Using restricted stock and pre-IPO data to estimate discounts for lack of marketability requires tact. Find out if an appraiser has used the data properly.
By Dr. Shannon P. Pratt and Alina V. Niculita, Valuators
Restricted stock and pre-IPO data are the most often used – and misused – sources for estimating discounts for lack of marketability (DLOM). And the DLOM is likely to be the biggest dollar issue in most disputed valuations of closely-held stock.
“Restricted stocks” are stocks of public companies that are identical in all respects to freely-traded stocks except that they have restrictions on their trading. Only institutions and high net worth investors can trade them.
The percentage discount between the price of an open-market transaction in a stock and the price of a restricted stock transaction on the same day in the same stock is a proxy for the DLOM.
Here are the correct steps to take when estimating DLOM.
1. Restricted Stock and Pre-IPO Data to Estimate Discounts: Selecting the Best Transactions
Most analysts just select some average number from one or more of the restricted stock and/or pre-IPO databases and use it for the DLOM. But, to derive the most valid results, the analyst should use the transactions in the databases that have characteristics most similar to the characteristics of the subject company.
Both the FMV restricted stock database and the Valuation Advisors pre-IPO database have enough transactions and enough data points per transaction (60 for FMV and 18 for Valuation Advisors) to select those transactions with characteristics closest to your subject company rather than relying on the mean or some other statistic in the database.
The most obvious metrics for comparability are size and profits. As both size and profits go up, the tendency is for the DLOM to go down. Size can be measured in terms of either sales or assets. For profits, any of several measures of profits can be used, and either the dollar amounts or the profits as a percentage of sales are good measures.
Unlike the restricted stock databases – which report the restricted stock and the freely-traded stock transactions on the same day – the pre-IPO events and the transactions when the company was private are usually months apart. To be a valid comparison, the analyst must make some adjustment for changes occurring between the two dates.
2. State Search Parameters in the Report
The analyst should state the parameters of the search in the report, and consider all items that meet the parameters. Insiders have various relationships to the company and other stockholders, so there may be some unexplained outliers in the DLOMs that should be disclosed and eliminated from the averages. Using the medians instead of the means as the measure of central tendency also blunts the impact of outliers.
The lower the range of DLOMs, the fewer transactions are needed. If the search produces too few transactions, the parameters can be widened.
Using the FMV restricted stock database, after a certain meaningful level – say 20% – the DLOM rises as the number of shares as a percentage of the shares outstanding goes up. Thus, a 35% block tends to have a higher DLOM than a 5% block. This is because of the blockage factor: a large block of stock is harder to place than a smaller block. Dr. Shannon Pratt has used this factor to successfully defend a 50% DLOM in court.[1]
3. Correct for Non-concurrent Dates Using Pre-IPO Data
DLOMs based on pre-IPO data have come under attack in the literature and have been rejected in the courts for the wrong reasons. The pre-IPO data are actually the most relevant data for DLOMs because they measure the percentage difference in price when the company was private vs. when the same company was public. (Dr. Shannon Pratt has used pre-IPO data very successfully in court.[2]
When an IPO occurs, the SEC requires disclosure of financials for the last three years. Therefore, the most important adjustment is to multiply the reported discount by the ratio of the price/earnings ratio (P/E) of the private transaction to the P/E at the time of the IPO. Another possible adjustment would be to multiply the DLOM result from above times the ratio of the industry P/E ratio at the time of the private transaction to the industry P/E ratio at the time of the IPO, because companies tend to have IPOs at high points in their industry P/Es.
4. Adjust Opposing Appraiser’s Numbers
If your appraiser has used these databases without taking the above steps, you should send him or her back to the drawing board. If the opposing appraiser has used these databases without taking the above steps, you should have your appraiser take the steps and apply them to the opposing appraiser’s calculations to see where he or she would come out.
[1] Howard v. Shay, 1998 U.S. Dist. LEXIS 23146 (C.D. Cal.).
[2] Okerlund v. United States, 365 F.3d 1044 (Fed. Cir. 2004) and Estate of Artemus D. Davis v. Commissioner, 110 T.C. 530, 1998 U.S. tax Ct. LEXIS 35, 110 T.C. No. 35 (1998).
Shannon Pratt is the founder and Alina Niculita the president of Shannon Pratt Valuations, Inc. Dr. Pratt has more than ten books in print on various business valuation topics and has testified on hundreds of occasions in various types of litigated matters. Ms. Niculita manages valuation engagements and has contributed to several business valuation books. www.shannonpratt.com
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