Federal court revisits Bajaj and restricted stock studies

BVWireIssue #60-1
September 12, 2007

It’s the first major case this year to address the valuation of restricted stock, including the all-important discount for lack of marketability (DLOM) as determined in part by various restricted stock studies.  Arising from “the failure of individual and corporate taxpayers to report one consistent value for almost 10 million shares” of restricted stock, Litman v. United States (August 22, 2007) finds the U.S. Court of Federal Claims considering several valuations by well-known and accredited business appraisers, including Dr. Mukesh Bajaj:

1. The taxpayer enlisted two experts, selected the more conservative opinion and subjected it to a “reasonability review” by a national accounting firm.  The conclusion, based primarily on a Black-Scholes and capital asset pricing analysis and relying on restricted stock studies as a “sanity check,” determined that the marketability discounts increased over the four-year period of legal and contractual restrictions from just about 50% to 79%.

2. The IRS expert relied primarily on an “option collar approach” (calculating the cost of put/call options on the stock less certain “key person” factors) as supported by three restricted stock studies to conclude a weighted average DLOM of 20.3%.

3. Dr. Bajaj, on behalf of the stock issuer and based on his own and one other restricted stock study, calculated an average DLOM of 20%.

Notably, the Court rejected reliance on the restricted stock studies, finding that the studies failed to disclose underlying data (and simply reported averages) or the experts focused on limited factors such as earnings or revenues.  It also rejected the IRS option collar analysis for failing to include “real world” variables. Ultimately, it concluded that the taxpayer’s methodology carried the most weight and adjusted its expert’s DLOM to 22% in the first year, and to 50% in the fourth.  The lengthy opinion is an important, must-read for business appraisers and attorneys, and we’ve posted it here. To review the debate on DLOM and restricted stock studies, see “A Response to Dr. Shannon Pratt’s Critique of my Work on Marketability Discounts,” by Mukesh Bajaj, Ph.D., currently available as a free download at BVResources.com.

Please let us know if you have any comments about this article or enhancements you would like to see.