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Providing Expert Guidance Since 1982

2010 Business Valuation Workshop Society of LCPAs Presented by: Vanessa Brown Claiborne President & Chief Executive Officer and Riley Busenlener Assistant Vice-President. Providing Expert Guidance Since 1982. Thursday, October 21, 2010. Table of Contents. Introduction

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Providing Expert Guidance Since 1982

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  1. 2010 Business Valuation Workshop Society of LCPAs Presented by: Vanessa Brown Claiborne President & Chief Executive Officer and Riley Busenlener Assistant Vice-President Providing Expert Guidance Since 1982 Thursday, October 21, 2010

  2. Table of Contents • Introduction • Lack of Marketability for Noncontrolling Ownership Interests in Closely Held Businesses • Restricted Stock Studies • Pre-Initial Public Offering Studies • Other Studies • Lack of Marketability for Controlling Ownership Interest in Closely Held Businesses • Factors Affecting Lack of Marketability and Illiquidity Discounts • Quantifying the Discount for Lack of Marketability • Court Decisions on Discounts • Questions 2

  3. I. Introduction • Marketability • The capability and ease of transfer or salability of an asset, business, business ownership interest, or security. • Liquidity • The degree to which an asset, business, business ownership interest, or security can readily be converted into cash without significant loss of principal. • For noncurrent assets, liquidity generally refers to marketability. 3

  4. I. Introduction • Lack of Marketability • The principal economic factor causing a lack of marketability (“LOM”) discount is the increase in risk caused by the inability to quickly and efficiently return the investment to a cash position. • More specifically, discounts are applied when valuing businesses because of the extreme contrasts between the ability to sell closely held business ownership interests as compared with publicly traded stock. • Discounts for noncontrolling business ownership interests tend to range from 30 to 50% from their publicly traded counterparts, while discounts for controlling interests generally range from 0 to 20%. • Every valuation is unique and should be analyzed on the basis of the individual facts and circumstances. 4

  5. I. Introduction 5

  6. I. Introduction • Levels of Ownership 6

  7. Table of Contents • Introduction • Lack of Marketability for Noncontrolling Ownership Interests in Closely Held Businesses • Restricted Stock Studies • Pre-Initial Public Offering Studies • Other Studies • Lack of Marketability for Controlling Ownership Interest in Closely Held Businesses • Factors Affecting Lack of Marketability and Illiquidity Discounts • Quantifying the Discount for Lack of Marketability • Court Decisions on Discounts • Questions 7

  8. II. LOM for Noncontrolling Ownership Interests • There are two types of empirical studies used to quantify valuation adjustments associated with the lack of marketability of noncontrolling ownership interests in closely held businesses: • Restricted Stock Studies • Studies that measure the difference between the private price of a restricted and the publicly traded stock price of the security the same company. • Pre-IPO Studies • Studies based on the difference between the initial pubic offering (IPO) price of a company and transactions in the same company’s stock prior to the IPO. 8

  9. Table of Contents • Introduction • Lack of Marketability for Noncontrolling Ownership Interests in Closely Held Businesses • Restricted Stock Studies • Pre-Initial Public Offering Studies • Other Studies • Lack of Marketability for Controlling Ownership Interest in Closely Held Businesses • Factors Affecting Lack of Marketability and Illiquidity Discounts • Quantifying the Discount for Lack of Marketability • Court Decisions on Discounts • Questions 9

  10. II.A. Restricted Stock Studies • Definition of restricted stocks • Restricted stocks are stocks of public companies that are restricted from public trading under SEC Rule 144. • They are the same in all aspects as freely tradable securities (dividends, voting rights, liquidation rights, etc.). • Although they cannot be sold on the open market, they can be bought by qualified institutional investors. Thus the restricted stock studies compare the price of a trade in restricted shares of a public company with the public market price on the same date. 10

  11. II.A. Restricted Stock Studies • Reasons for issuing restricted stock • Consideration for acquisitions • Private placements to raise capital • Compensation 11

  12. II.A. Restricted Stock Studies • History of Restricted Stock Restrictions • Until 1990, sales of restricted stocks were registered with the SEC, and the minimum holding period was two years. Discounts averaged 35%. • In 1990, the SEC removed the requirement to register sales of restricted stocks, which resulted in more trading of restricted stocks (greater liquidity), and thus lower discounts, averaging in the mid-20s. • In 1997, the SEC lowered the minimum holding period for restricted stocks from two years to one year. This resulted in a further reduction in discounts for restricted stock trades. One study had an average discount below 20%. • The “dribble out” rule: Once the minimum holding period is up, holders of restricted stock may ‘dribble out’ into the public market a maximum of 1% of the shares outstanding or 1% of the trading volume, whichever is greater, per quarter. 12

  13. II.A. Restricted Stock Studies • History of Restricted Stock Studies • The history of restricted stock study discounts closely reflects the history of restricted stock regulations. • Up until 1990, most studies showed average discounts of about 33% to 35%. • After 1990 (the year the SEC loosened restrictions), average discounts dropped to the mid-20s. • After 1997 (the year the SEC reduced the minimum-required holding period from two years to one year), average discounts dropped to the teens or low 20s. 13

  14. II.A. Restricted Stock Studies • SEC Institutional Investor Study (1966 – 1969) • Analyzed the discount at which transactions in restricted stock occurred compared with the prices of identical but unrestricted stock on the open market. • Study found that the size of discount is related to degree of marketability of the traded shares, with discounts lowest for NYSE companies, followed by American Stock Exchange companies, OTC SEC reporting companies, and then OTC non-reporting companies. • Average discount was 25.80% for all companies and 32.60% for non-reporting OTC companies 14

  15. II.A. Restricted Stock Studies • SEC Institutional Investor Study (continued) • Subsequent to the SEC’s restricted stock study, the IRS issued Revenue Ruling 77-287 to address the issue of valuing restricted stocks. • It was issued “to provide information and guidance to taxpayers, Internal Revenue Service personnel, and others concerned with the valuation, for Federal tax purposes, of securities that cannot be immediately resold because they are restricted from resale pursuant to Federal securities laws.” • The Ruling specifically references the SEC Institutional Investor Study. 15

  16. II.A. Restricted Stock Studies • Gelman Study (1968 - 1970) • Milton Gelman studied the prices paid for restricted securities by four closed-end investment companies specializing in restricted securities investments. • In 89 transactions between 1968 and 1970, Gelman found that: • Both arithmetic average and median price discounts were 33% • Almost 60% of the purchases were at price discounts of 30% or higher 16

  17. II.A. Restricted Stock Studies • Trout Study (1968 – 1972) • Robert Trout created a multiple regression model that provided an estimate of the price discount appropriate for a private company’s stock. • Analyzed 60 letter stocks purchased by mutual funds from 1668 to 1972. • Found an average price discount of 33.45% for restricted stock from freely traded stock. • Companies listed on national exchanges had lower discounts on their restricted stock transactions than did companies with stock traded OTC. 17

  18. II.A. Restricted Stock Studies • Maroney Study (1969 – 1972) • Robert E. Maroney analyzed prices paid in 146 transactions for restricted securities by 10 registered investment companies. • The range of discounts was from 10% to 90%. • Average discount for the 146 transactions studied was 35.6% and the median discount was 33.0% 18

  19. II.A. Restricted Stock Studies • Maher Study (1969 – 1973) • J. Michael Maher compared prices paid by mutual funds for restricted stock with prices paid for their unrestricted counterparts. • The mean price discount was 35.43%. • Maher further eliminated the top and bottom 10% of purchases in an effort to remove especially high and low risk situations. • Results were almost identical with the outliers removed, with a mean price discount of 34.73%. 19

  20. II.A. Restricted Stock Studies • Standard Research Consultants (1978 – 1982) • Analyzed recent private placements of common stock to test the SEC study. • Studied 28 private placements of restricted common stock. • Price discounts ranged from 7 to 91%. • Median discount was 45%. 20

  21. II.A. Restricted Stock Studies • Willamette Management Associates Study (1981 – 1984) • Analyzed private placements of restricted stocks. • Identified 33 “arm’s length” transactions in restricted stock for which the price of the restricted shares could be compared directly with the price of trades in identical but unrestricted shares of the same company at the same time. • Median price discount was 31.2%. • Depressed pricing the in the public stock market in the early 1980’s was most likely the cause of the lower average price discount. 21

  22. II.A. Restricted Stock Studies • Silber Study (1981 – 1988) • William L. Silber studied 69 private placements of common stock by publicly traded companies. • Average price discount was 33.75%. • Silber found that the size of the price discount tended to be higher for private placements that were larger as a percentage of the shares outstanding. • Also found that the size of the company, as measured by revenue, had small effect on the price discount. 22

  23. II.A. Restricted Stock Studies • FMV Opinions, Inc. Study (1980 – 1997) • Examined over 243 restricted stock transactions. • All transactions were prior to the Rule 144 amendment in 1997. • The overall mean discount was 22.1% and the median discount was 20.1%. • The standard deviation of the sample was 16.0%. • The median discount for exchange traded securities was 15.3%. • The median discount for over-the-counter traded securities was 22.4%. • FMV also analyzed the 243 transactions by SIC code. • Study concluded that industry is not especially important in determining discounts. • Size, risk,and liquidity are the most important determinants of the discount for the LOM. 23

  24. II.A. Restricted Stock Studies • FMV Opinions, Inc. (continued) • FMV Opinions recently introduced The FMV DLOM Calculator at BVMarketData.com.  • The Calculator utilizes data in The FMV Restricted Stock Study and applies the same methodology FMV Opinions uses in-house to calculate the discount for LOM.  • Based on a variety of financial metrics of the appraiser’s subject company, the Calculator streamlines the process for determining a discount for lack of marketability by automating the comparative analysis with restricted stock issuers and adjusting for market volatility and the additional illiquidity of private company stock.   • The Calculator also allows users to inflation-adjust all underlying restricted stock data.   24

  25. II.A. Restricted Stock Studies • Management Planning, Inc. Study (1980 – 1986) • Compared the prices paid in 53 private placements of restricted stock with the same company’s freely traded, stock market price. • Average lack of marketability discount was 27%. • Median lack of marketability discount was 25%. • Discounts ranged from 0% to 58%. • There was a clear size effect with smaller companies having larger discounts. • Average discount for companies with revenues under $10 million was 32.9%. 25

  26. II.A. Restricted Stock Studies • Management Planning, Inc. Study (continued) 26

  27. II.A. Restricted Stock Studies • Johnson Study (1991 – 1995) • Bruce Johnson studied 72 private placement transactions during the first half-decade after the Rule 144 restrictions were relaxed. • Average price discount of 20%. • Results ranged from a 10% premium to a 60% discount. 27

  28. II.A. Restricted Stock Studies • Johnson Study (continued) • Johnson analyzed four factors that influenced the size of the discount:(1) positive net income, (2) sales volume, (3) transaction value, and (4) net income strength. 28

  29. II.A. Restricted Stock Studies • Columbia Financial Advisors Study (1996-1997 & 1997-1998) • Study was divided into two parts: • Examined only private equity placements from January 1, 1996, through April 30, 1997 (before the reduction in the Rule 144 holding period). • Examined only private common equity placements from May 1, 1997, through December 31, 1998 (after the one-year holding period became effective on April 29, 1997). 29

  30. II.A. Restricted Stock Studies 30

  31. II.A. Restricted Stock Studies • Implications for using restricted stock study data as guidance to quantify lack of marketability discounts for closely held minority interests (BVR 2008 ed., page 1-4): • Only restricted stock studies prior to 1990 are relevant for estimating average discounts for marketability for closely held company interests. • The post-1990 restricted stock studies are still relevant for identifying factors that impact the differential level of the discounts for lack of marketability. • Because of the “dribble out” rule, blocks of restricted stock that constitute the largest percentage of the shares outstanding are most relevant for comparison with closely help stock valuations. 31

  32. Table of Contents • Introduction • Lack of Marketability for Noncontrolling Ownership Interests in Closely Held Businesses • Restricted Stock Studies • Pre-Initial Public Offering Studies • Other Studies • Lack of Marketability for Controlling Ownership Interest in Closely Held Businesses • Factors Affecting Lack of Marketability and Illiquidity Discounts • Quantifying the Discount for Lack of Marketability • Court Decisions on Discounts • Questions 32

  33. II.B. Pre-IPO Studies • Definition of a pre-IPO transaction • A pre-IPO transaction is a transaction involving a private company stock prior to an Initial Public Offering (IPO). • Pre-IPO studies • Pre-IPO studies compare the price of the private stock transaction with the public offering price. The percentage below the public offering price at which the private transaction occurred is a proxy for the discount for lack of marketability. 33

  34. II.B. Pre-IPO Studies • Robert W. Baird & Company Studies (1980 – 2000) • Eight studies conducted by John D. Emory. • Studied IPOs in which Baird & Company either participated or received prospectuses. • Analyzed IPOs to determine the relationships between: • the price at which the stock was initially offered to the public; and, • the price at which the latest private transaction occurred up to five months prior to the IPO. • The mean price discount for all nine studies (363 transactions) was 47%, and the median discount was 44%. 34

  35. II.B. Pre-IPO Studies • Robert W. Baird & Company Studies (continued) 35

  36. II.B. Pre-IPO Studies • Robert W. Baird & Company Studies (continued) 36

  37. II.B. Pre-IPO Studies • Willamette Management Associates Studies (1975 – 2000) • Studied prices of private stock transactions relative to those of subsequent offerings of stock of the same companies. • Source documents were SEC registration statements (Form S-1 & Form S-18) • Attempted to include only transactions that were on an arm’s length basis. • Transactions analyzed took place from 1 to 36 months before IPO. 37

  38. II.B. Pre-IPO Studies • Willamette Management Associates Studies (continued) • Compared P/E multiple of each private transaction with the subsequent public offering P/E multiple. • Companies that had no meaningful earnings were eliminated. • P/E multiples were adjusted for differenced in the industry aver P/E multiple between the time of the private transaction and the public offering. 38

  39. II.B. Pre-IPO Studies • Willamette Management Associates Studies (continued) • Formula used to derive the discount for the private transaction price from the public offering price: (P/Eo – P/Ep ((IP/Eo)/(IP/Ep))) / (P/Eo) P/Eo = Price per share of the public offering P/Ep = Price per share of the private transaction IP/Eo = Industry price index at time of offering IP/Ep = Industry price index at time of private transaction • Between 1975 and 1997, studies found mean discounts that ranged from 28.9% (1991) to 56.8% (1979), and median discounts that ranged from 31.8% (1991) to 73.1% (1984). 39

  40. II.B. Pre-IPO Studies • Willamette Management Associates Studies (continued) • Criticisms • The results are impossible to verify because Willamette Management will not provide data or calculations. • There is a self-selection bias in the determination of “qualifying transactions,” resulting in an overestimation of the discount for lack of marketability by excluding “troubled” companies. • Impossible to know if all transactions were at arm’s-length. 40

  41. II.B. Pre-IPO Studies • Valuation Advisors (1999 – 2006) • Analyzed transactions by length of time that the private transaction occurred prior to the IPO. • 1-90 days prior • 91-180 days prior • 181-270 days prior • 271-365 days prior • 1-2 years prior • No adjustments. • Findings support the hypothesis that the holding period is a major factor affecting the magnitude of the discount for LOM. • Valuation Advisors maintains a Pre-IPO LOM database that is updated monthly. The database has over 3,900 transactions. A license to use the database can be purchased on the company’s website. 41

  42. II.B. Pre-IPO Studies 42

  43. Table of Contents • Introduction • Lack of Marketability for Noncontrolling Ownership Interests in Closely Held Businesses • Restricted Stock Studies • Pre-Initial Public Offering Studies • Other Studies • Lack of Marketability for Controlling Ownership Interest in Closely Held Businesses • Factors Affecting Lack of Marketability and Illiquidity Discounts • Quantifying the Discount for Lack of Marketability • Court Decisions on Discounts • Questions 43

  44. II.C. Other Studies • D.B.H. Chaffe III Study (1993) • Mr. Chaffe, founder of Chaffe & Associates, estimated the cost of a put option as a proxy for measuring discounts for marketability, saying that the purchase of a put option, in effect, equated to the purchase of marketability. • He used the Black-Scholes pricing model to determine the amount of a marketability discount. • Found that the European option, which is exercisable only at the end of the option period, was an appropriate model for the SEC Rule 144 holding period of restricted shares. • The study supports a discount between 28% and 41% where restrictions on the put option lapse in two years or less. • At a four-year period, the range is 32% to 49%. 44

  45. II.C. Other Studies • Ronald Seaman’s LEAPS Study (2006, 2008) • LEAPS: Long-Term Equity Anticipation Securities • Exchanged listed options that grant the holder of the option the right, but not the obligation, to buy, in the case of a call, or to sell, in the case of a put, a specified amount of the underlying asset at a predetermined price on or before a given date. • A form of insurance against price fluctuations in publicly traded stocks. • Cost of a LEAPS put option, expressed as a percentage of the price of the stock, measures the cost of price protection against a loss in value. • Objective of the study (conducted in 2006 and again in 2008) was to determine what factors influenced the costs of price protection (or the size of discounts for LOM). 45

  46. II.C. Other Studies • Ronald Seaman’s LEAPS Study (continued) • Findings • Discounts change over time and are not constant in size. • Median discount for companies in 2006 study was 14.9% for the 18-month LEAPS put option and 17.4% for the 30-month option, an increase of 3.5%. • In the 2008 study, the median discount for all companies increased to 33.5% for the 14-month option and 40.6% for the 26-month option, an increase of 7.2%. • Discounts vary by industry and company size. The smaller the company, in revenues or assets, the larger the discount. • The greater the risk, as measured by the company’s beta, the greater the discount. • Discount for LOM analysis should be valuation date specific. 46

  47. II.C. Other Studies • Christopher Mercer’s Quantitative Marketability Discount Model (QMDM) • Introduced in 1994, the QMDM is a shareholder-level discounted cash flow model that is designed to help the valuation expert determine an appropriate marketability discount based on the investment characteristics of each subject illiquid interest of a closely held enterprise. • To use the QMDM, the appraiser must make the the following assumptions: 47

  48. Table of Contents • Introduction • Lack of Marketability for Noncontrolling Ownership Interests in Closely Held Businesses • Restricted Stock Studies • Pre-Initial Public Offering Studies • Other Studies • Lack of Marketability for Controlling Ownership Interest in Closely Held Businesses • Factors Affecting Lack of Marketability and Illiquidity Discounts • Quantifying the Discount for Lack of Marketability • Court Decisions on Discounts • Questions 48

  49. III. LOM for Controlling Ownership Interests • In federal estate tax cases and marital property cases it is often necessary to agree on the cash equivalent value for a controlling business ownership interest. • The courts have used language such as the following: • “Even controlling shares in a nonpublic corporations suffer from lack of marketability because of the absence of a ready private placement market and the fact that flotation costs would have to be incurred if the corporation were to publicly offer its stock.” (Pratt, page 440) 49

  50. III. LOM for Controlling Ownership Interests • Illiquidity Factors Affecting Controlling Ownership Interests • Unlike the owner of publicly traded securities, the owner of a controlling ownership interest in a closely help business cannot: • call a securities broker, • sell that ownership interest in seconds at a predetermined price and with a nominal transaction commission, and • realize the cash proceeds of the same in three business days. 50

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