Discounts and Control Premiums 15

Relevant Definitions 16

Basic Minority/Control Value Relationship 16

Prerogatives of Control 17

Factors Affecting Degree of Control 18

How the Valuation Methodology Affects the Minority Discount or Control Premium 25

Do Publicly Traded Minority Stock Prices Reflect Control Value? 29

Treatment of Control Premiums in the Delaware Courts 35

How the Purpose of the Valuation Affects Minority Discounts or Control Premiums 37

Summary 38

3 Empirical Data Regarding Minority Discounts and Control Premiums 41

Premiums Paid in Acquisitions 41

Identifying Industries with Higher or Lower Control Premiums 62

Caveats Regarding Use of Control Premium Data 63

Are Control Premiums Too High? 65

Percentage Discounts from Net Asset Value 66

Summary 66

4 Minority Discounts and Control Premiums in the Courts 68

Gift, Estate, and Income Tax Cases 70

Discounts for Lack of Control in Employee Stock Ownership Plan Cases 74

Dissenting Shareholder Cases 75

Shareholder Oppression Cases 80

Marital Dissolution Cases 80

Bankruptcy Case 82

Summary 82

5 Discounts for Lack of Marketability for Minority Interests: Concept and Evidence 86

Public Market Benchmark for Marketability 86

Empirical Evidence to Quantify Discounts for Lack of Marketability 87

Restricted Stock Studies 88

Pre–Initial Public Offering Discount for Lack of Marketability Studies 90

Courts’ Aversion to ‘‘Benchmarking’’ 91

Regulatory and Court Recognition of Empirical Marketability Discount Studies 92

Summary 92

6 Synopsis of Restricted Stock Studies 95

Securities and Exchange Commission Institutional Investor Study 96

Gelman Study 100

Trout Study 100

Moroney Study 101

Maher Study 101

Standard Research Consultants Study 101

Silber Study 101

FMV Opinions Study 103

Management Planning Study 104

Johnson Study 110

Columbia Financial Advisors Study 110

LiquiStat Database 111

Summary 111

7 LiquiStat Database (Restricted Stocks, Options, Warrants, and Convertible Securities) 113

Restricted Stock as a Basis 114

Biases Beyond Illiquidity in Traditional Restricted Stock Studies 114

How LiquiStat Is Different 115

Options and Warrants in LiquiStat 116

Convertible Securities in LiquiStat 117

Summary 117

8 Blockage Discounts 118

Blockage Is Distinct from Restricted Stock 119

Factors to Analyze in Quantifying Blockage Discounts 119

Must Consider Ways of Selling Stock 122

‘‘Price Pressure’’ and ‘‘Market Exposure’’ 122

Block Buyer Could Ameliorate Blockage Discount 122

Blockage Discounts Recognized in Estate and Gift Tax Regulations 123

Blockage Discounts in U.S. Tax Court 123

Financial Accounting Standards That May Affect Blockage Discounts 126

Blockage Discounts Used to Estimate Illiquidity Discounts 126

Summary 126

9 John Emory Pre–Initial Public Offering Discount for Lack of Marketability Studies—Complete Underlying Data 128

Study #1: Adjusted Study, January 1980–June 1981 129

Study #2: Adjusted Study, January 1985–June 1986 129

Study #3: Adjusted Study, August 1987–January 1989 130

Study #4: Adjusted Study, February 1989–July 1990 130

Study #5: Adjusted Study, August 1990–January 1992 130

Study #6: Adjusted Study, February 1992–July 1993 130

Study #7: Adjusted Study, January 1994–June 1995 131

Study #8: Adjusted Study, November 1995–April 1997 131

Study #9: Adjusted Study, Dot-Com Companies, May 1997–March 2000 131

Study #10: Adjusted Expanded Study, May 1997–December 2000 133

Summary 133

10 Valuation Advisors Discount for Lack of Marketability Study 182

Description of Study 182

Results of Study 184

Summary 185

11 Factors Affecting Discounts for Lack of Marketability for Minority Interests 186

Size of Distributions 187

Prospects for Liquidity 191

Pool of Potential Buyers 193

Risk Factors 194

Summary 198

12 Discounts for Lack of Marketability for Controlling Interests 200

Discounts for Lack of Marketability for Controlling Interests: A Controversial Concept 202

‘‘Control, Marketable’’ Is an Oxymoron 202

Bases from Which Controlling Interest Discounts for Lack of Marketability May Be Deducted 202

Factors Affecting Controlling Interest Discounts for Lack of Marketability 204

Public versus Private Company Acquisition Multiples 207

Court Treatment of Controlling Interest Discounts for Lack of Marketability 210

Summary 211

13 The Quantitative Marketability Discount Model: A Shareholder Level DCF Model 213

Introduction 213

The Structure of the Shareholder Level DCF Model 214

AVisual Representation of the Shareholder Level DCF Model 217

Factors Contributing to Marketability Discounts 218

Summary 223

14 Marketability Discounts in the Courts—Minority Interests 225

Gift and Estate Tax Cases 227

Employee Stock Ownership Plan Case 231

Dissenting Shareholder Cases 232

Minority Oppression Cases 234

Marital Dissolution Cases 234

Summary 238

15 Marketability Discounts in the Courts—Controlling Interests 241

Gift and Estate Tax Cases 241

Marital Dissolution Cases 243

Summary 244

16 Voting versus Nonvoting Stock 245

Voting versus Nonvoting Stock Scenarios 245

Empirical Studies Show Little Differential for Small Minority Interests 246

Transactions Involving Premiums for Control Blocks 251

Court Cases Involving Voting versus Nonvoting Stock 251

Summary 258

17 Key Person Discounts and Premiums 260

Empirical Evidence Supports Key Person Discount 261

Internal Revenue Service Recognizes Key Person Discount 263

Factors to Consider in Analyzing the Key Person Discount 264

Quantifying the Magnitude of the Key Person Discount 265

U.S. Tax Court Cases Involving Key Person Discounts 266

Key Person Discounts in Marital Dissolutions 270

Key Person Discounts in Other Types of Cases 272

Summary 274

18 Discounts for Trapped-In Capital Gains Taxes 276

Rationale for Trapped-In Capital Gains Tax Discount 277

‘‘General Utilities Doctrine’’ 277

Tax Court Recognizes Trapped-In Capital Gains 278

Internal Revenue Service Acquiesces to Trapped-In Capital Gains Discount 279

Subsequent Tax Cases Regularly Recognize Trapped-In Capital Gains Tax Discount 280

Trapped-In Capital Gains in Dissenting Stockholder Actions 282

Trapped-In Capital Gains in Bankruptcy Court 283

Trapped-In Capital Gains Taxes in Marital Dissolutions 283

Treatment of Capital Gains Tax Liability 286

Treatment of Capital Gains Tax Liability in S Corporations 288

Summary 288

19 Nonhomogeneous Assets (‘‘Portfolio’’) Discounts 291

Portfolio Discount Principle 291

Empirical Evidence Supporting Portfolio Discounts 292

How to Value Companies with Disparate Portfolios 294

Quantifying the Portfolio Discount 295

Portfolio Discounts in the Courts 295

Summary 298

20 Discounts for Environmental, Litigation, and Other Contingent Liabilities 300

Concept of the Contingent Liability Discount 300

Financial Accounting Standard #5 May Provide Guidance in Quantifying Contingent Liabilities 301

Treatment of Contingencies in the U.S. Tax Court 301

Treatment of Contingencies in Marital Dissolution 304

Summary 304

21 Discount Adjustments for Limited Partnership Interests and Other Asset Management Entities 305

Introduction 307

Partnership Features 307

Other State Law and Regulatory Issues 308

Compliance with Federal Income Tax Regulations 308

Compliance with Federal Transfer Tax Regulations 309

Analysis of Ownership and Classes of Interests 309

Analysis of Underlying Adjusted Net Asset Value 310

Analysis of Income Capacity Value 310

Valuation of Noncontrolling Entity Interests 311

Discounts for Lack of Control and Marketability 313

Court Cases Regarding Limited Partnership Values 315

Summary 321

22 Adjusting Values for Differences in Size 323

Income Approach 323

Market Approach 325

Criticisms of the Size Premium 329

Court Cases Involving the Size Premium 329

Summary 334

Sources of Additional Data 334

23 Discounts and Premiums in ESOP Valuations 337

ESOP Definition, Types, and Benefits 337

‘‘Adequate Consideration’’ for ESOP Valuation Purposes 338

Control Premiums in ESOP Valuations 339

Discounts for Lack of Marketability in ESOP Valuations 339

ESOP Court Cases 340

Summary 344

24 Discounts and Premiums in Divorce Disputes 345

Control Premiums in Divorce 345

Discounts for Lack of Marketability in Divorce 345

Discounts for Lack of Voting Rights in Divorce 346

Key Person Discounts in Divorce 346

The Effective Discount for Personal Goodwill in Divorce 346

Active versus Passive Appreciation 347

Summary 347

25 Discounts and Premiums in Corporate and Partnership Dissolution and Oppression Cases 349

Dissolution for Shareholder (Partner) Oppression 349

Discounts 351

California Oppression Cases 357

Delaware’s Approach 359

Summary 360

26 Discounts and Premiums in Fair Value for Financial Reporting 362

Introduction 362

Fair Value of Reporting Units 363

Fair Value of Share-Based Compensation 369

Summary 371

Additional Reading 371

27 Premium and Discount Issues in Undivided Interest Valuations 372

Description and Characteristics of Undivided Interests 373

Appraisal of Assets in Fee-Simple Interest 376

Factors Affecting the Value of an Undivided Interest 379

Valuation Adjustments for Undivided Interests 381

Court Decisions Related to Undivided Interest Discounts 389

Summary 395

28 Common Errors in Applying Discounts and Premiums 397

Using Synergistic Acquisition Premiums to Quantify Premiums for Control 398

Assuming That the Discounted Cash Flow Valuation Method Always Produces a Minority Value 398

Assuming That the Guideline Public Company Method Always Produces a Minority Value 398

Valuing Underlying Assets Rather Than Stock or Partnership Interests 399

Using Minority Interest Marketability Discount Data to Quantify Marketability Discounts for Controlling Interests 399

Using Only Restricted Stock Studies (and Not Pre–Initial Public Offering Studies) as Benchmark for Discounts for Lack of Marketability 399

Inadequate Analysis of Relevant Factors 400

Indiscriminate Use of Average Discounts or Premiums 400

Applying (or Omitting) a Premium or Discount Inappropriately for the Legal Context 400

Applying Discounts or Premiums to the Entire Capital Structure Rather than Only to Equity 401

Quantifying Discounts or Premiums Based on Past Court Cases 401

Using an Asset Appraiser to Quantify Discounts or Premiums for Stock or Partnership Interests 401

Summary 401

Appendix A Bibliography 403

Books 403

Articles 404

Periodicals 407

Appendix B Data Resources 410

Control Premiums/Minority Discounts 410

Discounts for Lack of Marketability 410

Discounts from Net Asset Value for Limited Partnership Interests 412

Discounts from Net Asset Value for REITs and REOCs 413

Discounts from Net Asset Value for Closed-End Investment Funds 413

Discount and Capitalization Rates 414

Appendix C How Much Can Marketability Affect Security Values? 416

I. The Framework 417

II. The Upper Bound 418

III. A Comparison 420

IV. Conclusion 422

References 422

Appendix D Internal Revenue Service Revenue Ruling 77-287 424

Section 1. Purpose 424

Sec. 2. Nature of the Problem 424

Sec. 3. Background and Definitions 424

Sec. 4. Securities Industry Practice in Valuing Restricted Securities 425

Sec. 5. Facts and Circumstances Material to Valuation of Restricted Securities 427

Sec. 6. Weighing Facts and Circumstances Material to Restricted Stock Valuation 428

Sec. 7. Effect on Other Documents 429

Appendix E Securities and Exchange Commission Rules 144 and 144A 430

History 442

Appendix F Table of Cases 448

Index 455