Quarterly Journal of the Business Valuation Committee of the American Society of Appraisers

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1 Complimentary Preview Quarterly Journal of the Business Valuation Committee of the American Society of Appraisers Volume 35 Issue 3 Fall Editor s Column Dan McConaughy, PhD, ASA 78 AMERICAN SOCIETY OF APPRAISERS: Business Valuation Committee Special Topics Paper #1: Use of Offers as Indications of Value in the Market Approach 81 Estimating Discounts for Lack of Marketability: Understanding Alternative Approaches Put Options Versus Monetizing an Option Collar Jay E. Fishman, FASA, and Bonnie O Rourke, ASA 86 EBITDA Single-Period Income Capitalization for Business Valuation Z. Christopher Mercer, FASA, CFA, ABAR 103 Two Theories of Control Eric Sundheim, BA, ASA, and Jordan Sundheim, MA, BA 112 From the Chair William A. Johnston, ASA Subscribe Here for $140 Annually

2 Volume 35 Number 3 Ó 2016, American Society of Appraisers Estimating Discounts for Lack of Marketability: Understanding Alternative Approaches Put Options Versus Monetizing an Option Collar Jay E. Fishman, FASA, and Bonnie O Rourke, ASA The method for calculating a discount for lack of marketability (DLOM) has been a subject of debate for several years. Professionals have searched for alternatives to the traditional sources to quantify the DLOM. This search has led to increasing reliance on the use of financial derivatives to help determine a proxy for the DLOM. The most common derivative used to quantify DLOM is some form of put option. However, research is ongoing concerning the use of derivatives to estimate the DLOM. Recent literature has discussed the use of at-the-money collars and prepaid variable forward contracts to arrive at the DLOM. Another article in the spring 2015 edition of the Business Valuation Review takes a different position on how derivatives should be used to estimate a DLOM. This article highlights and discusses the differences between these approaches. Introduction Methods for estimating a discount for lack of marketability (DLOM) continue to be a subject of debate. Assets for which one may need to estimate a DLOM may include interests in closely held firms, restricted stock of a public company, or other nontradable assets. Valuation professionals have searched for alternatives to the traditional sources (reliance on restricted stock and pre initial public offering studies) to help quantify the DLOM. This search has led to increasing use of financial derivatives to help estimate the DLOM. For stock of public companies, prices for financial derivatives may be observed in the market (or constructed) for the actual subject stock. For interests in closely held companies, hypothetical financial derivatives may serve as a proxy in quantifying the DLOM. Today, the use of financial derivatives to estimate the DLOM has become an integral part of the valuation professional s toolkit. The most common derivative used to quantify DLOM is some form of put option. Research is ongoing concerning the use of derivatives to estimate the DLOM. For example, in the spring of 2015, Barenbaum, Schubert, and Garcia 1 (BS&G) Jay E. Fishman, FASA, and Bonnie O Rourke, ASA, are managing directors of Financial Research Associates, with offices in Pennsylvania, New Jersey, and New York. 1 Lester Barenbaum, Walter Schubert, and Kyle Garcia, Determining the Lack of Marketability Discounts: Employing an Equity Collar, Journal of Entrepreneurial Finance (Spring 2015). Available at digitalcommons.pepperdine.edu/jef/vol17/iss1/3. published an article that expanded upon the work of Fishman and Barenbaum 2 discussing the use of at-themoney collars (equity collars) and prepaid variable forward contracts (PVFC) to arrive at the estimated DLOM. The authors Finnerty and Park (F&P) 3 took a different position on how derivatives should be used to estimate a DLOM in their article, Collars, Prepaid Forwards, and the DLOM: Volatility Is the Missing Link, in the spring 2015 edition of the Business Valuation Review. This article hopefully will help practitioners understand the underlying differences between the BS&G and F&P approaches. Background F&P suggest using an option pricing model to measure the price risk associated with the lack of marketability based on the cost of buying put options to hedge the risk of a price decline during the period the asset is restricted. 4 F&P model the DLOM as the value of an average strike put option. BS&G suggest the use of a PVFC coupled with a zero-cost collar as an appropriate measure of the 2 Jay E. Fishman, and Lester Barenbaum, Do Put Options Overstate Discounts for Lack of Marketability? Financial Valuation and Litigation Expert (April/May 2013). 3 John D. Finnerty, and Rachel W. Park, Collars, Prepaid Forwards, and the DLOM: Volatility Is the Missing Link, Business Valuation Review (Spring 2015). 4 John D. Finnerty, and Rachel W. Park, Collars, Prepaid Forwards, and the DLOM: Volatility Is the Missing Link, Business Valuation Review (Spring 2015), 25. Business Valuation Review Fall 2016 Page 81

3 DLOM. PVFCs and zero-cost collars are two common financial derivatives used by insiders to monetize equity positions in their firm s stock. A survey by Bettis, Bizjak, and Kalpathy 5 found that, in over 2,000 derivative transactions initiated by 1,000 insiders at almost 600 unique firms from 1996 to 2006, more than 70% of the transactions were either PVFCs or zero-cost collars. 6 Definitional Issues In our view, a key factor that drives the differences between the BS&G and F&P approaches lies in the application of different definitions of DLOM and the related concept of liquidity used by the appraisal profession. 7 The International Glossary of Business Valuation Terms has the following definitions: Marketability: The ability to quickly convert property to cash at minimal cost. Liquidity: The ability to quickly convert property to cash or pay a liability. The American Society of Appraisers ( ASA ) has adopted somewhat different definitions: Marketability: The capability and ease of transfer or salability of an asset, business, business ownership interest, or security. Liquidity: The ability to readily convert an asset, business, business ownership interest, security or intangible asset into cash without significant loss in principle. (emphasis added) These definitions of marketability and liquidity are reflective of the definitions that pervade business valuation literature. Pratt stated: We will define marketability as the ability to convert the business ownership interest (at whatever ownership level) to cash quickly, with minimum transaction and administrative costs in so doing and with a high degree of certainty realizing the expected amount of net proceeds. 8 5 Carr Bettis, John Bizjak, and Swaminathan Kalpathy, WhyDoInsiders Hedge Their Ownership? An Empirical Examination, Financial Management (Fall 2015): Carr Bettis, John Bizjak, and Swaminathan Kalpathy, WhyDoInsiders Hedge Their Ownership? An Empirical Examination, Financial Management (Fall 2015): business valuation/professional standards/business valuation standards and glossary. Includes both the International Glossary of Business Valuation Terms and the ASA Business Valuation Standards Glossary. 8 Shannon P. Pratt, and Alina V. Niculita, Valuing A Business: The Analysis and Appraisal of Closely Held Companies (New York: McGraw Hill Companies, 2008), 417. Hitchner has expressed marketability in the following terms: Marketability expresses the relative ease and promptness with which a security or commodity may be sold when desired, at a representative price, without material concession in price merely because of the goal of a prompt sale 9 (bold for our emphasis in this article). Definitional differences drive different views In our view, it is the differences in the definitions of marketability that are central to the differences between the methods discussed in the BS&G and F&P articles. As noted above, relevant illiquid assets 10 include interests in a closely held firm, restricted stock of a public company, or other nontradable assets. BS&G rely on what might be considered a traditional view of what a marketability discount captures. BS&G view the DLOM in the context of fair market value, assuming that the potential future changes in value are incorporated into the asset s current value, and that a hypothetical sale generates cash at the point in time corresponding to the valuation date. To BS&G, cash or cash equivalency at a specific point in time is the essence of fair market value. In other words, the DLOM is the cost of converting the value of an illiquid asset to its current cash equivalent at a specific time. F&P state: The DLOM measures the loss of value due to a loss of selling flexibility during the period the restrictions are in place. This is different from preserving the market value of the unrestricted asset at the beginning of the restriction period [emphasis added] F&P s emphasis on the loss of selling flexibility raises concerns that are faced by holders of restricted stock. BS&G s position is that this differs from the DLOM in a fair market value context. Another difference in the two approaches is the assumed point in time when the asset is converted to cash. F&P assume that the asset is held until the end of the restriction period, and at that point, the asset becomes liquid. BS&G assume the collar with borrowing creates liquidity at the valuation date. Fundamental differences in these definitions drive the differences in the approach to calculating the DLOM. 9 James Hitchner, Financial Valuation: Applications and Models, Third Edition (Hoboken, N.J.: John Wiley & Sons, 2011), We understand that there can be differences between illiquidity and marketability, but as used in this context, we believe they converge as interests in closely held businesses may be highly illiquid and may be, due to shareholder agreements, even nonmarketable. 11 John D. Finnerty, and Rachel W. Park, Collars, Prepaid Forwards, and the DLOM: Volatility Is the Missing Link, Business Valuation Review (Spring 2015), 2. Page 82 Ó 2016, American Society of Appraisers

4 Estimating Discounts for Lack of Marketability: Understanding Alternative Approaches Figure 1 Payoff Table F&P believe that the DLOM should be the cost of eliminating the risk of the asset losing value over the period of the restriction. The assumption is that the owner will hold the illiquid asset until the end of the restriction period. The risk of loss is eliminated, but the owner has the opportunity to receive any increase in value enjoyed by the asset at the end of the restriction period. BS&G believe that the application of a DLOM is designed to produce the cash equivalent value at the valuation date. Both the risk of loss and any potential upside are eliminated. The value is locked in, and cash (value minus the DLOM) is received at the valuation date. Comparing a Put Option to Monetizing a Collar Assume an individual has a share of stock that is restricted from sale for one year. It has a freely traded current value of $30. The security does not pay dividends, it has an expected standard deviation of returns equal to 30 percent, and the risk-free rate is 1 percent. The individual can eliminate the risk of a loss by purchasing a put option. The put affords the right, but not the obligation, to sell the share for $30 at the end of the restriction period. 12 The model yields a put 12 When the underlying asset is restricted from sale for one year, the put option would not be exercised until its expiration, at the end of the oneyear restriction period. option value of $3.74. F&P use the cost of the put option to determine the DLOM. With a cost of $3.74, the put option implies a DLOM of percent ($3.74/ $30). BS&G argue that the cost of the put option is not an appropriate measure of a DLOM for two reasons. A put option not only preserves value, but also allows for potential capital appreciation, and it does not provide for the current monetization of the asset s value. As shown in Figure 1, the proceeds from purchasing a put option will vary from $26.26 to $46.70 depending upon the asset s share price when the put contract expires. In addition, no money is received until the put contract has expired. In contrast, the cost of a hedging strategy employs an at-the-money equity collar along with the interest cost of borrowing funds to monetize the underlying asset s current value. This directly captures the cost of providing liquidity to a non-traded asset. As shown on Figure 1, the outcome of such a strategy is that the holder of the restricted asset is guaranteed to receive $ This consists of the $30 minus the cost of borrowing the $30 at an assumed rate of 4 percent ($1.20), plus the $ Typically the transaction cost of purchasing a put option is not included in the estimated marketability discount. Business Valuation Review Fall 2016 Page 83

5 earned on the creation of the collar. 14 This represents a DLOM of 3.1 percent ($0.93/$30.00). The collar hedges both the downside risk of receiving less than $30, as well as the potential upside to receive more than $30. The equity collar ensures that the investor will receive the current fair market value of the underlying asset at the end of the collar s term. However, as stated above, BS&G believe that creating marketability should monetize the underlying asset at its current value, at the current time (the valuation date), and that the cost of the monetized equity collar is a better proxy for the DLOM than a put option alone. Given that the holder of the restricted asset is guaranteed to receive $30 one year from now, plus the earnings of the collar transaction, monetizing the position at a low rate of interest is feasible. Thus, BS&G argue that the financing cost to monetize the asset, less the net proceeds of the equity collar, is the best proxy for the DLOM. BS&G believe that whether a put option is used to eliminate the possibility of loss, or a collar is utilized to preserve value, the need to monetize either position is warranted. A DLOM should include the cost of creating the cash-equivalent value at the valuation date. Volatility and Correlation F&P correctly argue that the collar approach reduces or eliminates volatility as a concern in calculating the DLOM. 15 The point of the collar is to reduce the impact of volatility on the market position as much as possible. An at-the-money collar essentially removes the volatility issue when the asset under analysis can be fully hedged. The impact of volatility is largely cancelled by the combination of the call and put options. Volatility does affect the put strategy advocated by F&P, however, as increased volatility drives the put option value, and therefore the DLOM, upward. The F&P article also discusses the issue of correlation. 16 The article points out that poor correlation results in an imperfect hedge. However, poor correlation impacts the use of both the put option and collar models. If a reasonably close proxy cannot be used to hedge the illiquid asset, then both the put option and collar models fail to preserve value. Neither instrument will fully 14 Under the assumptions employed in Figure 1, the value of the call option is $4.01. The proceeds of the collar are ($4.01 $3.74) ¼ $0.27. The cost of borrowing is 4 percent 3 $30.00 ¼ $1.20. Therefore, the net proceeds are: $30.00 þ $.27 $1.20 ¼ $ John D. Finnerty, and Rachel W. Park, Collars, Prepaid Forwards, and the DLOM: Volatility Is the Missing Link, Business Valuation Review (Spring 2015), John D. Finnerty, and Rachel W. Park, Collars, Prepaid Forwards, and the DLOM: Volatility Is the Missing Link, Business Valuation Review (Spring 2015). protect the holder from downside risk on their restricted asset. The BS&G article includes a discussion of the effectiveness of a put option and a collar when the underlying asset cannot be hedged. 17 Implementation A potential weakness of both the put option and the equity collar methods is that as the correlation falls, less of the position can be effectively hedged, and a lender may become less willing to monetize the asset. In several estate and gift tax cases, the US Tax Court has criticized the use of hedging instruments to estimate DLOM based upon the feasibility of employing the strategy. 18 However, customized collar contracts are created by commercial and investment banks. 19 BS&G claim that they recently valued an illiquid asset in a litigation setting, and an investment bank was willing to monetize the illiquid asset using an equity collar coupled with a loan. However, the Tax Court has recently found that variable prepaid forward contracts (VPFCs) represent a current sale of the underlying asset, which suggests that the cost of a VPFC can be a mechanism to estimate the DLOM. 20 Summary In summary, whether or not the cost of monetizing a collar or the cost of a put option provides an appropriate DLOM depends upon the definition of the DLOM. As summarized in Table 1, the different approaches proposed by F&P and BS&G are based upon different assumptions and produce different results. Monetizing a collar is an appropriate methodology when the DLOM represents the cost of achieving a cash equivalent of an illiquid asset at the valuation date. The put option will make more sense when a DLOM should allow for no capital loss and preserve capital appreciation of the illiquid asset. In addition, the put option as currently used, allows the holder of the asset to hold the asset until the end of the restriction period. The put option calculation of the DLOM does not provide the seller of the illiquid position any funds at the valuation date. 17 For example, a public corporation s by-laws may prevent an insider from engaging in any hedging activities with regard the stock of that public company owned by the insiders. 18 Litman v. United States, 78 Fed., Cl. 90 (2007) and Murphy v. United States, 94923, Mukesh Bajaj, David J. Denis, Stephen P. Ferris, and Atulya Sarin, Firm Value and Marketability Discounts, Journal of Corporation Law (Fall 2001). 20 Jeffrey L. Rubinger and Summer A. LePree, Tax Court finds variable prepaid forward contract gives rise to current sale, Journal of Taxation (January 2011). Page 84 Ó 2016, American Society of Appraisers

6 Estimating Discounts for Lack of Marketability: Understanding Alternative Approaches Table 1 Different Approaches to Estimating DLOM F&P Put Option DLOM BS&G Monetized Collar DLOM Timing of monetizing asset (assuming perfect correlation between the End of restriction period Current date underlying illiquid asset and the hedge instruments) Possible loss in asset value Eliminated Eliminated Possible increase in asset value Unlimited Eliminated Effect of volatility on DLOM Higher volatility, higher Eliminated by collar cost of put option Effect of less-than-perfect correlation Reduces effectiveness Reduces effectiveness Best proxy for DLOM Cost of put option Cost of interest to borrow against hedged asset value From a practical point of view, it may be argued that both methods suffer from limitations whenever a reasonable proxy cannot be located. For example, it may be difficult or nearly impossible to locate an appropriate proxy to estimate a DLOM for interests in smaller entities because constructing a proxy using data on public companies may not result in an appropriate comparison. When the underlying asset cannot be hedged, the effectiveness of both an at-the-money collar and a put option is compromised. The different points of view discussed by F&P and BS&G are primarily driven by differences in the definition of marketability. The goal of this article is to highlight the differences and encourage continued discussion in the valuation community. Business Valuation Review Fall 2016 Page 85

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