Discounts for Lack of Marketability: Are Traditional DLOM Studies Still Relevant?

Transcription

1 Discounts for Lack of Marketability: Are Traditional DLOM Studies Still Relevant? 7 th Annual MNCPA Business Valuation Conference October 17, 2007 Golden Valley, MN James R. Hitchner, CPA/ABV, ASA Managing Director, The Financial Valuation Group President, The Financial Consulting Group Editor in Chief, Financial Valuation and Litigation Expert Journal 3340 Peachtree Road, NE Suite 1785, Tower Place Atlanta, GA jhitchner@fvginternational.com This presentation is copyrighted 2007 by The Financial Valuation Group. All rights reserved. 1

2 The information in this presentation is based mostly on two valuation texts: Financial Valuation Applications and Models, second edition, September, 2006 Edited by Jim Hitchner and coauthored by Mel Abraham, Jim Alerding, Terry Allen, Larry Cook, Mike Crain, Don Drysdale, Bob Duffy, Ed Dupke, Nancy Fannon, John Gilbert, Chris Hamilton, Tom Hilton, Jim Hitchner, Steve Hyden, Greg Koonsman, Mark Kucik, Eva Lang, Derald Lyons, Mike Mard, Harold Martin, Mike Mattson, Ed Moran, Ray Moran, Jim Rigby, Ron Seigneur, Robin Taylor, Linda Trugman, Kevin Yeanoplos, Sam Wessinger and Don Wisehart (Used with permission, all rights reserved, John Wiley & Sons, Inc., Hoboken, N.J.) Financial Valuation Workbook, second edition, September, 2006 Coauthored by Jim Hitchner and Mike Mard. (Used with permission, all rights 2 reserved, John Wiley & Sons, Inc., Hoboken, N.J.)

3 ~ Jim Hitchner, CPA/ABV, ASA ~ Managing Director of The Financial Valuation Group (FVG) in Atlanta, GA, a national financial advisory services firm specializing in valuation and litigation services Founding member of the Financial Consulting Group, L.C. (FCG), a national association of professional services firms dedicated to excellence in valuation, financial and litigation consulting More than 27 years of professional experience, including 25 years in valuation services and two years in real estate development Over seven years with Phillips Hitchner Group Partner-in-charge of valuation services for the Southern Region of Coopers & Lybrand (currently PricewaterhouseCoopers), where he spent more than nine years Senior appraiser with the national appraisal firm American Appraisal Associates in both the financial and industrial valuation groups 3

4 ~ Jim Hitchner, CPA/ABV, ASA ~ Managing director of The Financial Valuation Group (FVG) in Atlanta A national financial advisory services firm specializing in valuation and litigation services Founding member and president of the Financial Consulting Group (FCG) A national association of professional services firms that offer valuation, financial and litigation services 27 years in valuation services Over seven years with Phillips Hitchner Group Partner-in-charge of valuation services for the Southern Region of Coopers & Lybrand Senior appraiser with American Appraisal Associates 4 in both the financial and industrial valuation groups

5 ~ Jim Hitchner ~ Qualified expert witness; has provided testimony on valuations in numerous state and federal courts Co-authored over 20 courses; taught over 60 courses Published over 60 articles; made over 100 presentations Faculty member teaching valuation courses for judges for National Judicial College and Flaschner Judicial Institute Editor in Chief, Financial Valuation and Litigation Expert Journal Editor/co-author of the books (all published by Wiley): Financial Valuation: Applications and Models (2 nd edition Sept. 2006) Financial Valuation Workbook (2 nd edition Sept. 2006) Valuation for Financial Reporting: Fair Value Measurements and Reporting, Intangible Assets, Goodwill, and Impairment (2 nd edition Sept. 2007) 5

6 ~ Today s Agenda ~ Levels of value 3, 4 or 5 or 6? Marketability vs. liquidity yes, there is a difference DLOMs for control it s in the application Control premiums vs. strategic/synergistic premiums same, similar or just plain wrong? Levels of ownership interests yes, it does matter 6

7 ~ Today s Agenda (continued) ~ DLOMs Pre-IPO studies Restricted stock studies QMDM Qualitative and quantitative applications The Bajaj attacks on traditional DLOM studies Rebuttals on the Bajaj attacks Alternate methods (briefly discussed) Longstaff method NICE model 7

8 Based primarily on restricted stock and IPO studies More adequately represents take-over study premiums Levels of Value (new view) Synergistic (or Investment) (or Acquisition) Value Control Standalone Value As If Freely Traded Minority Interest Value Nonmarketable Minority Interest Value 8 Currently no empirical data exists to quantify marketability discounts on controlling interests

9 Levels of Value - Newer View Control strategic (public or private company) Minority/control standalone liquid (public company) Control liquid (private company) Control standalone (private company) Restricted stock equivalent value* Minority non-marketable (private company) * Shannon Pratt has been presenting this concept 9

10 Liquid Marketable Illiquid Nonmarketable New Labels Examples: Public stock Liquid Control in a private co. Marketable illiquid Minority in a private co. Nonmarketable Real estate Marketable illiquid Machinery & equipment Marketable illiquid 10

11 Control vs. Strategic Control premiums quantify the value of controlling the destiny of the company Acquisition or strategic premiums quantify the quality of a particular investment as viewed by a specific investor Data does not separate the two types of premiums 11

12 Levels of Ownership Control Interests Minority Interests % ownership 2. Ownership sufficient to liquidate, merge, etc % operating control 4. 50% - 50% ownership 5. Less than 50%, but the largest block of stock ownership 6. Less than 50%, but with swing vote powers 7. Less than 50%, but with cumulative voting powers 8. Pure minority interests Control Interests Minority Interests 12

13 Marketability Discounts for Controlling Interests While some experts support a discount, there remains no direct empirical evidence to support a DLOM for a controlling interest 13

14 Summary of the Emory Pre-IPO Studies Period of Study Number of Transactions Mean Disc. Median Disc. May 1997 December 2000 (a) 28 50% 52% May 1997 December 2000 (b) 36 48% 44% May 1997 March 2000 (c) 53 54% 54% November 1995 April % 42% January 1994 June % 45% February 1992 July % 44% (a) Expanded study (b) the limited study (c) the Dot.com study (d) to avoid double counting, transactions from the Dot.Com and Limited Study are included only as a part of the Expanded Study 14

15 Summary of the Emory Studies (continued) Period of Study Number of Transactions Mean Disc. Median Disc. August 1990 January % 40% February 1989 July % 40% August 1987 January % 45% January 1985 June % 43% January 1980 June % 66% Combined Results(d) % 48% (a) Expanded study (b) the limited study (c) the Dot.com study (d) to avoid double counting, transactions from the Dot.Com and Limited Study are included only as a part of the Expanded Study 15

16 Hitchner/Morris Study No. 1 Jan June 1995 Fifth Month. The mean and median discounts on the 47 transactions taking place in the fifth month prior to the IPOs were 54 and 50 percent Fourth Month. The mean and median discounts on the 43 transactions that took place in the fourth month prior to the IPOs were both 51 percent. Third Month. The mean and median discounts on the 56 transactions taking place in the third month prior to the initial public offerings were 43 and 42 percent. 16

17 Emory Study - Dec Discounts versus Time Between Transactions and IPO Days Mean Median Count % 25% % 38% % 43% % 50% % 54% 130 Total

18 Summary of Studies of Restricted Securities Transactions Study Period of Study Discount for Lack of Marketability Securities Exchange Comm % Hall & Polacek % Silber % Stryker & Pollack % Maher % Gelman % Moroney (1) 35.5% Trout % (1) Did not state exact time, but within this time frame 18

19 Summary of Studies of Restricted Securities Transactions (continued) Study Period of Study Discount for Lack of Marketability Arneson Opinion (2) 50% or greater Willamette % Mgt. Planning Inc % FMV Opinions, Inc % Johnson Study % Columbia Financial Gr % Columbia Financial Gr.* % * one-year waiting period 19

20 FMV Opinions Study ( ) Restricted Stock Study Results by SIC Code Range 1000s 2000s 3000s 4000s 5000s 6000s 7000s 8000s No. Transactions Average Discount 21.60% 23.40% 24.50% 21.00% 12.00% 16.90% 24.20% 23.00% Median Discount 18.50% 19.40% 24.00% 15.40% 12.50% 13.40% 23.70% 25.60% Standard Deviation 15.10% 15.10% 17.10% 14.20% 7.60% 15.10% 15.60% 18.70% 20

21 FMV Opinions Study Additional Conclusions Highly profitable firms tend to have lower discounts than the average. The top decile of the sample, arranged by profitability, has a median discount of 11.0 percent. Dividend-paying firms tend to have lower discounts than the average. The size of the block privately placed shows a strong negative correlation with the discount. 21

22 FMV Opinions Study Additional Conclusions Private placements where the stock has been issued with registration rights have lower discounts than private placements without such rights. Firms with low shareholders equity tend to have significantly higher discounts than the average. The bottom quintile of the sample, arranged by book value, has an average discount of 29.0 percent. 22

23 FMV Opinions Study Additional Conclusions Stocks that are more liquid (high trading volume) than the average tend to have lower discounts Private placements that are very large compared with the monthly trading volume for the stock will tend to sell at higher discounts 23

24 FMV Restricted Stock Discounts and Firm Risk Factors Quintile Percentage Discount 3.00% 12.80% 20.10% 30.70% 43.10% Market-to-Book Ratio Total Assets ($000s) 42,132 23,794 16,305 11,544 6,047 Revenues ($000s) 18,108 23,475 12,250 9,721 6,700 Price per Share $10.00 $8.38 $6.00 $4.25 $

25 Quantitative Marketability Discount Five key inputs: Model (QMDM) Marketable minority value of the stock Expected growth rate of a marketable minority shareholder interest Expected holding period Required rate of return for a nonmarketable minority interest Expected dividend payments 25

26 Qualitative Applications for DLOMs Accessibility and reliability of fin. Info. Number of shareholders Concentration of control owners Number of potential buyers Access to capital marketplace Size of the business Vol. of comparable private transactions 26

27 Qualitative Applications for DLOMs Owners with adversarial relationships or an inconsistent business philosophy Desirability of the business Existence of restricted stock agreements Existence of noncompete agreements Yield Liquidity of control owners 27

28 Qualitative Applications for DLOMs The existence of other liquid assets on the part of the owners may reduce the desire or need to transfer the business Quality and competence of management team Existence and effect of pending litigation Size of block of stock 28

29 Qualitative Applications for DLOMs Existence and extent of contractual restrictions Degree and effect of industry regulations Effects of state law Existence of swing vote attributes Relationship between controlling and noncontrolling shareholders 29

30 DLOM Adjustment Example Marketability Adjustment Factors Warrants an ABOVE average Discount Impact on Marketability Discount Warrants an AVERAGE Discount Warrants an BELOW average Discount STARTING POINT 35% 35% 35% History and Outlook Financial Factors Management Holding Period Redemption Policy Transfer of Control Restrictions on Transfer Cash Distribution Policy Information Access and Reliability Cost of Public Offering Other Factor 1 Other Factor 2 Other Factor 3, etc No Change 30 ENDING POINT >35% 35% <35%

31 Bajaj Firm Value and Marketability Discounts Three types of studies traditionally used to determine a DLOM: 1) IPO approach 2) Restricted stock studies 3) Acquisitions approach? Mukesh Bajaj, David J. Denis, Stephen P. Ferris and Atulya Sarin, Firm Value and Marketability Discounts, Journal of Corporation Law, October Based in part on a White Paper prepared by Business Valuation Services, Inc., Dallas, TX, Nov. 10,

32 Criticisms of IPO Approach discounts appear to be implausibly large. Implied annualized rate of 231% Equilibrium compensation for insider buyers Serious sample selection problem 32

33 Criticisms of Restricted Stock Approach substantial cross-sectional variation in discounts of restricted shares. (Silber study) premature to label resulting discount a marketability discount. Part of discount could compensate investors for future services such as advice, oversight or providing capital in 33 the future

34 Criticisms of Restricted Stock Approach Early restricted stock studies only examined restricted stock issues, not other private placements of equity More recent academic studies (Wruck 1989; Hertzel and Smith 1993) do compare restricted stock to similar issues of registered shares Wruck found difference in average discounts between restricted and registered shares to be 17.6% 34

35 Criticisms of Restricted Stock Approach Difference in median discounts was 10.4% Since each type of shares may have been given as compensation, but only restricted shares have marketability impairments, this suggests that the difference in discounts is a gauge for the marketability discount. The Wruck study did not control for systematic differences in the characteristics of firms issuing registered and restricted shares. 35

36 Criticisms of Restricted Stock Approach Private placements are undertaken by companies with these characteristics that can affect the discount: Limited tangible assets Engaged in speculative development of new products In financial distress 36

37 Criticisms of Restricted Stock Approach Discounts as compensation for higher information and monitoring costs Discounts are not solely by compensation for future services rendered or due to lack of marketability, but are also caused by these factors Hertzel and Smith found discount for restricted shares was only 13.5% greater than that of registered shares 37

38 Criticisms of Restricted Stock Approach Investors can use equity swaps and collars Restricted stock approach better than the IPO approach DLOMs less than half previous amounts 38

39 Separate Analysis of Discounts in Private Equity Placements Comprehensive study of private placement transactions in the 1990s January 1, 1990 to December 31, observations with 52% in OTC, 9 ASE, 7 NYSE 39

40 Separate Analysis of Discounts in Private Equity Placements Mean and median averages for size of placement $ 13 mil $ 8 mil Mean and median averages for % stock placed 16% 15% Mean and median averages for firm mkt. Cap. $ 118 mil $ 62 mil DISCOUNTS Type Number Mean Median Min. Max. All Registered Unregistered

41 Separate Analysis of Discounts in Private Equity Placements In 37 cases of 88, private placement involved registered shares Registered shares can be transacted freely with a ready market Despite their marketability, registered shares were also placed at discounts averaging 14.04% (median=9.85%) 41

42 Separate Analysis of Discounts in Private Equity Placements Private placements of unregistered shares involve an average discount of 28.13% This is about 14.09% higher than the averaged discount on registered placements 42

43 Separate Analysis of Discounts in Private Equity Placements Bajaj, et al, looked at the following: Fraction of total shares offered as a % Business risk -- volatility of daily returns Financial distress -- Altman Z-Score Proceeds from placement in $mil 43

44 Separate Analysis of Discounts in Private Equity Placements most of the variables hypothesized as potential determinants of the discount do, indeed, vary systematically with the level of discounts. Consistent with speculation that firms with ambitious growth plans require closer scrutiny by investors prior to the consummation of the placement and greater monitoring subsequent to it. 44

45 Separate Analysis of Discounts in Private Equity Placements Volatility of the firm s returns is greater in high-discount placements Companies making high-discount placements are financially weaker Z-Score a function of the company s solvency, liquidity, return on assets, debtservicing capacity, etc. 45

46 Separate Analysis of Discounts in Private Equity Placements Bajaj s research indicates that firms with unregistered vs. registered shares were significantly weaker financially and had smaller issue proceeds Indicates that 12.5% additional discount of unregistered vs. registered shares is for other factors besides a DLOM Prepared a multivariate regression of the various factors indicating that they had significant explanatory power 46

47 Separate Analysis of Discounts in Private Equity Placements Regression indicated that unregistered shares had a discount 7% higher than registered shares 47

48 Separate Analysis of Discounts in Private Equity Placements the appropriate benchmark for discounts is provided by the total private placement discount or the discount observed in the acquisition approach. distinction between the total valuation discount and liquidity discount is key. In such cases, the applicable discount is only for the lack of liquidity. 48

49 Editor s Column: Rebuttal to Bajaj: answers to criticisms of pre-ipo studies, Shannon Pratt s Business Valuation Update, June recent flawed attacks on the pre-ipo studies have gone largely or totally unrebutted, casting unwarranted doubts on the validity of the pre-ipo studies. answer some of the attacks against the use of pre-ipo transaction evidence by Dr. Bajaj and a few others. 49

50 Editor s Column: Rebuttal to Bajaj: answers to criticisms of pre-ipo studies, Shannon Pratt s Business Valuation Update, June Criticism: Sample selection ad hoc and unexplained More IPOs than what studies cover No description of what firms were considered or not or how the data was picked Pratt says: Valuation Advisors Discount for Lack of Marketability Database cover every company IPO in recent years (over 2,200 transactions in all). 50

51 Editor s Column: Rebuttal to Bajaj: answers to criticisms of pre-ipo studies, Shannon Pratt s Business Valuation Update, June Criticism: that IPO prices are inflated because of hype. Pratt says: But many responsible studies have concluded that the opposite is true IPOs are, often intentionally, underpriced. 51

52 Editor s Column: Rebuttal to Bajaj: answers to criticisms of pre-ipo studies, Shannon Pratt s Business Valuation Update, June Criticism: that a 50% discount 6 months before an IPO implies 200% annualized returns, which simply defies logic. Pratt says: This argument is flawed in two ways: 1) It implies that investors in pre-ipo stock can gain liquidity at the time of the IPO. 1) It implies that a comparable investment opportunity will be available 52

53 Editor s Column: Rebuttal to Bajaj: answers to criticisms of pre-ipo studies, Shannon Pratt s Business Valuation Update, June Criticism: the earnings at the time of the IPO may be higher than the earnings at the time of the private transaction. Pratt says: The reported results of the Willamette studies already reflect an adjustment for differences in earnings average 45-50% discount after the 53 adjustments.

54 Editor s Column: Rebuttal to Bajaj: answers to criticisms of pre-ipo studies, Shannon Pratt s Business Valuation Update, June Criticism: data errors in the John Emory studies Pratt says: Emory rechecked all his data from 1980 forward, and the corrections resulted in less than one percentage point change in the results. 54

55 Editor s Column: Rebuttal to Bajaj: answers to criticisms of pre-ipo studies, Shannon Pratt s Business Valuation Update, June Criticism: Insider buyers receive compensation for services rather than for the lack of marketability Pratt says: the Willamette studies attempt to eliminate insiders. The Emory and Valuation Advisors studies contain a substantial amount of arm s-length transactions, usually with institutional investors, who usually have rights that 55 make their stock more valuable

56 Editor s Column: Rebuttal to Bajaj: answers to criticisms of pre-ipo studies, Shannon Pratt s Business Valuation Update, June Criticism: Only companies that eventually have successful IPOs are selected, thus a biased sample Pratt says: Only about 20% of companies that file for IPOs fail to have them when scheduled. Some are merely delayed, and others are acquired. Still others remain as viable private companies. Very few 56 actually become worthless.

57 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April (Gross, Estate of Heck, McCord, and Lappo), a new approach developed by Dr. Mukesh Bajaj ( the Bajaj approach ) to determine discounts for lack of marketability has been given significant weight by the Tax Court. 57

58 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April Bajaj s statistical analysis is only as good as the underlying assumptions and rigor of the analysis. Bajaj s analysis rest on two flawed assumptions: 1) Registered shares are liquid. 2) All restricted shares are equally illiquid. 58

59 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April Registered shares are not necessarily liquid Ownership of more than 10% of a publicly company is subject to the dribble-out provisions of the SEC s rule

60 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April Bajaj s 38 private placement transactions involving registered shares, on average (median), constitute 13.1% of the total shares outstanding. This means that, on average, the registered shares in his study were in fact restricted under Rule 144, and had significantly limited marketability. 60

61 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April Moreover, the study fails to examine the underlying trading volume of the private placement companies. In other words, the public price reflects a significantly more liquid security than the registered shares in Bajaj s private placement study. 61

62 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April All restricted shares are not equally illiquid. Ex: S/H A s 1% restricted stock block vs. S/H B s 30% block Assuming 1% rule, S/H B s holding period is 8 1/2 years compared to S/H A s 1 year Bajaj s analysis makes the implicit assumption that a 1% restricted stock block and a 30% restricted stock block in the same public 62 company would have the same discount.

63 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April Bajaj s conclusion that the discounts, in part, reflect monitoring costs, the promise of future investment, and future management advice do not stand a rigorous analysis. The very act of monitoring presupposes one can do something about the investment. if one monitors an illiquid investment, and things change, that investor cannot sell the investment 63

64 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April Bajaj should have removed from a study designed to assess investors reactions to a lack of liquidity any transactions that included the promise of future investment. Bajaj believes a promise of future investment may have occurred, but was unreported. However, because a legal promise of future investment is part of the terms of a private placement purchase, such a promise should have been reported, and Bajaj s assumption is invalid. 64

65 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April Finally, Bajaj claims part of the discount is a return for advice provided to management. If so then: It must be assumed that the investor expects the advice to be taken Otherwise, there is no value to be obtained by giving it Suggests the restricted stock investment carries with it aspects of influence or control 65

66 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April Bajaj examined three primary company and transactional characteristics 1) The percentage block (i.e., high-growth companies 2) volatility (i.e., business risk) 3) Z-score (i.e., financial distress) 66

67 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April Bajaj claims that high-growth companies are more likely to issue large percentage blocks and will require more monitoring, future investment, and advice. As support for this hypothesis, he points to the higher discounts associated with higherpercentage-block private placements. The more likely explanation is that not all restricted stock (or registered stock) is equally illiquid. 67

68 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April Bajaj shows that private placements of stock in highly volatile public companies have higher discounts to support his thesis that these companies will require more monitoring, future investment, and advice. However, he does not consider the more likely reason that the value of liquidity increases with a more uncertain or volatile future. 68

69 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April Indeed, Bajaj demonstrates that discounts for private placements of stock in companies suffering from financial distress are also higher. However, Bajaj uses this fact to support his theory that higher monitoring costs, greater need for future investment, and greater need for advice are the reasons behind the discounts. 69

70 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April Perhaps the better explanation is that such stocks are more volatile, and with the possibility of bankruptcy, an investor who will be unable to sell his or her shares for a given period will demand a greater discount not for monitoring, not for future funding, and not for advice but for the simple reason that when the liquidity restrictions are over, the company may be bankrupt. 70

71 Lance S. Hall, The new and winning IRS approach to determine discounts for lack of marketability, Valuation Strategies, March/April Bajaj should be commended for looking beyond the average restricted stock discount used by most appraisers. He won in court because his analysis was superior to the opposing experts. 71

72 Alternate Methods Longstaff Method NICE model 72