How the book A Reviewer’s Handbook to Business Valuation: Practical Guidance on the Use and Abuse of a Business Appraisal came into existence:
Given Paul Hood’s experience as an attorney working with business appraisers and reviewing business appraisal reports, and the recurring frustrations caused by the seemingly divergent practices of business appraisers, he sensed the need for a resource for people like him – people who were not appraisers but who need to better understand business appraisal theory, appraisal standards, and the issues present in the business appraisal profession.
Those needs led to a book, A Reviewer’s Handbook to Business Valuation: Practical Guidance on the Use and Abuse of a Business Appraisal, co-authored with Tim Lee of Mercer Capital, which seeks to identify and explore these sometimes confusing and confounding issues to bring clarity to users of business appraisal services.
Tim authored Part I: Foundations – Valuing a Business. Meant for users of business appraisal services, this section of the book provides is a practical overview of valuation theory and practice presented in proper context so that the reader can be a more knowledgeable user of appraisal services.
The excerpt below is taken from Chapter 9, Valuation Discounts and Premiums.
There is a protracted and clouded legacy of information and dogma surrounding the universe of discounts and premiums in business valuation. It seems logical enough to us that as elements of business valuation, the underlying quantification and development of discounts and premiums should be financial in basis, just as other valuation methods are founded on financial principles. Much of the original doctrine surrounding the determination of discounts and premiums was based on reference to varying default information sources, whose purveyors continue the ongoing compilation of transaction evidence (public company merger and acquisition activity, restricted stock transactions, pre-IPO studies, etc.). After begrudging bouts of evolution, there has been a maturation toward more disciplined and methodical support for valuation discounts and premiums. Perhaps as the state of the profession concerning discounts and premiums has progressed, so, too, has the divide in skill and knowledge among valuation practitioners become wider. Certainly this seems to be the case regarding many users and reviewers of appraisal work (ostensibly the legal community and the IRS).
There remains ample debate (and outright discord) concerning numerous issues in the discount and premium domain, several of which are highlighted in Chapter 19. Unfortunately, in the quest for better clarification on the determination of discounts and premiums there has developed an arms’ race of sorts. Despite the emergence of compelling tools and perspective, no method or approach appears to have the preponderance of support in the financial valuation community. Nowhere is this truer than with the marketability discount (also known as discount for lack of marketability). Given attention elsewhere in this book on the topic of marketability discounts and the plethora of methods underlying marketability discount quantification, we will attempt to maintain an orbital perspective in this chapter.
Readers are referred to Chapter 19 of this book, which provides a detailed list and description of the growing body of marketability discount models and studies. Also in Chapter 19 are discussions concerning marketability discounts on controlling interests. Accordingly, we will keep the discussion here limited.
The ASA defines a marketability discount as an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. Augmenting the consideration of marketability is the concept of liquidity, which the ASA defines as the ability to readily convert an asset, business, business ownership interest, security, or intangible asset into cash without significant loss of principal. Lack of marketability and lack of liquidity overlap in many practical regards. However, lack of liquidity is often attached to a controlling interest, while marketability discounts are used to describe minority interests.
Despite the proliferation of marketability discount studies and models, most models fall into one of three primary categories. These categories are based on the underlying nature of the analysis or evidence from which each model emanates. They include market-based perspectives (commonly referred to as benchmark analysis), options-based models, and income-based (rate-of-return) models. Although it is not our place to define a given model as the model, we do recognize that some models (or perspectives) provide general guidance for the appraiser regardless of the specific model employed. The following is a list of the so-called Mandelbaum factors, which are derived from Tax Court Judge David Laro’s ruling in Mandelbaum v. Commissioner. In essence, these factors serve a similar guidepost for the assessment of marketability as does Revenue Ruling 59-60 serves for the valuation of closely held interests in general.
- The value of the subject corporation’s privately traded securities vis-à-vis its publicly traded securities (or, if the subject corporation does not have stock that is traded both publicly and privately, the cost of a similar corporation’s public and private stock)
- An analysis of the subject corporation’s financial statements
- The corporation’s dividend-paying capacity, its history of paying dividends, and the amount of its prior dividends
- The nature of the corporation, its history, its position in the industry, and its economic outlook
- The corporation’s management
- The degree of control transferred with the block of stock to be valued
- Any restriction on the transferability of the corporation’s stock
- The period of time for which an investor must hold the subject stock to realize a sufficient profit
- The corporation’s redemption policy
- The cost of effectuating a public offering of the stock to be valued, e.g., legal, accounting, and underwriting fees
This list extends to considerations beyond the pure question of marketability. However, the ruling is instructive in its breadth. The Mandelbaum process is characterized by many appraisers as a qualitative or scoring procedure. However, most of the parameters are mathematically represented by financial elements and assumptions under the income- and options-based models. Such parameters are also used, to the degree possible, in searching out market evidence from restricted stock transactions, which are documented in varying degrees by numerous studies over several decades. Regarding Mandelbaum, we believe the guidance is useful; we note with some levity that the accumulation of models seems easily characterized by the axiom “be careful what you ask for—you just might get it.”
Benchmarking analysis relies primarily on pre-IPO studies and restricted stock transactions. In essence, benchmarking calls for the use of market-based evidence to determine a lack of marketability discount. Some appraisers have pointed out the oxymoron of benchmark (market transaction) analysis for use in determining marketability discounts.1 On the same note, other appraisers cite the restricted stock studies for capturing market evidence that at its core demonstrates the diminution to value associated with illiquidity. Imputed evidence concerning the implied rates of return for restricted stock lends support to other marketability models.
Options-based models, most of which are derivations and evolutions of the Black-Scholes Option Pricing Model, are based on assessing the cost to insure future liquidity in the subject interest. Rate-of-return models are based on modeling the expected returns to the investors as a means for determining a valuation that results in an adequate rate of return given the investment qualities of the subject interest.
There is no one method that is acknowledged as superior to all others. Indeed, virtually every method employed by the valuation universe has been challenged or debated in the courts as well as by and among the professional ranks of appraisers.
There is no better concluding discussion to the topic of marketability discounts than is provided in Chapter 19, “Ten Burning Issues within the Appraisal Profession.”
The application of a discount or premium to an initial indication of value is an often controversial and necessary input to the valuation process. Fortunately, appraisers are equipped with numerous income and market methodologies to derive reasonable estimates of the appropriate discount or premium for the subject interest. As with the determination of the initial indication of value, it is ultimately up to the valuation analyst to choose the appropriate methodology based on the facts and circumstances of the subject interest.
Unfortunately, none of the available methodologies are perfect, and all of them are subject to varying degrees of criticism from the courts and other members of the appraisal community. Critics of the various market approaches often cite the lack of contemporaneous transaction data that are rarely comparable or applicable to the subject interest. Arguments against the income methodologies often focus on the model’s inputs, particularly the holding period assumption, which is typically unknowable for most private equity investments.
The number of discount methodologies and their respective criticisms will, in all likelihood, continue to expand into the foreseeable future. It is ultimately up to the appraiser to consider the various options and determine the appropriate model or study applicable to the subject interest. There are no hard-and-fast rules or universal truths that are applicable to all appraisals when it comes to the selection of an appropriate discount methodology. Appraiser judgment is ultimately the most critical input to any valuation, particularly in regard to the application of an appropriate discount methodology or control premium.
Admittedly, the number of discount methodologies and their corresponding criticisms can be a bit overwhelming to anyone unaccustomed to reviewing or writing business valuation reports. At the end of the day, the most important thing to keep in mind is how reasonable the discount (or premium) is in light of the liquidity and/or ownership characteristics of the interest being appraised. An appraisal may have carefully considered all the pertinent discount methodologies and their criticisms, but if the ultimate conclusion is not reasonable or appropriate for the subject interest, it will probably not hold up in court or communicate meaningful information for the end user of the report. Appraisers should always investigate the reasonableness of their conclusions when preparing valuation reports and related analyses.
The point of this chapter is not to advocate any particular discount methodology over another, but rather to apprise the users and reviewers of valuation reports of the various advantages and criticisms pertaining to these methodologies. It is our understanding that such discussions are typically omitted from most appraisal reports despite the high demand for this information from the end users of these reports, particularly in a litigated context. We also hope that this chapter offers some perspective on the salient features and common criticisms of the major discount methodologies, so appraisers can weigh the respective merits and disadvantages of the approaches and make an informed decision as to how to proceed.
1 Travis Harms and Matt Crow, The Market Approach and/versus the Income Approach, , 2007 ASA Advanced Business Valuation Speech, San Diego, CA.