Marketability Discounts Prove Critical Factors in Appraisal

When equity interests are transferred, appraisal reports are often required for tax purposes.

When the subject interest represents a minority interest in the underlying business or asset, the interest is typically valued at a discount from net asset value to reflect, among other factors, the lack of marketability. When such discounts are incorporated, it is critical that the appraisal report be prepared by a qualified appraiser and be prepared in such a way to withstand the scrutiny of Internal Revenue Service (IRS).

In August, 2011, a document was publicly released that has been used by IRS in reviewing appraisal reports, specifically, discounts for lack of marketability (DLOM). The report, titled Discount for Lack of Marketability - Job Aid for IRS Valuation Professionals (Job Aid), was prepared to provide a background and context for the DLOM, review past and existing practices, and provide insight into the strengths and weaknesses of the practices.

The report summarizes IRS' position regarding a number of weaknesses that examiners have seen as part of their review of submitted appraisal reports, including:

• inappropriate use of restricted stock studies;
• use of analytical models without market data support; and
• reliance on court case results to support appraisal conclusions.

Inappropriate Use of Restricted Stock Studies

Transactions involving restricted stock have been used for many years by members of the business valuation community to quantify DLOM, and numerous studies have been published over the years. The premise behind the restricted stock studies is that the effect of lack of marketability can be quantified by comparing the sale price of publicly traded shares to the sale price of restricted shares of the same company.

In the Job Aid, IRS provides an overview of a number of the restricted stock studies and highlights their respective weaknesses. For example, the Job Aid highlights the fair market value (FMV) restricted stock database of transactions. As described in the Job Aid, an IRS engineer completed an analysis of the 475 transactions in the database. The conclusions were: (i) the FMV model is flawed in explaining the DLOMs on restricted stock transactions; (ii) valuations cannot confidently rely on the FMV model; and (iii) neither the FMV model nor a regression analysis can be applied to FMV’s database. These conclusions stress the importance of considering a variety of data sources rather than relying on one particular study.

Additionally, the Job Aid cautions against the following:

• Using simple average or median indications from restricted stock studies. The Job Aid states that one should not use measures of central tendency (e.g., averages or medians) without an examination of the underlying data and comparison to specific transaction or company data. It is important to stratify the underlying data from various restricted stock studies, and then select discounts after taking into consideration factors such as earnings, revenues, asset size, earnings volatility and asset price volatility.
• Not analyzing transactions and reflecting other factors. The Job Aid discusses adjusting a discount for factors not incorporated into the studies or methodologies to account for specific facts and circumstances around the subject interest. It is critical that the appraisal make qualitative adjustments for these factors (which are not considered in the restricted stock data), with the ones having the most impact on the concluded discount being dividend/distribution policy, amount of control associated with the subject interest, and restrictions on transferability or sale of the interest.
• Not reflecting relative holding period. When using a restricted stock analysis, the Job Aid states that it is imperative that the expected holding period of the subject company stock or interest be compared to the restricted stock study holding period being used.

Analytical Models

In addition to the studies mentioned above, a number of researchers have taken an analytical approach to quantifying DLOM. The Job Aid highlights a few based on option pricing theory. It is not uncommon to see many 409A valuations used for tax purposes to simply rely on an option model to calculate a discount for lack of marketability to apply to the common stock value. The Job Aid, however, clearly says that this methodology should be used as a proxy only and that this type of model cannot be used without consideration of other qualitative factors to arrive at a final conclusion.

The Job Aid notes that it is not uncommon for a valuation expert to propose a theoretical model as the basis for the determination of a DLOM. However, although the model seems conceptually sound, there is no attempt to validate the model using actual current market data and, for this reason, there is no way for the reviewer to perform a reality check. The DLOM must be firmly based on current market evidence, no matter how conceptually sound a model may appear.

Court Cases

Sometimes a valuation expert will base a decision as to the choice of DLOM on previous court decisions. The Job Aid notes, "... it must be remembered that judges are not valuators and are not constrained to the environment in which professional valuators operate." A judge can adopt any approach that is considered useful and can arrive at any result that seems reasonable in the court's view. The Job Aid goes on to say that court cases can be an excellent source of information when legal precedent is in question, but can be a very questionable source when valuation guidance is needed.

In summary, it is critical to obtain a comprehensive appraisal prepared by a qualified appraiser when valuing fractional equity interests. As highlighted by the Job Aid, it is important that the appraiser utilize all available data and carefully consider the specific facts and circumstances.