Does using pre-IPO data for DLOM double count the discount?

The use of pre-IPO studies to  measure a discount for lack of marketability has gained acceptance among  valuation analysts and the Tax Court. Still, though, there is some criticism  over this method. One notion kicking around recently  is “double counting,” meaning that some of the transactions in the pre-IPO  databases are calculated with a DLOM already in them.

Not  true: “Double counting of discounts is not  occurring when viewed in the larger context of the transaction,” says Brian Pearson of Valuation Advisors  LLC, who developed the Valuation Advisors Lack of Marketability Discount Study.  This is the only online database of pre-IPO private stock and option  transaction data from 1985 to the present. It recently hit the 10,000 mark in  terms of the number of transactions it contains.

In a recent interview with Business Valuation Update, Pearson  reacted to the idea that the discount is double counted. “While it is true that  some of the transactions include a prior discount, it helps to understand the  process by which this ‘discount’ was calculated,” he says. “Under the fair  value standards for option and stock issuance and the AICPA’s guide to fair  value, the commonly used valuation method of PWERM (probability-weighted  expected return method) requires consideration of a DLOM. So if the enterprise  value is $10 per share and the CPA BV professional, under the fair value  guidelines, assigns a 30% discount, the reported transaction price is $7. If  the company goes public at $12, in theory, you have two discounts at two  different periods (30% and 20%). However, this is where the theory of multiple  discounts fails, since in reality the transaction is just one transaction, from  the time of investment until the time of liquidity (i.e., the IPO date).”

He continues: “Prior to the fair value standards, in an  arm’s-length negotiation of the price, the same process would have occurred,  except it would simply have been reported as a $7 transaction with the discount  as ((12 - 7)/12), or 41.66%. Thus, the concept of “two discounts,” although  implicit in the process, wasn’t being publicly reported. In fact, the same  level of DLOM is occurring in both situations—it’s just that the fair value  standards for pre-IPO transactions shed better light on the process of how such  pre-IPO values are being arrived at now.”

Free  article: Read the complete interview with Pearson in  the article “Is the Lingering Criticism of Using Pre-IPO Studies for DLOM  Justified?” available from BVR as a free  download.