Discounts for lack of marketability (DLOMs) have frequently been the subject of controversy in valuations. The reason: applying a DLOM – an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability – can result in significant value reduction compared with the pro rata value of a business interest.
At Quist, we address this with several methods that can be classified into four main categories, each with its advantages and disadvantages:
- Benchmark study: utilizes restricted stocks and initial public offering pricing data;
- Security-based approach: utilizes theoretical option pricing models, illiquidity estimates demonstrated by traded stock prices, and option prices;
- Analytics: utilizes historical studies on private placement of equity; and
- Other approaches: Quantitative Marketability Discount Model (QMDM), Nonmarketable Investment Company Evaluation (NICE), etc.
Business Valuation Resources (BVR) recently conducted a survey of valuation experts on methodology and practice for estimating a DLOM and received over 200 responses.
According to BVR, the results pointed out several areas of concern within the valuation community:
The use of restricted stock studies remains the most cited methodology for quantifying a DLOM, with 90% respondents saying they use this methodology. However, about 2/3rd of those respondents say they use the “benchmark average approach” and only about 1/3rd say they use the “restricted stock comparative analysis approach (RSCAA).”
The response raises concern because the benchmark average approach alone often times does not provide the necessary detail and analysis to selecting a DLOM, even when coupled with a Mandelbaum Factor analysis (a qualitative assessment of the subject company). In one case, the court said the following about the approach:
“[The Valuation expert] simply lists the average discounts observed in several such studies, effectively asking us to accept on faith the premise that the approximate average of those results provides a reliable benchmark for the transferred interests.”
According to BVR, the 1/3rd of respondents who use the RSCAA are on a better track. Under this approach, the DLOM is based on a comparison of financial characteristics of the subject company to restricted stock that also takes market volatility into account. In another case, the court rejecting other approaches, including the benchmark average approach, and said this:
“As for the lack of marketability discount, the Court finds reliability in the fact that [the valuation expert] endeavored to understand and incorporate the market dynamics of restricted stock sales….The better method is to analyze the data from the restricted stock studies and relate it to the gifted interests.”
Best practices would dictate that when estimating DLOMs, using multiple methods is better. However, in BVR’s survey, 21% of respondents said they only use one DLOM method and 38% respondents said they use only two DLOM methods.
At Quist Valuation, we’ve always relied on a multi-pronged approach to valuation and the determination of the DLOM. In adhering to best practices expounded by BVR, we combine both qualitative and quantitative factors in our determination of a DLOM in order to provide our clients the support to withstand the highest scrutiny by the IRS.
Contact us here for more information.
Temple v. U.S., No. 9:03-CV-165 (March 10, 2006).
Peracchio v. Commissioner, T.C. Memo. 2003-80 (Sept. 25, 2003).