Financial professionals involved with wealth management need to be aware of the effects of court cases relating to valuation of minority interests in small businesses and related securities. Cases brought to the tax court in recent years have shed some light on the relatively obscure subject of discounted values caused by reduced marketability and control for minority interests. This is an issue that is faced by professional advisors regarding gift and estate taxes, and for financial planning. The cases will be pointed out in this article.
Prior to these cases, appraisers generally treated valuation of such discounts as a relatively minor adjunct to the valuation of the basic (majority) position. Many either used “industry standards” for marketability discounts of, say, 35% without support, or they attempted to support these values with statistics from studies of restricted stock of public companies (which can be sold, usually at a discount, from their unrestricted brethren, and by IPO studies of stock values before and after the Initial Public Offering. The courts have virtually all rejected such valuations in the case of closely held securities, and laid down some principles which, if adhered to in appraisals, should significantly limit the chances of litigation. And, if litigated it should dramatically enhance the chances of winning.
All appraisals are a defensible opinion of value, prepared by an expert, for an ownership interest. Such an ownership interest is often referred to as a “bundle of rights.” Normally ownership in fee contains the most valuable bundle of rights, and lesser forms such as ownership of a security interest, lease, license, or other such instrument will reduce the bundle of rights – and hence the value. Further, restrictions on marketability or control of such minority interests results in a reduction of value.
If the asset to be valued is a minority interest, and/or if it is subject to restricted marketability, and/or lack of control, appropriate discounts to value must be applied. Over the years, many appraisers have adopted policies that separated the lack of control discount from the lack of liquidity or marketability discount. However, this appears to be a difference without a distinction. All discounts from value appear to be, in the end, evidence of impairments in marketability. The fact that such discounts, even if treated as separate discounts, are multiplicands which are multiplied by each other to derive a final discount figure illustrates this point.
Though the appropriateness of applying such discounts in these situations has been universally accepted by the IRS and the courts, recent court decisions have shown a fair amount of disagreement over the means of quantifying the appropriate discounts. (IRS Revenue Ruling 77-287 deals with marketability discounts for “restricted securities,” but it is silent on “exempted securities,” which make up the vast majority of privately held securities. Both are defined and described in the Securities Act of 1933.) The cases indicate a complete analysis is required.
To quantify the “marketability discount,” because of a lack of available specific data, some appraisers have been relying on two sources of data from public company transactions; Initial Public Offering Studies, and Restricted Stock Studies to defend their discount opinion. The “standard” discount often derived from these studies is typically between 30% to 40%. Three cases against the Commissioner in 2003 found that such studies, based upon data from public companies, were not sufficient basis to value closely held private (exempt and unregistered) ownership. Upon a deeper look the reasons are fairly obvious:
* Initial Public Offering Studies (IPO) show the difference in the price of a stock before the offering and after, and an appraiser may attempt to infer that this is direct evidence to support a marketability discount for an exempt security. This is erroneous for the following reasons:
* Stock values of privately held companies typically are based upon investment value – that is, an investor will be interested in both the current return, and the amortization factor (risk abatement factor) which indicates how long it will take to recover the initial investment. This is necessary because of the high degree of illiquidity of non-public securities.
* The IPO price, on the other hand, reflects a speculative value – that is, the investor is looking mainly towards price appreciation. By its nature once publicly traded, the stock should have high liquidity, so recovery of the investment is not an investment concern. Thus, this study is relevant only to companies anticipating an IPO. Unfortunately, these companies represent less than 1% of the companies extant in the U.S.
* Restricted Stock Studies deal with stocks of public companies that have been temporarily restricted from sale for two years (later for one year) in the public markets (usually by virtue of securities regulations under Rule 144). Nonetheless, there is no prohibition in selling these securities in private transactions where they usually sell at an average of 30% or so less than publicly traded stock. But these are applicable only to publicly traded stocks that have only a temporary restriction from public markets, and not on the general ”permanent” illiquidity problem faced by small privately held companies which would make them far less marketable.
* Control discounts, (or more appropriately control-based marketability discounts) for small privately held companies are magnified in comparison with publicly held companies for a simple reason – in privately held companies the only practicable way to recover the investment is liquidation (sale) of the company. Without control, an investor does not have the right to exercise this option. Thus minority interests in closely held companies are very difficult to sell. In practice, in the past appraisers have often attempted to base discounts for lack of control on control premium studies of public companies. The two are not the same at all.
The case of Mandelbaum v. Commissioner, T.C.M 1995-255 determined that use of irrelevant data is unacceptable, and sets forth some basic factors which might comprise the discount, but specified that this list was not exclusive, and other factors may (and should) apply as the situation dictates. It basically states that a complete analysis must be done which is relevant to the subject. The factors listed to be evaluated included but were not limited to:
IRS Revenue Ruling 77-287 deals with marketability discounts for “restricted securities”, but it is silent on “exempted securities,” which make up the vast majority of privately held securities. Both are defined and described in the Securities Act of 1933.
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