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Originally published in the February 2014 issue of the Update.

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Business Valuation Resources, LLC 1000 SW Broadway, Suite 1200 | Portland, OR 97205 (503) 291-7963 | [email protected] www.BVResources.com BUSINESS VALUATION UPDATE TIMELY NEWS, ANALYSIS, AND RESOURCES Vol. 20, No. 2, February 2014 FOR DEFENSIBLE VALUATIONS

Is the Lingering Criticism of Using Pre-IPO Studies for DLOM Justified?

The use of pre-IPO studies to measure a discount that] is not freely tradable.” In 2003, the Tax for lack of marketability has gained acceptance Court rejected the use of pre-IPO studies in among valuation analysts and the Tax Court even McCord v. Commissioner. Dr. Mukesh Bajaj though the method continues to be a target of was the expert witness for the IRS, and the some criticism. Of course, criticism can be made court opinion states: “[I]n his rebuttal testi- of all data that BV practitioners use. The trouble mony, Dr. Bajaj offers a compelling criticism is, this criticism can sometimes be based on “old” of both the Willamette studies and [the Emory facts, which can lead to misinformation. studies].” There was no such criticism directed at the Valuation Advisors Pre-IPO database. Pre-IPO studies and restricted studies are Bajaj proposed an alternative method that was the two general types of empirical evidence of the a variation of analysis. existence and magnitude of the DLOM. Restricted stock studies compare the trading prices of a com- Valuation analysts have been extremely critical pany’s publicly held stock sold on the open market of the McCord decision. Restricted are, with those of unregistered or restricted shares of by definition, stocks of publicly traded compa- the same company sold in private transactions. nies that are prohibited from public trading for The pre-IPO studies move a step closer to mea- some limited time. When the restrictions expire, suring DLOM for closely held business interests they can be freely sold into an established public than the restricted stock studies. They consist of market. But an interest in a private company that transactions in privately held stocks prior to an has no established market (and is not likely to compared with the subse- ever have an established market) is less mar- quent public offering price in the same stock. ketable than the restricted stock of a . Therefore, DLOM calculations based Over the years, three main sources of pre-IPO on a group of restricted stocks need to have an data have emerged. The Willamette Management upward adjustment to reflect the lesser market- Associates studies cover the period from 1975 to ability of the closely held interest. 2002. The John Emory studies cover the period from 1980 to 2000. The Valuation Advisors Lack The alternative to using restricted stock studies is of Marketability Discount Study is an ongoing to use pre-IPO studies. Many valuation analysts study and commercial database that has current use both methods, plus information from other information and is updated regularly. sources. Regardless, there is some ongoing criti- cism over the use of pre-IPO studies to measure Key court cases. In 1998, the Tax Court recog- DLOM. nized the relevance of pre-IPO studies in Davis v. Commissioner, finding that “the prevaluation BVU recently sat down with Brian Pearson date data in the IPO studies are relevant and of Valuation Advisors LLC, who developed the provide some insight into the price differences Valuation Advisors Lack of Marketability Pre-IPO between stock that is freely tradable and [stock Discount Study. This is the only online database

Reprinted with permission from Business Valuation Resources, LLC

bvresources.com Is The Lingering Criticism Of Using Pre-ipo Studies For Dlom Justified?

of pre-IPO privately owned stock, convertible BUSINESS VALUATION UPDATE , and transaction data from Executive Editor: Andrew Dzamba 1985 to the present, and it recently surpassed Publisher: Sarah Andersen the 10,000 mark in terms of the number of trans- Legal Editor: Sylvia Golden, Esq. actions in the database. This makes it the largest Managing Editor: Janice Prescott source of DLOM data for BV professionals. Desktop Editor: Monique Nijhout Customer Service: Retta Dodge BVU: What is the source of the information VP of Sales: Lexie Gross President: Lucretia Lyons contained in the study and database? CEO: David Foster Brian Pearson: Before a company has an IPO, it EDITORIAL ADVISORY BOARD files a prospectus with the SEC. These prospec- CHRISTINE BAKER THEODORE D. ISRAEL tuses are available through the SEC’s EDGAR CPA/ABV/CFF CPA/ABV/CFF, CVA MEYERS, HARRISON & PIA ECKHOFF ACCOUNTANCY CORP. database and also from the investment bankers NEW YORK, NY SAN RAFAEL, CA who underwrite the offering. We receive a copy NEIL J. BEATON JARED KAPLAN, ESQ. CPA/ABV, CFA, ASA MCDERMOTT, WILL & EMERY of each prospectus and review it. We then record ALVAREZ & MARSAL VALUATION CHICAGO, IL SERVICES GILBERT E. MATTHEWS CFA any transactions involving the company’s stock, SEATTLE, WA SUTTER SECURITIES INCORPORATED stock options, or convertible preferred stock SAN FRANCISCO, CA JOHN A. BOGDANSKI, ESQ. prior to going public (i.e., when it was still a LEWIS & CLARK Z. CHRISTOPHER MERCER LAW SCHOOL ASA, CFA MERCER CAPITAL private company). PORTLAND, OR MEMPHIS, TN ROD BURKERT JOHN W. PORTER, ESQ. BVU: Do you update the data​base as new CPA/ABV, CVA BAKER & BOTTS BURKERT VALUATION ADVISORS, LLC HOUSTON, TX companies go public? MADISON, SD RONALD L. SEIGNEUR MICHAEL A. CRAIN MBA, ASA, CPA/ABV, CVA, CFF CPA/ABV, ASA, CFA, CFE SEIGNEUR GUSTAFSON BP: Yes. We get prospectuses for new IPOs THE FINANCIAL VALUATION GROUP LAKEWOOD, CO usually the week after they go public. It takes FORT LAUDERDALE, FL BRUCE SILVERSTEIN, ESQ. YOUNG, CONAWAY, STARGATT & some time to review the information and compile NANCY J. FANNON TAYLOR ASA, CPA/ABV, MCBA WILMINGTON, DE it for the database, but the database is updated MEYERS, HARRISON & PIA PORTLAND, ME JEFFREY S. TARBELL for new IPOs at least once per month. ASA, CFA JAY E. FISHMAN HOULIHAN LOKEY FASA, CBA SAN FRANCISCO, CA BVU: Does your study include all IPOs? FINANCIAL RESEARCH ASSOCIATES GARY R. TRUGMAN BALA CYNWYD, PA ASA, CPA/ABV, MCBA, MVS LYNNE Z. GOLD-BIKIN, ESQ. TRUGMAN VALUATION ASSOCIATES BP: Our database is exhaustive. It includes all PLANTATION, FL WEBER GALLAGHER NORRISTOWN, PA KEVIN R. YEANOPLOS IPOs except REITs, LPs, and companies with no CPA/ABV/CFF, ASA LANCE S. HALL, ASA BRUEGGEMAN & JOHNSON transactions. REITs and LPs typically pay high FMV OPINIONS YEANOPLOS, P.C. dividends, which give them a yield, which is dif- IRVINE, CA TUCSON, AZ ferent than most privately owned common stock, Business Valuation Update™ (ISSN 1088-4882) is published monthly by Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, which typically doesn’t pay recurring dividends. Portland, OR, 97205-3035. Periodicals Postage Paid at Portland, OR, and at additional mailing offices. Postmaster: Send address changes to LPs are pass-through entities, which typically Business Valuation Update™, Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 97205-3035. share profits with partners, whereas REITs, by The annual subscription price for the Business Valuation Update™ is $419. law, must distribute 85% of their current-year Low-cost site licenses are available for those wishing to distribute the BVU to their colleagues at the same firm. Contact our sales department for details. ordinary income to owners. Since these dif- Please feel free to contact us via email at customerservice@BVResources. com, via phone at 503-291-7963, via fax at 503-291-7955 or visit our web site ferences are significant, we choose to exclude at BVResources.com. Editorial and subscription requests may be made via email, mail, fax or phone. these transactions from the database. Please note that by submitting material to BVU, you are granting permission for the newsletter to republish your material in electronic form. BVU: There’s been some criticism over the Although the information in this newsletter has been obtained from sources that BVR believes to be reliable, we do not guarantee its accuracy, and such years about the data in the pre-IPO studies. information may be condensed or incomplete. This newsletter is intended for information purposes only, and it is not intended as financial, investment, One that is coming up recently is the issue legal, or consulting advice. of “double counting” of the discount. That Copyright 2014, Business Valuation Resources, LLC (BVR). All rights reserved. No part of this newsletter may be reproduced without express written is, some of the transactions in the database consent from BVR. are calculated with a DLOM already in them. Reprinted with permission from Business Valuation Resources, LLC

2 Business Valuation Update February 2014 Is The Lingering Criticism Of Using Pre-ipo Studies For Dlom Justified?

BP: Double counting of discounts is not occur- are worth much less. Then the real “discount” is ring when viewed in the larger context of the likely larger, since I have no immediate or likely transaction. While it is true that some of the avenue to gain liquidity. transactions include a prior discount, it helps to BVU: There’s also been the argument that understand the process by which this “discount” IPOs are overpriced due to hype. was calculated. Under the fair value standards for option and stock issuance and the AICPA’s BP: Interestingly, that argument is counter to guide to fair value, the commonly used valua- another argument that IPOs are underpriced in tion method of PWERM (probability-weighted order to have a successful offering. Both argu- method) requires consideration ments are wrong. The privately held company of a DLOM. So if the is $10 per owners generally don’t like to underprice the share and the CPA BV professional, under the fair offering since they receive less money if they value guidelines, assigns a 30% discount, the are selling shares, and it only makes the under- reported transaction price is $7. If the company writers look good. Conversely, if you overprice goes public at $12, in theory, you have two dis- the offering (such as Facebook) and the stock counts at two different periods (30% and 20%). price falls, the offering is viewed poorly and the However, this is where the theory of multiple underwriters get a lot of bad press, which they discounts fails, since in reality the transaction is do not want. Clearly, both sides, the owners and just one transaction, from the time of investment underwriters, have an incentive to “get it right” until the time of liquidity (i.e., the IPO date). and not be greedy at the expense of the other.

Prior to the fair value standards, in an arm’s-length Also, another key issue is that the investor road negotiation of the price, the same process would show helps both parties gauge demand for the have occurred, except it would simply have been shares. If it’s high, the offering price may be reported as a $7 transaction with the discount raised or the number of shares sold increased. as ((12 - 7)/12, or 41.66%). Thus, the concept of If demand is too low, the opposite happens, or “two discounts,” although implicit in the process, the offering may be pulled altogether. wasn’t being publicly reported. In fact, the same level of DLOM is occurring in both situations—it’s With the exception of a very well-known just that the fair value standards for pre-IPO trans- company like Facebook where media and user actions shed better light on the process of how hype created a huge demand for the shares such pre-IPO values are being arrived at now. allowing the underwriters and company owners to get piggy, I think you can see that the process Let’s look at it another way. If I assess ABC is really driven by investor demand counterbal- Company and believe on a 100% controlling basis anced by the underwriters’ ability to gauge the that it’s worth $10 per share, I am certainly not demand and set a fair price. In 95 out of 100 going to pay that as a shareholder when there times, it works perfectly. Thus, both the overpric- is no market to sell such shares. Let’s say we ing and underpricing criticisms are unfounded. agree on a price at $7 per share, which reflects my illiquidity concerns and a 30% DLOM. Then, BVU: Do IPO studies imply overly large two years later, the company has an IPO at $15 returns? per share. The implied two-year DLOM is 53.33%. The fact that I determined a DLOM to get to my BP: When investors buy into a closely held IPO $7-per-share value reflects the reality of the mar- company, they usually expect a 20%-to-35% ketplace of real investors. The price per share is return. If the company performs better, their going to reflect my illiquidity concerns, not the pro returns are even better, and this would support rata share of a 100% controlling value. Thus, the the ability to both go public and the high rates DLOMs in our database are consistent with the of return implied by the discounts. Further, when change in value from the stock being illiquid to the you go beyond one year, the returns begin to stock being liquid. If ABC Company doesn’t go compound, offering even more support for the public, clearly the shares aren’t worth $15—they returns implied from the pre-IPO discounts. Reprinted with permission from Business Valuation Resources, LLC

February 2014 bvresources.com 3 Is The Lingering Criticism Of Using Pre-ipo Studies For Dlom Justified?

Also, the database has many negative discounts. determining the price per share that was used This shows that, even in a “successful” company by them in their purchase (and is what we use in that managed to have an IPO, it was previously the database to determine the discounts). Clearly, worth more, and investors have lost money on actual performance will differ from projections paper. When you can lose money on a success- used to determine the original price, but most of ful offering, it shows why returns need to be high this difference (which represents future projected on pre-IPO transactions. A further example of growth) should have already been considered in this outcome is the money lost by investors in the original transaction. failed pre-IPOs. This is, of course, potentially a zero . These negative factors must BVU: Any other comments you’d like to make? also be considered in the “total” return investors receive, not just the successful, high-rate-of- return IPOs that are easy to identify. BP: If you’re going to use pre-IPO studies as one of your DLOM methods—and the IRS and BVU: What about the issue of a difference in Tax Court have pretty much said you should— earnings between the time of a transaction you should use the latest data. Our database and the IPO? is updated monthly. For example, in 2013, we added more transactions to the database than BP: Clearly, if a company is growing, there will in any year since 1999. Also, it’s the largest data- be an increase in the earnings during this time base of such information in the world. If you’re frame. This is to be expected. Presumably, a not using the most currently available data or you reasonably intelligent investor is going to ask to are simply citing older studies in your valuation review forward projections that would incorpo- reports, you are simply highlighting that your rate such growth in earnings. research and data are old and outdated. The price you pay for any asset is supposed to reflect all known future information. Therefore, an For more information on the Valuation Advisors investor would clearly review and assess such Lack of Marketability Discount Study, go to www information, so a lot of these changes in earnings .bvmarketdata.com, which includes details of the should have been considered by the investor in database, sample data, FAQs, and more.

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4 Business Valuation Update February 2014