Business Valuation Discounts and Premiums

SHANNON P. PRATT, CFA, FASA, MCBA, CM&AA, is the Chairman and CEO of Shannon Pratt Valuations, Inc., a premier business valuation firm, and is the founder and Editor Emeritus of Business Valuation Resources, LLC. Over a distinguished career of close to four decades, he has performed valuation engagements for M&A, ESOPs, gift and estate taxation, marital dissolution, shareholder oppression and dissent, and numerous other purposes. He has conducted many fairness and solvency opinions, has testified in a wide variety of federal and state courts across the country, and frequently participates in arbitration and mediation proceedings. Dr. Pratt is one of the most successful and respected authors in his field. He is the author or coauthor of several industry standards, including The Market Approach to Valuing Businesses, Standards of Value, Business Valuation and Taxes, Cost of Capital, Business Valuation Body of Knowledge, all published by Wiley, as well as PPC's Guide to Business Valuation, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, Valuing Small Businesses and Professional Practices, and The Lawyer's Business Valuation Handbook.

• List of Exhibits xvAbout the Author xixAbout the Contributing Authors xxiForeword xxvPreface xxviiAcknowledgments xxix1 Overview of Business Valuation Discounts and Premiums and the Bases to Which They Are Applied 1Discounts and Premiums Are Big-Money Issues 2‘‘Entity Level’’ versus ‘‘Shareholder Level’’ Discounts and Premiums 3How the Valuation Approaches Used Affect the Level of Value 8Use of Public Company Data to Quantify Discounts and Premiums 9How the Standard of Value Affects Discounts and Premiums 10American Society of Appraisers Business Valuation Standard VII:Valuation Discounts and Premiums 12Summary 132 Minority Discounts and Control Premiums 15Relevant Definitions 16Basic Minority/Control Value Relationship 16Prerogatives of Control 17Factors Affecting Degree of Control 18How the Valuation Methodology Affects the Minority Discount or Control Premium 25Do Publicly Traded Minority Stock Prices Reflect Control Value? 29Treatment of Control Premiums in the Delaware Courts 35How the Purpose of the Valuation Affects Minority Discounts or Control Premiums 37Summary 383 Empirical Data Regarding Minority Discounts and Control Premiums 41Premiums Paid in Acquisitions 41Identifying Industries with Higher or Lower Control Premiums 62Caveats Regarding Use of Control Premium Data 63Are Control Premiums Too High? 65Percentage Discounts from Net Asset Value 66Summary 664 Minority Discounts and Control Premiums in the Courts 68Gift, Estate, and Income Tax Cases 70Discounts for Lack of Control in Employee Stock Ownership Plan Cases 74Dissenting Shareholder Cases 75Shareholder Oppression Cases 80Marital Dissolution Cases 80Bankruptcy Case 82Summary 825 Discounts for Lack of Marketability for Minority Interests: Concept and Evidence 86Public Market Benchmark for Marketability 86Empirical Evidence to Quantify Discounts for Lack of Marketability 87Restricted Stock Studies 88Pre–Initial Public Offering Discount for Lack of Marketability Studies 90Courts’ Aversion to ‘‘Benchmarking’’ 91Regulatory and Court Recognition of Empirical Marketability Discount Studies 92Summary 926 Synopsis of Restricted Stock Studies 95Securities and Exchange Commission Institutional Investor Study 96Gelman Study 100Trout Study 100Moroney Study 101Maher Study 101Standard Research Consultants Study 101Silber Study 101FMV Opinions Study 103Management Planning Study 104Johnson Study 110Columbia Financial Advisors Study 110LiquiStat Database 111Summary 1117 LiquiStat Database (Restricted Stocks, Options, Warrants, and Convertible Securities) 113Restricted Stock as a Basis 114Biases Beyond Illiquidity in Traditional Restricted Stock Studies 114How LiquiStat Is Different 115Options and Warrants in LiquiStat 116Convertible Securities in LiquiStat 117Summary 1178 Blockage Discounts 118Blockage Is Distinct from Restricted Stock 119Factors to Analyze in Quantifying Blockage Discounts 119Must Consider Ways of Selling Stock 122‘‘Price Pressure’’ and ‘‘Market Exposure’’ 122Block Buyer Could Ameliorate Blockage Discount 122Blockage Discounts Recognized in Estate and Gift Tax Regulations 123Blockage Discounts in U.S. Tax Court 123Financial Accounting Standards That May Affect Blockage Discounts 126Blockage Discounts Used to Estimate Illiquidity Discounts 126Summary 1269 John Emory Pre–Initial Public Offering Discount for Lack of Marketability Studies—Complete Underlying Data 128Study #1: Adjusted Study, January 1980–June 1981 129Study #2: Adjusted Study, January 1985–June 1986 129Study #3: Adjusted Study, August 1987–January 1989 130Study #4: Adjusted Study, February 1989–July 1990 130Study #5: Adjusted Study, August 1990–January 1992 130Study #6: Adjusted Study, February 1992–July 1993 130Study #7: Adjusted Study, January 1994–June 1995 131Study #8: Adjusted Study, November 1995–April 1997 131Study #9: Adjusted Study, Dot-Com Companies, May 1997–March 2000 131Study #10: Adjusted Expanded Study, May 1997–December 2000 133Summary 13310 Valuation Advisors Discount for Lack of Marketability Study 182Description of Study 182Results of Study 184Summary 18511 Factors Affecting Discounts for Lack of Marketability for Minority Interests 186Size of Distributions 187Prospects for Liquidity 191Pool of Potential Buyers 193Risk Factors 194Summary 19812 Discounts for Lack of Marketability for Controlling Interests 200Discounts for Lack of Marketability for Controlling Interests: A Controversial Concept 202‘‘Control, Marketable’’ Is an Oxymoron 202Bases from Which Controlling Interest Discounts for Lack of Marketability May Be Deducted 202Factors Affecting Controlling Interest Discounts for Lack of Marketability 204Public versus Private Company Acquisition Multiples 207Court Treatment of Controlling Interest Discounts for Lack of Marketability 210Summary 21113 The Quantitative Marketability Discount Model: A Shareholder Level DCF Model 213Introduction 213The Structure of the Shareholder Level DCF Model 214AVisual Representation of the Shareholder Level DCF Model 217Factors Contributing to Marketability Discounts 218Summary 22314 Marketability Discounts in the Courts—Minority Interests 225Gift and Estate Tax Cases 227Employee Stock Ownership Plan Case 231Dissenting Shareholder Cases 232Minority Oppression Cases 234Marital Dissolution Cases 234Summary 23815 Marketability Discounts in the Courts—Controlling Interests 241Gift and Estate Tax Cases 241Marital Dissolution Cases 243Summary 24416 Voting versus Nonvoting Stock 245Voting versus Nonvoting Stock Scenarios 245Empirical Studies Show Little Differential for Small Minority Interests 246Transactions Involving Premiums for Control Blocks 251Court Cases Involving Voting versus Nonvoting Stock 251Summary 25817 Key Person Discounts and Premiums 260Empirical Evidence Supports Key Person Discount 261Internal Revenue Service Recognizes Key Person Discount 263Factors to Consider in Analyzing the Key Person Discount 264Quantifying the Magnitude of the Key Person Discount 265U.S. Tax Court Cases Involving Key Person Discounts 266Key Person Discounts in Marital Dissolutions 270Key Person Discounts in Other Types of Cases 272Summary 27418 Discounts for Trapped-In Capital Gains Taxes 276Rationale for Trapped-In Capital Gains Tax Discount 277‘‘General Utilities Doctrine’’ 277Tax Court Recognizes Trapped-In Capital Gains 278Internal Revenue Service Acquiesces to Trapped-In Capital Gains Discount 279Subsequent Tax Cases Regularly Recognize Trapped-In Capital Gains Tax Discount 280Trapped-In Capital Gains in Dissenting Stockholder Actions 282Trapped-In Capital Gains in Bankruptcy Court 283Trapped-In Capital Gains Taxes in Marital Dissolutions 283Treatment of Capital Gains Tax Liability 286Treatment of Capital Gains Tax Liability in S Corporations 288Summary 28819 Nonhomogeneous Assets (‘‘Portfolio’’) Discounts 291Portfolio Discount Principle 291Empirical Evidence Supporting Portfolio Discounts 292How to Value Companies with Disparate Portfolios 294Quantifying the Portfolio Discount 295Portfolio Discounts in the Courts 295Summary 29820 Discounts for Environmental, Litigation, and Other Contingent Liabilities 300Concept of the Contingent Liability Discount 300Financial Accounting Standard #5 May Provide Guidance in Quantifying Contingent Liabilities 301Treatment of Contingencies in the U.S. Tax Court 301Treatment of Contingencies in Marital Dissolution 304Summary 30421 Discount Adjustments for Limited Partnership Interests and Other Asset Management Entities 305Introduction 307Partnership Features 307Other State Law and Regulatory Issues 308Compliance with Federal Income Tax Regulations 308Compliance with Federal Transfer Tax Regulations 309Analysis of Ownership and Classes of Interests 309Analysis of Underlying Adjusted Net Asset Value 310Analysis of Income Capacity Value 310Valuation of Noncontrolling Entity Interests 311Discounts for Lack of Control and Marketability 313Court Cases Regarding Limited Partnership Values 315Summary 32122 Adjusting Values for Differences in Size 323Income Approach 323Market Approach 325Criticisms of the Size Premium 329Court Cases Involving the Size Premium 329Summary 334Sources of Additional Data 33423 Discounts and Premiums in ESOP Valuations 337ESOP Definition, Types, and Benefits 337‘‘Adequate Consideration’’ for ESOP Valuation Purposes 338Control Premiums in ESOP Valuations 339Discounts for Lack of Marketability in ESOP Valuations 339ESOP Court Cases 340Summary 34424 Discounts and Premiums in Divorce Disputes 345Control Premiums in Divorce 345Discounts for Lack of Marketability in Divorce 345Discounts for Lack of Voting Rights in Divorce 346Key Person Discounts in Divorce 346The Effective Discount for Personal Goodwill in Divorce 346Active versus Passive Appreciation 347Summary 34725 Discounts and Premiums in Corporate and Partnership Dissolution and Oppression Cases 349Dissolution for Shareholder (Partner) Oppression 349Discounts 351California Oppression Cases 357Delaware’s Approach 359Summary 36026 Discounts and Premiums in Fair Value for Financial Reporting 362Introduction 362Fair Value of Reporting Units 363Fair Value of Share-Based Compensation 369Summary 371Additional Reading 37127 Premium and Discount Issues in Undivided Interest Valuations 372Description and Characteristics of Undivided Interests 373Appraisal of Assets in Fee-Simple Interest 376Factors Affecting the Value of an Undivided Interest 379Valuation Adjustments for Undivided Interests 381Court Decisions Related to Undivided Interest Discounts 389Summary 39528 Common Errors in Applying Discounts and Premiums 397Using Synergistic Acquisition Premiums to Quantify Premiums for Control 398Assuming That the Discounted Cash Flow Valuation Method Always Produces a Minority Value 398Assuming That the Guideline Public Company Method Always Produces a Minority Value 398Valuing Underlying Assets Rather Than Stock or Partnership Interests 399Using Minority Interest Marketability Discount Data to Quantify Marketability Discounts for Controlling Interests 399Using Only Restricted Stock Studies (and Not Pre–Initial Public Offering Studies) as Benchmark for Discounts for Lack of Marketability 399Inadequate Analysis of Relevant Factors 400Indiscriminate Use of Average Discounts or Premiums 400Applying (or Omitting) a Premium or Discount Inappropriately for the Legal Context 400Applying Discounts or Premiums to the Entire Capital Structure Rather than Only to Equity 401Quantifying Discounts or Premiums Based on Past Court Cases 401Using an Asset Appraiser to Quantify Discounts or Premiums for Stock or Partnership Interests 401Summary 401Appendix A Bibliography 403Books 403Articles 404Periodicals 407Appendix B Data Resources 410Control Premiums/Minority Discounts 410Discounts for Lack of Marketability 410Discounts from Net Asset Value for Limited Partnership Interests 412Discounts from Net Asset Value for REITs and REOCs 413Discounts from Net Asset Value for Closed-End Investment Funds 413Discount and Capitalization Rates 414Appendix C How Much Can Marketability Affect Security Values? 416I. The Framework 417II. The Upper Bound 418III. A Comparison 420IV. Conclusion 422References 422Appendix D Internal Revenue Service Revenue Ruling 77-287 424Section 1. Purpose 424Sec. 2. Nature of the Problem 424Sec. 3. Background and Definitions 424Sec. 4. Securities Industry Practice in Valuing Restricted Securities 425Sec. 5. Facts and Circumstances Material to Valuation of Restricted Securities 427Sec. 6. Weighing Facts and Circumstances Material to Restricted Stock Valuation 428Sec. 7. Effect on Other Documents 429Appendix E Securities and Exchange Commission Rules 144 and 144A 430History 442Appendix F Table of Cases 448Index 455