A Premium Perspective on

Discounts
Presenters:
Robert J. Grossman, CVA, CPA/ABV, ASA, CBA
Espen Robak, CFA

June 8, 2011
San Diego, California
 TABLE OF CONTENTS

1. Fundamentals of Discounts & Premiums

2. Control Premium/Minority Discount Basics

3. Revenue Ruling 93‐12 and “Swing Vote”

4. Nonvoting v. Voting Interests

5. Lack of Marketability Discount

6. Empirical Studies Supporting DLOM

7. Alternative Discount Computation Methodologies

 OVERVIEW & REVIEW
OF FUNDAMENTALS

ƒ Discounts and premiums do not exist by

themselves
ƒ No direct evidence
ƒ “They are the fallout of using less than perfect
data to measure value.”
– Michael Bolotsky
 OVERVIEW & REVIEW
OF FUNDAMENTALS

ƒ Summit on DLOM
– San Diego – September 18, 2008
ƒ Howard Lewis Comments:
– Market‐based data is best in supporting discounts
– Percentage discount should reflect valuator effort
– Georgetown University – November 9, 2010
ƒ David Laro Comments:
– “No methods currently available to business
valuators could successfully defeat Daubert
challenge.”
 OVERVIEW & REVIEW
OF FUNDAMENTALS

ƒ Burden of Proof
– The burden of proving the propriety of the
discounts and/or premiums utilized falls,
ultimately, to the business valuator
– The most common basis for not successfully
defending discount level challenges is the failure
to properly reconcile the subject equity interest
characteristics with third party inferential
observations
 OVERVIEW & REVIEW
OF FUNDAMENTALS

ƒ Fundamentals
– Fair market value set by market
 OVERVIEW & REVIEW
OF FUNDAMENTALS

ƒ Fundamentals
– Fair market value set by market
– Investors are risk adverse
 OVERVIEW & REVIEW
OF FUNDAMENTALS

ƒ Fundamentals
– Fair market value set by market
– Investors are risk adverse
– Base of application must be defined
 OVERVIEW & REVIEW
OF FUNDAMENTALS

ƒ Fundamentals
– Fair market value set by market
– Investors are risk adverse
– Base of application must be defined
– No “prescribed” ranges of discounts/premiums
 OVERVIEW & REVIEW
OF FUNDAMENTALS

ƒ Fundamentals
– Fair market value set by market
– Investors are risk adverse
– Base of application must be defined
– No “prescribed” ranges of discounts/premiums
– DLOC & DLOM are separate and distinct
 OVERVIEW & REVIEW
OF FUNDAMENTALS

ƒ Fundamentals
– Fair market value set by market
– Investors are risk adverse
– Base of application must be defined
– No “prescribed” ranges of discounts/premiums
– DLOC & DLOM are separate and distinct
– DLOC & DLOM are multiplicative, NOT additive
 OVERVIEW & REVIEW
OF FUNDAMENTALS

ƒ Fundamentals
– Fair market value set by market
– Investors are risk adverse
– Base of application must be defined
– No “prescribed” ranges of discounts/premiums
– DLOC & DLOM are separate and distinct
– DLOC & DLOM are multiplicative, NOT additive
– Minority interests do not total to proportionate
share of enterprise value
 OVERVIEW & REVIEW
OF FUNDAMENTALS

ƒ General Factors that Influence Applicability

and Size of Discount or Premium
– Purpose of the valuation – divorce, ESOP, etc.
– Attendant rights and characteristics of the specific
interest under valuation
– Ownership Structure – voting v. nonvoting
– Management team quality
– Size of company
– Size of block of stock/swing vote
– Propriety of salaries, etc.
 OVERVIEW & REVIEW
OF FUNDAMENTALS

ƒ General Factors that Influence Applicability

and Size of Discount or Premium
– Stock related issues – restrictions, dividend paying
history, rights of first refusal
– Financial condition
– Regulatory restrictions
– State incorporation statutes
– Market desirability
– Potential synergies, if any
– Investment time horizon/holding period
 OVERVIEW & REVIEW
OF FUNDAMENTALS
EXHIBIT I: "LEVEL OF VALUE" IN TERMS OF Synergistic
CHARACTERISTICS OF OWNERSHIP $12.00 (Strategic)
per share Value

20% strategic acquisition

premium

a
$10.00 Value of control shares
per share

20% minority interest Control Minority

discount; 25% control Premium Discount
premium

"Publicly traded equivalent

$8.00 value" or "Stock Market
A combined 20% discount per share Value" of minority shares
and a 45% discount for 45% total discount for if freely traded
lack of marketability equals lack of marketability 25% discount for lack Discount for
a total of 56% discount (25% + 20% may be of marketability for restricted stock
from value of control sharesb taken additively) retricted stock of public company

$6.00 Value of retricted stock

Additional 20% discount per share of public company
for private company stock Additional discount
(taken from pulicly traded for private company
equivalent value $8/share) company stock

$4.40 Value of nonmarketable

per share minority (lack of control)
shares
Notes:
a
Control shares in a privately held company may also be subject to some discount for lack of marketability, but usually not nearly as much as minority shares.
b
Minority and marketability discounts normally are multiplicative rather than additive. That is, they are taken in sequence.
$10.00 Control Value
-2.00 Less: Minority interest discount (.20 x $10.00)
8.00 Marketable minority value
-3.60 Less: lack of Marketability discount (.45 x 8.00)
$4.40 Per-share value of non-marketable minority shares
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Control is paramount to the investor having

influence over the attainment of the future
benefits of ownership and the distribution of
those benefits of ownership!
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Assessing Levels of Control

– Board of Directors representation
• Direct representation
• Indirect representation via cumulative
voting rights

– Contractual restrictions
• Loan agreements with restrictive covenants
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Assessing Levels of Control

– Other agreements
• Organization agreements
• Shareholder agreements
• Buy/sell agreements
• Employment agreements
• Voting trusts
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Assessing Levels of Control

– Industry regulations
– State corporate and entity laws
– Voting rights
– Financial condition of business
– Size of block of stock
– Concentration of ownership
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Valuation Platforms
– Income Approach
• Capitalized returns
• Discounted future returns

– Minority or control freely‐traded value

– Control vs. Minority platform

• Depends on the numerator

– Most, if not all, of the difference in minority or

control freely‐traded value as a platform rests
with whether the future benefit stream has been
adjusted for control prerequisites
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Valuation Platforms
– Market Approach
• Guideline company method:
minority freely‐traded value
• Merger and acquisition method:
control marketable value

– Asset‐Based Approach
• Net asset value method
• Excess earnings method
• Control marketable value
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Range of CONTROL

Control Value 100% equity ownership interest

Control interest with liquidating control

51% operating control

Two equity holders, each with a 50% interest

Minority shareholder with largest block

Minority with "swing vote" attributes

Minority with "cumulative voting" rights

Pure minority - no control

MINORITY
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Minority Discount Evidence

– Factset Mergerstat® Review
– HLH&Z Control Premium Study
– Coolidge Study
– SEC Studies ‐ SEC, June 1987
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

Example of ABC Company Computation of Control Premium

DAYS BEFORE
DATE PRICE PER SHARE TRANSACTION

Day 1‐Mon. $21.50 6

Day 2‐Tues. $21.25 5

Day 3‐Wed. $23.25 4

Day 4‐Thurs. $23.75 3

Day 5‐Fri. $24.00 2

Date of
Day 9‐Tues. $28.00 Announcement
Observed Premium (28.00 – 21.25)/21.25 = 31.8%
- Announcement to fifth prior day -
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Computation of Implied Minority Discount From

Mergerstat® Review Data
Formula:
x=1‐[1/(1+y)] x = implied minority discount
y = median premium paid
Application (from Mergerstat® Review 2008):
x=1‐[1/(1+.247)]
x=1‐(1/1.247)
x=1‐.8019
x=.198
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Factset Mergerstat®
– Excludes negative premiums from average
– 2010 Average – 51.5%
• With negative premium 46.5%
– 2010 Median – 34.6%
• With negative premium 32.5%
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Factset Mergerstat®
– 5 Highest premiums
• 203.9% to 433.3%
– 5 Lowest premiums
• ‐50.1% to ‐97.0%

(excludes Chapter 11 sellers)

 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Factset Mergerstat®
– 2010 Distribution

20% and less 93 26%

20% to 40% 109 31%

40% to 60% 62 18%

60% to 80% 33 9%

80% to 99.9% 16 5%

100% and Over 36 11%

349 100%
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Factset Mergerstat®
– Use of Factset Mergerstat® as a baseline measure of
control premiums requires careful consideration and
judgment
 CONTROL PREMIUMS
AND MINORITY DISCOUNTS

ƒ Factset Mergerstat®
– Synergistic considerations
• Premiums include control considerations and
synergistic considerations.
 REV. RUL. 93-12 & “SWING VOTE”
CONSIDERATIONS

ƒ Revenue Ruling 93‐12

– Replaces Revenue Ruling 81‐253
– Represents IRS acquiescence on numerous cases
– Provides taxpayer with an opening to apply a
discount for lack of control (minority) in family‐
related stock ownership situations
– DOES NOT GUARANTEE A DISCOUNT!
 REV. RUL. 93-12 & “SWING VOTE”
CONSIDERATIONS

ƒ “Swing Vote” Qualities

– TAM 9436005 & TAM 9449001
• Rulings consider the element of value attributable
to joining two blocks of ownership together to
attain a different level of control
• Rulings recognize that, for gift tax
purposes, value is determined with
regard to donee (minority) rather than
the donor (majority)
– “Swing Vote” premium will almost always be smaller
than the minority interest discount
 LACK OF MARKETABILITY
DISCOUNTS

ƒ Revenue Ruling 77‐287

– Deals with restricted stock studies
– Discusses the 1971 SEC study
– Sets non‐letter stock factors for consideration
in assessing marketability
 LACK OF MARKETABILITY
DISCOUNTS

ƒ Revenue Ruling 77‐287

– Weighing the facts
• All relevant facts and circumstances
• Primary consideration:
– Earnings
– Net assets
– Net sales
– “Securities traded on a public market generally are
worth more to investors than those that are note
traded on a public market.”
 LACK OF MARKETABILITY
DISCOUNTS

ƒ Determinations
– Historically, benchmark methodologies based on IPO
Studies and Restricted Stock Studies
 LACK OF MARKETABILITY
DISCOUNTS

ƒ Alternative Methodologies
– Quantitative Marketability Discount Model (QMDM)
• DCF modeling incorporating holding period
– Hedging Models
• Not so useful for smaller privately‐held companies
 LACK OF MARKETABILITY
DISCOUNTS

ƒ VCF Longstaff DLOM Methodology

– Mark Vianello advocates a DLOM determination
based on formulas developed by Francis A. Longstaff
in a 1995 article titled “How Much Can Marketability
Affect Security Values” (“Look back” option pricing
theory)
• Journal of Finance, Volume L, No. 5, December
1995
 LACK OF MARKETABILITY
DISCOUNTS

ƒ VCF Longstaff DLOM Methodology

– Not attempting to measure “value” of liquidity, per
se, but rather the “risk associated with the lack of
liquidity”
 LACK OF MARKETABILITY
DISCOUNTS

ƒ Comparative Analysis with Restricted Stock

Approach (CARS)
– Using fundamental available data to “drill” into
studies to identify a better connection between the
subject company and the companies within the
studies on which the data was based
 LACK OF MARKETABILITY
DISCOUNTS

ƒ Comparative Analysis with Restricted Stock

Approach (CARS)
– Two Primary Databases
• FMV Opinions, Inc.
• Pluris DLOM Database