BUSI 534 Week 1 Valuation Issue Essay Example

Shorter Holding Periods, Smaller Discounts: Is the Restricted Stock Evidence for Marketability Discounts Out of Date?

The Issue

When an appraiser values a minority interest in a private company, the last and often largest adjustment is the discount for lack of marketability (DLOM). A discount of 25 or 35 percent can move a gift tax return, a divorce settlement or a shareholder buyout by hundreds of thousands of dollars. For decades, the most cited evidence for the size of that discount has been the restricted stock studies, which compare the prices of unregistered shares of public companies with the prices of the same companies' freely traded shares. The issue this essay addresses is whether that evidence still measures what appraisers need it to measure, now that the rules governing restricted stock have changed twice.

Why Restricted Stock Became the Benchmark

Hitchner (2017) explains that the level of value matters: a marketable minority value assumes shares can be sold for cash within days, and a private minority interest cannot. Restricted stock offered a natural experiment. A company's unregistered shares are identical to its traded shares in every respect except that they cannot be resold publicly until a holding period expires. Any difference in price, the reasoning goes, measures the cost of waiting. Silber (1991) studied private placements of restricted stock when the required wait was two years and found that even creditworthy companies had to accept discounts of more than 30 percent to sell a significant block, with larger discounts when the restricted block was large relative to the traded shares.

How the Rules Changed

The holding period behind those discounts did not stay fixed. The Securities and Exchange Commission shortened the Rule 144 holding period from two years to one year in 1997, and in amendments effective in February 2008 it cut the period to six months for shares of companies that file reports with the Commission (U.S. Securities and Exchange Commission, 2007). An investor buying restricted stock after 2008 therefore faced a wait of six months, after which the shares could be sold into an active market. Not surprisingly, the discounts observed in later transactions were generally smaller than those in the early studies.

A discount for waiting six months to sell into a liquid market says little about owning a share that may never find a buyer at all. The holder of a 10 percent interest in a family company has no registration date to wait for and no public market at the end of the wait. If an appraiser averages restricted stock studies from different regulatory periods, the result mixes discounts for two-year, one-year and six-month waits and applies them to an interest whose expected holding period may be ten years or longer.

What the Professional Guidance Says

The professional organizations have pushed appraisers toward reasoning rather than averages. The Internal Revenue Service (2009), in a job aid prepared for its own valuation staff, criticized what it called the benchmark approach of selecting a discount from the average of published studies without relating the studies to the subject interest, and it pointed out that restricted stock data reflect holding periods far shorter than those of most private interests. The guide states that it is not an official position, but it shows how examiners are trained to read an appraisal. The American Institute of Certified Public Accountants (2007) requires members performing valuation engagements to consider the characteristics of the subject interest, including its marketability, and to document the basis for each conclusion. Courts apply a similar test. In Mandelbaum v. Commissioner (1995), the Tax Court started from restricted stock and initial public offering studies but then adjusted the discount for nine factors specific to the shares, among them the restrictions on transfer, the expected holding period, the company's redemption policy and its dividend history.

A Better Practice

The restricted stock studies are not useless. They remain direct market evidence that investors pay a large price for illiquidity, and their pattern, larger discounts for larger blocks and riskier companies, still helps an appraiser reason. What has changed is how they should be used. A careful report should identify the regulatory period of each study it relies on, explain how the subject interest's expected holding period differs, and support the final discount with factors specific to the interest, such as distribution history and the realistic paths to a sale. Hitchner (2017) recommends that discounts be explained in a way a reader can follow. An unexplained average, however well sourced, no longer meets that standard.

Other kinds of evidence can fill part of the gap. Studies of private transactions before initial public offerings compare prices paid for shares while a company was private with the later offering price, and quantitative models estimate the cost of being unable to sell for a given period, much as an option to sell would be priced. Each has weaknesses, but using more than one lets an appraiser test whether a discount drawn from restricted stock is plausible for an interest with no exit in sight. The appraiser's judgment then rests on several lines of evidence instead of one.

References

American Institute of Certified Public Accountants. (2007). Statement on Standards for Valuation Services No. 1: Valuation of a business, business ownership interest, security, or intangible asset (VS Section 100). AICPA.

Hitchner, J. R. (Ed.). (2017). Financial valuation: Applications and models (4th ed.). Wiley.

Internal Revenue Service. (2009). Discount for lack of marketability: Job aid for IRS valuation professionals. https://www.irs.gov/pub/irs-lbi/dlom.pdf

Mandelbaum v. Commissioner, T.C. Memo. 1995-255 (1995).

Silber, W. L. (1991). Discounts on restricted stock: The impact of illiquidity on stock prices. Financial Analysts Journal, 47(4), 60-64. https://doi.org/10.2469/faj.v47.n4.60

U.S. Securities and Exchange Commission. (2007). Revisions to Rules 144 and 145 (Release No. 33-8869). https://www.sec.gov/files/rules/final/2007/33-8869.pdf