Valuation Concepts inside: Pre-IPO studies <> Experts debate their use in determining marketability discounts How appraisers value real estate holding entities DCF calculations are only as good as the numbers you provide Prescription for change <> Payment reform, managed care affect how medical practices are valued spring 2005 J.L. PIERSON & CO. LLC BUSINESS VALUATION NYNJCT-BV.COM (203) 325-2703 Business Valuation (203) 434-4648 P.O. BOX 2392 DARIEN CT 06820-0392 Pre-IPO studies Experts debate their use in determining marketability discounts When valuing a company, appraisers commonly apply and tax courts. But they have also come under scrutiny marketability discounts to reflect the difference in and become the target of some criticism. liquidity between shares in closely held businesses vs. publicly traded companies. Support for the method Several firms have analyzed transactions involving The holders of closely held shares lack the ability to sell company shares before and after their IPOs. A Robert their holdings on short notice and, therefore, the shares W. Baird & Co. study analyzed over 1,500 transactions can be less attractive investments. According to the between 1980 and 2000 that occurred five months Valuation Advisors’ Lack of Marketability Discount or nearer the IPO. Another study by Willamette Study, the median discount in 2003 was 40.1% (down Management Associates considered all public offerings from 63.3% four years earlier). listed in Thomson Financial’s IPO Reporter between 1975 and 1993 and analyzed share transactions 36 A contested method months prior to their IPOs. The discounts between private and public transactions vary under different market conditions and can be diffi- cult to calculate. One method of calculating marketabil- Over the past decade, pre-IPO studies ity discounts is to use pre-IPO studies. These studies have, in many cases, gained acceptance compare the price of common stock at the time of an among valuation professionals and initial public offering (IPO) with the “arm’s length” transaction pricing (or the agreed-upon price of two tax courts. But they have also come entities acting in their own self-interest) before the IPO. under scrutiny and become the target of some criticism. For example, if a shareholder sells stock at $5 per share prior to the IPO and the stock later sells to the public The Baird study found a marketability discount consis- at $10 per share, the marketability discount can be con- tently above 40% — higher than the discounts of sidered to be 50%. previously conducted restricted stock studies. (Restricted Over the past decade, pre-IPO studies have, in many stock studies compare the prices private investors pay for cases, gained acceptance among valuation professionals restricted shares with the prices public investors pay for shares that have been registered with the Securities and Exchange Commission.) The Willamette study more or less corroborated the Baird study’s conclusions. Davis v. Commissioner, a 1998 tax court decision, recognized the relevance of pre-IPO studies. The court found that “in determining the lack-of- marketability discount that is applicable here … the prevaluation date data in the IPO studies are relevant and provide some insight into the price differences between stock that is freely tradable and … is not freely tradable.” 2 Restricted stock studies come under scrutiny Dr. Mukesh Bajaj, well-known for his testimony disputing the validity of pre-IPO studies in McCord v. Commissioner, is also an outspoken critic of restricted stock studies. Bajaj has argued that restricted stocks trade at a discount for several reasons besides lack of marketability. One of these is the fact that private buyers of restricted stock demand a discount to compensate them for monitoring the company’s performance and for providing professional advice. A 2001 study conducted by Bajaj and several colleagues compared two types of private placements: registered and unregistered. The study found that the average discount for registered private placements was 14.04%. The unregistered shares showed an average discount of 28.18% — a significant difference. After adjusting for other factors that might affect the size of the gap between registered and unregistered private placement discounts — including block size, business risk and placement proceeds — Bajaj concluded that the average discount attributed exclusively to marketability was only 7.23%. Criticism of the method The fact that buyers of shares prior to a public offering The validity of pre-IPO studies, however, has been are likely to be insiders is a more general concern about undermined somewhat by criticism of the data support- the use of pre-IPO studies for determining marketability ing their use. discounts. Also, some experts believe the discount on pre-IPO shares reflects a discount for the possible The Willamette Management study has been criticized failure of the business, not just lack of marketability. by various valuation practitioners for several reasons. Because Willamette Management considers its data to The court in McCord v. Commissioner, a 2003 tax court be proprietary, some of it cannot be verified, including decision, rejected the use of IPO studies. Dr. Mukesh the subjects’ management, redemption policies and Bajaj, an expert witness testifying on behalf of the restrictions on the transferability of stock. Commissioner of Internal Revenue, theorized that any IPO premium over pre-IPO prices may reflect more than just lack of marketability. Instead, he proposed private placement analysis (a variation of the restricted stock analysis). Determining value The McCord decision has been widely criticized by valuation professionals. Many appraisers claim that while restricted stock will eventually be publicly traded, closely held shares most likely will not. Therefore, lack of marketability discounts based on restricted stock studies need to be increased when applied to closely held businesses. The Willamette study also contains very few companies that paid dividends. Some valuation analysts believe it’s Of course, an alternative to restricted stock studies is difficult to analyze the correlation between dividend pre-IPO studies. And, many valuation experts use a policy and the size of the marketability discount. combination of restricted stock studies and IPO studies, along with other sources of information. Hiring an Both the Baird and Willamette studies have been criti- expert who understands how to properly apply conclu- cized for implying unrealistically high returns, and for sions from the various studies is vital to developing a including transactions that may reflect compensation to business valuation that can withstand scrutiny. <> insiders, who tend to receive shares at discounted prices. 3 How appraisers value real estate holding entities When determining the fair market value of closely held Real estate holding entities vary widely; in fact, the real estate holding entities, valuation professionals only thing many have in common is the simple often apply discounts, or adjustments, to the value of fact that they own real estate. The most common entities for lack of control or lack of marketability. categories include: Lack of control (or minority interest) discounts are Equity — distributing, with low or no debt. These applied when an owner has insufficient influence over the partnerships own equity interests in income-producing management or operations of a company. Lack of mar- real estate, such as apartments or office buildings. ketability discounts are applied when opportunities for Operating cash distributions are made to the partners selling ownership interests are limited. Both can signifi- on a regular basis and the entity is not overly encum- cantly reduce the value of the interest being appraised. bered with debt. Equity — distributing, with moderate-to-high debt. Identifying discounts These own equity interests in income-producing real When appraisers value a real estate holding entity, they estate. They make operating cash distributions to the examine financial statements and operating agreements partners on a regular basis, but the entities are lever- to arrive at a fair market value of the underlying assets. aged with debt. Next, they subtract liabilities to reach a net asset value (NAV). This number is further adjusted by applying Equity — nondistributing. These own equity control and marketability discounts. interests in real estate, but cannot make distributions due to high debt service or property improvement Both knowing when discounts are applicable and funding needs. deciding the right discount that will hold up under scrutiny are challenging. One resource valuation Undeveloped land. These partnerships own undevel- professionals consult is Direct Investments Spectrum oped land for the purpose of value enhancement Newsletter (formerly The Partnership Spectrum), through rezoning, annexation and land planning prior published by Partnership Profiles, Inc. to selling to a developer. Operating distributions are not common to this type of entity. Another frequently used source is data from the National Association of Real Estate Investment Trusts. Ultimately, the appropriate source to use depends on Discounting trends the type of entity being valued and its comparability to According to the 2003 Spectrum, the overall average the underlying data in the respective source. price-to-value discount for real estate holding entities has declined steadily over the past decade. (In the