How to Quantify and Support Your DLOM using Rates of... Speaker Introduction How to Quantify and Support Discounts for

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How to Quantify and Support Your DLOM using Rates of Return
BVR’s Advanced Webinar Series on DLOMs: Part 2
How to Quantify and Support Discounts for
Lack of Marketability using Rates of Return
Featuring:
Bruce A. Johnson, ASA
Munroe, Park & Johnson
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© 2013 Munroe, Park & Johnson, Inc.
How to Quantify and Support Your
DLOM using Rates of Return
Speaker Introduction
Bruce A. Johnson, ASA is a partner in the business valuation firm of
Munroe, Park and Johnson, Inc. He holds a degree in engineering and MBA
from Texas A&M University. He is a member of the Business Valuation
Committee of the American Society of Appraisers. He was the expert witness
for the taxpayer in the Estate of Elsie J. Church and Estate of Emily Klauss.
He has written multiple publications on discounts for lack of marketability, S
Corp tax issues and the valuation of family limited partnerships.
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© 2013 Business Valuation Resources, LLC
Overview
Discounts for lack of marketability occur in third party transactions
(restricted stocks, IPOs, private transactions) because investors
recognize that the lack of marketability of an interest increases the risk
of an investment in the interest. As a result, an investor purchases the
privately held interest at a discount in order to increase the rate of return
on their investment. This increased rate of return offsets the additional
risk caused by the illiquidity of the investment. This webinar will discuss
how to take the concept and use it to quantify and support your discount
for lack of marketability in a business appraisal.
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Seminar Overview
•
•
•
•
•
•
•
Overview
What is a Discount for Lack of Marketability?
•
The Basics
•
What causes DLOMs in third party transactions
•
Court Cases and Quotes
Examination of Historical Studies
•
Restricted Stock Studies
•
IPO Studies
Methodology to Use Rates of Return to Determine the DLOM
Studies Supporting Incremental Increase
•
Public vs. Private Equity Returns
•
Restricted Stock Returns
•
Long Term vs. Short Term Bonds
Case Studies
Conclusion
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Three Approaches to Value
• Income Approach
• Market Approach
• Asset Based (or Cost) Approach
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Income Approach
Empirical Method
• Capitalization of Net Cash Flow
• Discounted Net Cash Flow
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Market Approach
Empirical Method
• Price to Earnings
• MVIC to EBITDA
• Price to NAV
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Cost Approach
Not typically used to value a Noncontrolling Interest
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Inappropriate for Noncontrolling Interests
The subject ownership interest should be able to cause
the sale of the company’s assets ... Accordingly, the
NAV method is more appropriate for valuing controlling
interests than minority interests.
PPC Guide to Business Valuations
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Traditional Method
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Discount for Lack of Marketability
• Traditional Method is Based on Averages from:
•
•
IPO/Private Placement Studies
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Years
Studied
1966-1969
1968-1970
1969-1972
1969-1973
1968-1972
1978-1982
1981-1984
1981-1988
1979-1992
1991-1995
1996-1997
1997-1998
Name of Study
SEC Institutional Investor
Milton Gelman
Robert E. Moroney
J. Michael Maher
Robert Trout
Standard Research Consultants
Willamette Management Assoc
William L. Silber
FMV Opinions, Inc.
Bruce A. Johnson
Columbia Financial Advisors
Average
Number of
Discount
Transactions
0.258
398
33.0%
89
35.6%
146
35.4%
na
33.5%
60
45.0% *
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31.2% *
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33.8%
69
23.0%
100
20.0%
72
21.0%
23
13.0%
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* denotes median
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Johnson Restricted Stock Study
Sorted by Current Year Net Income
Positive net income
Negative net income
Sorted by Previous Year Net Income
Positive net income
Negative net income
Sorted by Sales Current Year
Greater than $12.7M
Less than $12.7M
Sorted by Transaction Value
Greater than $8.3M
Less than $8.3M
Average
Std Dev
16%
23%
12%
17%
16%
23%
13%
17%
18%
22%
14%
17%
16%
25%
14%
16%
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IPO Studies
Emory Studies
Study
Mean
1996-1997
1994-1995
1992-1993
1990-1992
1989-1990
1987-1989
1985-1986
1980-1981
43%
45%
45%
42%
45%
45%
43%
60%
Median
42%
45%
44%
40%
40%
45%
43%
66%
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Prior Court Rulings
• Some appraisers improperly rely on prior
court rulings to derive discounts for lack of
control and lack of marketability.
• The IRS frequently cites prior court case
rulings at the appeals level to support levels
of discounts.
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Court Scrutiny of DLOM
•
2003 - Estate of Peracchio:
[the taxpayer’s expert] makes no attempt whatsoever
to analyze the data from those [restricted stock]
studies as they relate to the transferred interests.
Rather, he simply lists the average discounts … asking
us to accept on faith the premise that the approximate
average of those results provides a reliable benchmark
for the transferred interests. Absent any analytical
support, we are unable to accept that premise …”
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Court Scrutiny of DLOM
•
2005 – Kelley v. Commissioner:
“… [the taxpayer’s appraiser] did not analyze the data
from these [DLOM] studies…therefore we cannot
accept the premise that this average discount [for lack
of marketability] is appropriate.”
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Tax Courts Wants More
The primary objection of the Tax Court has
been the lack of rationale used to support
discounts for lack of control and lack of
marketability. It is not a question of whether
discounts … are appropriate. It is how the
amounts of these discounts have been
determined that has raised concerns.
Comprehensive Guide for the Valuation of Family Limited Partnerships, 2nd Ed., 2.
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• Income Approach used rates of return from
publicly held investments
• Market Approach used pricing multiples
(Price to NAV ratios) from publicly held
investments
• Both approaches result in a value estimate
“as if marketable”
• Need to adjust for lack of marketability
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You can sell any asset, no matter how illiquid it is
perceived to be, if you are willing to accept a lower
price for it. Consequently, we should not categorize
assets into liquid and illiquid assets but allow for a
continuum on liquidity…
Aswath Damodaran
NYU Stern School of Business
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Adjustment for lack of marketability can be
accomplished by:
• The application of a discount for lack of
marketability
• Increasing the required return to
compensate for the increased risk of
the illiquid investment
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The application of a discount for lack of
marketability results in an increase in
the effective rate of return of the
investment.
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Marketability Discount 101
Noncontrolling, Marketable Value
DLOM
$100
20.0%
Noncontrolling, Nonmarketable Value
($20)
$80
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Application of DLOM
Impact on Rate of Return
Price Income Return
$100
DLOM
20.0%
$80
$12
12.0%
$12
15.0%
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Question
Consider the following two alternative
investments:
1.
Noncontrolling, marketable interest
yielding a 12% return
2.
Noncontrolling, nonmarketable
interest yielding a 12% return
Which investment is more attractive?
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Question
How much greater return is required on the
nonmarketable interest for it to be as
desirable to an investor as the marketable
interest yielding a 12% return?
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We are faced with the same question when
valuing a privately held interest in a privately
held company.
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Empirical Data
Three research studies indicate that investors
generally require a 30% to 45% increase in their rate
of return above a marketable interest when an
interest is not marketable.
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Study A
Private Equity vs.
Public Equity Returns
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What if we could compare the historical
returns of publicly traded stock to
privately held stock?
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This would enable us to quantify a range or
benchmark that investors require for illiquidity.
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Comparison of Returns
Publicly Traded Equity – Ibbotson’s Stocks
Bonds Bills and Inflation
Private Held Equity – Cambridge Associates
LLC U.S. Venture Capital Index®
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Cambridge Associates LLC
U.S. Venture Capital Index®
Cambridge Associates, LLC created a database to monitor
investments made by venture capital and other alternative
asset partnerships.
It measures the average aggregated return for venture
capital investments over the past 25 years.
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Cambridge Associates LLC
U.S. Venture Capital Index®
• 1,298 entities as of December 31, 2010
• The end to end pooled mean performance
calculation is similar to the IRR, however it is
measuring the return between two points in time.
The calculation takes into account the beginning
NAV as the initial investment.
• Return is based on cash flows to investors net of
fees and fund expenses.
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National Venture Capital Association
“Limited partners make these investments in
venture funds knowing that the investment will be
long-term. It may take several years before the first
investments start to return proceeds; in many
cases the invested capital may be tied up in an
investment for seven to ten years. Limited partners
understand that this illiquidity must be factored into
their investment decision.”
Source: www.nvca.org
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“Venture capitalists will help companies grow, but they
eventually seek to exit the investment in three to seven
years. An early stage investment make take seven to ten
years to mature, while a later stage investment many only
take a few years, so the appetite for the investment life
cycle must be congruent with the limited partnerships’
appetite for liquidity. The venture investment is neither a
short term nor a liquid investment, but an investment that
must be made with careful diligence and expertise.”
Source: www.nvca.org
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Life Cycle Stages
Seed Capital – investment made before there is a real product or
company organized
Early Stage – investment made in first or second stage of
development
Balanced Stage – financing provided for growth
Late Stage - providing financing to help the company grow to a
critical mass to attract public financing through a stock offering
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Venture Capital Returns
• Ideally, we would like to examine funds with
Longest Holding Period
• These funds would include Seed and Early
Stage funds
• However, these funds may also contain
additional risks – other than liquidity
• Cambridge Study comprised of 863 early stage,
168 late/expansion stage, 264 multi stage and 3
venture debt funds
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Arithmetic Historical Returns
25 Years
Privately Held Stocks
18.7%
*
Publicly Traded Small Stocks
12.9%
**
* Source: Cambridge Associates LLC U.S. Venture Capital Index®
** Source: Ibbotson Associates' Stocks Bonds Bills and Inflation, 2011
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Historical Return Requirement
25 Years
Privately Held Stocks
Publicly Traded Small Stocks
18.7%
12.9%
Difference
5.8%
Incremental Return as a Percent
45.2%
Partnership Profiles, Inc. – 4th Edition FLP Book
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Study B
Restricted Stock Returns
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Historical Returns for Restricted Stock
An examination was conducted of the underlying data
used in a restricted stock study that was published in the
December 1999 issue of Shannon Pratt’s Business
Valuation Update.
The study examined 72 restricted stock transactions that
occurred prior to 1995.
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Restricted Stock
Restricted stock of a public company is identical to its
counterpart that is traded on a major exchange except that
restricted stock cannot be openly traded for a designated
period of time.
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Restricted Stock
Prior to 1990, the stock of small companies could be sold
by a public company without making a public offering.
The securities sold in this type of transaction were subject
to certain restrictions which stated that the stock could
not be resold without being registered with the SEC or
qualifying for a Rule 144 exemption.
Originally, Rule 144 allowed the limited resale of
unregistered, restricted securities after a holding period of
2 years.
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Restrictions Eased & Discounts Declined
Rule 144A - In 1990, the SEC implemented new
regulations that allowed qualified institutional investors to
trade restricted stock among themselves without filing
registration documents.
This created a limited market for restricted stocks and
thereby increased liquidity. In 1997, the SEC reduced the
Rule 144 holding period from 2 years to 1 year. This
change further increased the liquidity of restricted stocks.
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Years
Studied
1966-1969
1968-1970
1969-1972
1969-1973
1968-1972
1978-1982
1981-1984
1981-1988
1979-1992
1991-1995
1996-1997
1997-1998
Name of Study
SEC Institutional Investor
Milton Gelman
Robert E. Moroney
J. Michael Maher
Robert Trout
Standard Research Consultants
Willamette Management Assoc
William L. Silber
FMV Opinions, Inc.
Bruce A. Johnson
Average
Discount
25.8%
33.0%
35.6%
35.4%
33.5%
45.0% *
31.2% *
33.8%
23.0%
20.0%
21.0%
13.0%
Discounts
Declined
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* denotes median
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Restricted Stock Return
Publicly Traded Return
EPS / Publicly Traded Price
= Marketable Return
Restricted Stock Return
EPS / Restricted Stock Price
= Illiquid Return
Increase in Return
(Illiquid Return/Marketable Return) - 1 = Percent Increase
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Historical Return Requirement
For the 25 transactions for which information was
available, the average increase between the return
using the restricted stock price and the return using the
publicly traded price was 29.5%.
Partnership Profiles, Inc. – 4th Edition FLP Book, 131.
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Study C
Long Term vs. Short Term
Government Bond Returns
(Horizon Risk)
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Long v. Short Term Government Bonds
• Equivalent risk of principal at maturity
• Long term bond is exposed to greater
interim risk due to market fluctuations
• The increase in risk results in an increased
required rate of return
• For a long term bond to be equally
marketable, investors generally demand an
increase in the rate of return
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30 Year Comparison
16.00%
14.00%
12.00%
20 Yr Government Bond
10.00%
8.00%
6.00%
4.00%
3 Mo Treasury Bill
2.00%
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
0.00%
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Average Differential
20 Year Treasury Bond
3 Month Treasury Bill
Incremental Increase
30 Year
Average
7.2%
5.2%
2.0%
35 Year
Average
7.4%
5.5%
1.8%
40 Year
Average
7.3%
5.6%
1.7%
39.3%
32.9%
30.8%
Average Differential
Average Percentage Increase
1.9%
34.3%
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Long v. Short Term Bonds
Principal
Income
Yield
$1,000
$52
5.2%
20 Year Treasury Bond
$732
$52
7.1%
Effective discount
-26.8%
3 Month Treasury Bill
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Benchmark for Increase in Return
Increased Yield
1.9%
Divided by Short Term Rate
=
36.5%
5.2%
Partnership Profiles, Inc. – Sample Report #11, 40.
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Summary of 3 Studies
Studies
Private Equity vs. Public Equity Returns
Restricted Stock Transactions
LT vs. ST Bond Horizon Risk
Average
Incr Return
45.2%
29.5%
34.3%
Note: These are not discounts. They are a percentage increase in the rate of
return to compensate for the risk of illiquidity.
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Conclusion
The increase in the rate of return should be
30% to 45%.
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Case Study 1
Capitalization of NCF
Noncontrolling, Marketable Value = $125,000 per share
Annual Cash Flow = $21,250 per share
Noncontrolling, Nonmarketable Value =
?
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Yield Calculation Using the Annual NCF
Noncontrolling, Mktble Value
Yield Calculation:
$21,250 / $125,000 =
Value
$125,000
17.0%
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How much of a DLOM must be deducted to
increase the rate of return from 17.0% to a level
that is 30% to 45% higher?
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Value After
DLOM
DLOM
ROR
% Increase
0%
$125,000
17.0%
15%
$106,250
20.0%
17.6%
20%
$100,000
21.3%
25.0%
25%
$93,750
22.7%
33.3%
30%
$87,500
24.3%
42.9%
35%
$81,250
26.2%
53.8%
40%
$75,000
28.3%
66.7%
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Goal = 30% to 45% Increase
Studies
Average
Incr Return
45.2%
29.5%
34.3%
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Value After
DLOM
DLOM
ROR
% Increase
0%
$125,000
17.0%
15%
$106,250
20.0%
17.6%
20%
$100,000
21.3%
25.0%
25%
$93,750
22.7%
33.3%
30%
$87,500
24.3%
42.9%
35%
$81,250
26.2%
53.8%
40%
$75,000
28.3%
66.7%
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Value
$125,000
Less DLOM
25% ($31,250)
Noncontrolling, Nonmktble Value
$93,750
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25% LOM Discount
Value
Return
$125,000
17.0%
$93,750
22.7%
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Value
$125,000
Less DLOM
30% ($37,500)
Noncontrolling, Nonmktble Value
$87,500
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30% LOM Discount
Value
Return
$125,000
17.0%
$87,500
24.3%
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Case Study 2
Discounted NCF
Noncontrolling, Marketable Value = $200,000 per share
Annual Cash Flow = 5 Year Projection
Noncontrolling, Nonmarketable Value =
?
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Case Study 2
Income Approach – 5 Year Model
Annual NCF
EPS Growth
2013
$30,000
2014
$33,000
10.0%
2015
$34,650
5.0%
2016
$35,690
3.0%
2017
$36,760
3.0%
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ROR Prior to DLOM
Noncontrolling, Marketable Value = $200,000
Internal Rat 17.9%
Year 1
NCF
Year 2
Year 3
Year 4
$30,000 $33,000 $34,650 $35,690
Year 5
Terminal
$36,760 $216,236
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Mechanics
Noncontrolling, Marketable Value = $200,000
Internal Rate of Return
17.9%
Year 0
NCF
Year 1
Year 2
Year 3
Year 4
Year 5
($200,000) $30,000 $33,000 $34,650 $35,690 $252,996
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NCF Calculation
How much of a DLOM must be deducted to
increase the rate of return from 17.9% to a level
that is 30% to 45% higher?
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Case Study 2
Value After
DLOM
$200,000
$170,000
$160,000
$150,000
$140,000
DLOM
15%
20%
25%
30%
ROR
17.9%
23.1%
25.1%
27.3%
29.7%
% Increase
29.0%
40.3%
52.7%
66.4%
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Case Study 2
DLOM
15%
20%
25%
30%
Value After
DLOM
$200,000
$170,000
$160,000
$150,000
$140,000
ROR
17.9%
23.1%
25.1%
27.3%
29.7%
Noncontrolling,
Nonmktble Value
($200,000)
($170,000)
($160,000)
($150,000)
($140,000)
2013
$30,000
$30,000
$30,000
$30,000
$30,000
2014
$33,000
$33,000
$33,000
$33,000
$33,000
2015
$34,650
$34,650
$34,650
$34,650
$34,650
2016
$35,690
$35,690
$35,690
$35,690
$35,690
2017
$252,997
$252,997
$252,997
$252,997
$252,997
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Goal = 30% to 45% Increase
Average
Incr Return
Studies
45.2%
29.5%
34.3%
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Case Study 2
DLOM
15%
20%
25%
30%
Value After
DLOM
$200,000
$170,000
$160,000
$150,000
$140,000
ROR
17.9%
23.1%
25.1%
27.3%
29.7%
% Increase
29.0%
40.3%
52.7%
66.4%
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Case Study 2
Less Discount for Lack of Marketability
20%
$200,000
($40,000)
$160,000
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Calculation Using the Forecast of NCF
20% LOM Discount
Value
Return
$200,000
17.9%
$160,000
25.1%
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Points to Remember
-Discount for Lack of Marketability-
Fact: A DLOM can be supported using rate of return
methodology.
…the consensus conclusion that we draw is that illiquid
investments trade at lower prices than liquid investments
and generate higher returns…
Aswath Damodaran
NYU Stern School of Business
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Points to Remember
Conclusion
Fact: Discounts occur in arm’s length transactions as a
result of an investor’s requirement for an increased
return.
“. . . while discounts … are a means to an end, that end
is the rate of return sought by an investor.”
Comprehensive Guide for the Valuation of Family Limited Partnerships, 4th Ed., 146.
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How to Quantify and Support Your DLOM using Rates of... Speaker Introduction How to Quantify and Support Discounts for

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