Business Valuation Discounts and Premiums SECOND EDITION Shannon P. Pratt E1FFIRS 03/10/2009 11:19:30 Page 2 E1FFIRS 03/10/2009 11:19:30 Page 1 Business Valuation Discounts and Premiums E1FFIRS 03/10/2009 11:19:30 Page 2 E1FFIRS 03/10/2009 11:19:30 Page 3 Business Valuation Discounts and Premiums Second Edition SHANNON P. PRATT John Wiley & Sons, Inc. E1FFIRS 03/10/2009 11:19:31 Page 4 This book is printed on acid-free paper. 1 Copyright # 2009 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. 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HG4028.V3P682 2009 658.15–dc22 2009005644 Printed in the United States of America 10987654321 E1FFIRS 03/10/2009 11:19:31 Page 5 To the Appraisal Foundation and the Appraisal Standards Board publishers of the Uniform Standards of Professional Appraisal Practice (USPAP) which has done much to improve consistency in the appraisal profession. E1FFIRS 03/10/2009 11:19:31 Page 6 E1FTOC 03/16/2009 11:20:2 Page 7 Contents List of Exhibits xv About the Author xix About the Contributing Authors xxi Foreword xxv Preface xxvii Acknowledgments xxix 1 Overview of Business Valuation Discounts and Premiums and the Bases to Which They Are Applied 1 Discounts and Premiums Are Big-Money Issues 2 ‘‘Entity Level’’ versus ‘‘Shareholder Level’’ Discounts and Premiums 3 How the Valuation Approaches Used Affect the Level of Value 8 Use of Public Company Data to Quantify Discounts and Premiums 9 How the Standard of Value Affects Discounts and Premiums 10 American Society of Appraisers Business Valuation Standard VII: Valuation Discounts and Premiums 12 Summary 13 2 Minority Discounts and Control Premiums 15 Relevant Definitions 16 Basic Minority/Control Value Relationship 16 Prerogatives of Control 17 Factors Affecting Degree of Control 18 How the Valuation Methodology Affects the Minority Discount or Control Premium 25 Do Publicly Traded Minority Stock Prices Reflect Control Value? 29 Treatment of Control Premiums in the Delaware Courts 35 How the Purpose of the Valuation Affects Minority Discounts or Control Premiums 37 Summary 38 3 Empirical Data Regarding Minority Discounts and Control Premiums 41 Premiums Paid in Acquisitions 41 Identifying Industries with Higher or Lower Control Premiums 62 Caveats Regarding Use of Control Premium Data 63 Are Control Premiums Too High? 65 vii E1FTOC 03/16/2009 11:20:2 Page 8 viii Contents Percentage Discounts from Net Asset Value 66 Summary 66 4 Minority Discounts and Control Premiums in the Courts 68 Gift, Estate, and Income Tax Cases 70 Discounts for Lack of Control in Employee Stock Ownership Plan Cases 74 Dissenting Shareholder Cases 75 Shareholder Oppression Cases 80 Marital Dissolution Cases 80 Bankruptcy Case 82 Summary 82 5 Discounts for Lack of Marketability for Minority Interests: Concept and Evidence 86 Public Market Benchmark for Marketability 86 Empirical Evidence to Quantify Discounts for Lack of Marketability 87 Restricted Stock Studies 88 Pre–Initial Public Offering Discount for Lack of Marketability Studies 90 Courts’ Aversion to ‘‘Benchmarking’’ 91 Regulatory and Court Recognition of Empirical Marketability Discount Studies 92 Summary 92 6 Synopsis of Restricted Stock Studies 95 Securities and Exchange Commission Institutional Investor Study 96 Gelman Study 100 Trout Study 100 Moroney Study 101 Maher Study 101 Standard Research Consultants Study 101 Silber Study 101 FMV Opinions Study 103 Management Planning Study 104 Johnson Study 110 Columbia Financial Advisors Study 110 LiquiStat Database 111 Summary 111 7 LiquiStat Database (Restricted Stocks, Options, Warrants, and Convertible Securities) 113 Restricted Stock as a Basis 114 Biases Beyond Illiquidity in Traditional Restricted Stock Studies 114 How LiquiStat Is Different 115 Options and Warrants in LiquiStat 116 Convertible Securities in LiquiStat 117 Summary 117 E1FTOC 03/16/2009 11:20:2 Page 9 Contents ix 8 Blockage Discounts 118 Blockage Is Distinct from Restricted Stock 119 Factors to Analyze in Quantifying Blockage Discounts 119 Must Consider Ways of Selling Stock 122 ‘‘Price Pressure’’ and ‘‘Market Exposure’’ 122 Block Buyer Could Ameliorate Blockage Discount 122 Blockage Discounts Recognized in Estate and Gift Tax Regulations 123 Blockage Discounts in U.S. Tax Court 123 Financial Accounting Standards That May Affect Blockage Discounts 126 Blockage Discounts Used to Estimate Illiquidity Discounts 126 Summary 126 9 John Emory Pre–Initial Public Offering Discount for Lack of Marketability Studies—Complete Underlying Data 128 Study #1: Adjusted Study, January 1980–June 1981 129 Study #2: Adjusted Study, January 1985–June 1986 129 Study #3: Adjusted Study, August 1987–January 1989 130 Study #4: Adjusted Study, February 1989–July 1990 130 Study #5: Adjusted Study, August 1990–January 1992 130 Study #6: Adjusted Study, February 1992–July 1993 130 Study #7: Adjusted Study, January 1994–June 1995 131 Study #8: Adjusted Study, November 1995–April 1997 131 Study #9: Adjusted Study, Dot-Com Companies, May 1997–March 2000 131 Study #10: Adjusted Expanded Study, May 1997–December 2000 133 Summary 133 10 Valuation Advisors Discount for Lack of Marketability Study 182 Description of Study 182 Results of Study 184 Summary 185 11 Factors Affecting Discounts for Lack of Marketability for Minority Interests 186 Size of Distributions 187 Prospects for Liquidity 191 Pool of Potential Buyers 193 Risk Factors 194 Summary 198 12 Discounts for Lack of Marketability for Controlling Interests 200 Discounts for Lack of Marketability for Controlling Interests: A Controversial Concept 202 ‘‘Control, Marketable’’ Is an Oxymoron 202 E1FTOC 03/16/2009 11:20:2 Page 10 x Contents Bases from Which Controlling Interest Discounts for Lack of Marketability May Be Deducted 202 Factors Affecting Controlling Interest Discounts for Lack of Marketability 204 Public versus Private Company Acquisition Multiples 207 Court Treatment of Controlling Interest Discounts for Lack of Marketability 210 Summary 211 13 The Quantitative Marketability Discount Model: A Shareholder Level DCF Model 213 Introduction 213 The Structure of the Shareholder Level DCF Model 214 A Visual Representation of the Shareholder Level DCF Model 217 Factors Contributing to Marketability Discounts 218 Summary 223 14 Marketability Discounts in the Courts—Minority Interests 225 Gift and Estate Tax Cases 227 Employee Stock Ownership Plan Case 231 Dissenting Shareholder Cases 232 Minority Oppression Cases 234 Marital Dissolution Cases 234 Summary 238 15 Marketability Discounts in the Courts—Controlling Interests 241 Gift and Estate Tax Cases 241 Marital Dissolution Cases 243 Summary 244 16 Voting versus Nonvoting Stock 245 Voting versus Nonvoting Stock Scenarios 245 Empirical Studies Show Little Differential for Small Minority Interests 246 Transactions Involving Premiums for Control Blocks 251 Court Cases Involving Voting versus Nonvoting Stock 251 Summary 258 17 Key Person Discounts and Premiums 260 Empirical Evidence Supports Key Person Discount 261 Internal Revenue Service Recognizes Key Person Discount 263 Factors to Consider in Analyzing the Key Person Discount 264 Quantifying the Magnitude of the Key Person Discount 265 U.S. Tax Court Cases Involving Key Person Discounts 266 Key Person