BVR’s recent survey on methodology and practice for estimating a discount for lack of marketability (DLOM) garnered over 200 responses. The survey asked about specific methods and tools used, such as restricted stock studies, option price modeling, pre-IPO studies, and many more. In examining the results, we identified several areas where the responses raised some red flags that were worth consideration.
Approach with restricted stock studies
The use of restricted stock studies remained the most-cited methodology for quantifying a DLOM, with 90% of respondents saying that they use this method. The survey explored this further by asking: If using restricted stock studies, what overall approach do you use? About two-thirds (63%) said they use the “benchmark average approach,” and about a third (37%) said they use the “restricted stock comparative analysis approach (RSCAA).”
This response raises a concern because the benchmark average approach may not provide the necessary detail and analysis. Under this approach, restricted stock studies and their averages are shown, including a discussion of Mandelbaum factors in relation to the subject company, and then a conclusion of DLOM is presented. In one case, the court said this about such an approach: “[The valuation expert] simply lists the average discounts observed in several such studies, effectively asking us to accept on faith the premise that the approximate average of those results provides a reliable benchmark for the transferred interests.”1
The 37% of survey respondents who said they use the RSCAA are on a better track. Under this approach, the DLOM is based on a comparison of financial characteristics of the subject company to restricted stock that also takes market volatility into account (including a Mandelbaum discussion). What has the court said about this approach? In one case, the court rejected other approaches, including the benchmark average approach, and said this: “As for the lack-of-marketability discount, the Court finds reliability in the fact that [the valuation expert] endeavored to understand and incorporate the market dynamics of restricted stock sales.… The better method is to analyze the data from the restricted stock studies and relate it to the gifted interests.”2
The late U.S. Tax Court Judge David Laro summed all this up by saying: “I think we as judges want to see some empirical data; we want to see some analysis; we want to see the detail; we want to see how you arrive at this. The data has to be current; the analysis has to be in-depth; the information has to be empirical before, I think, we ought to buy into somebody’s opinion on lack of marketability. That may be asking a lot of the valuation industry, but I think it is what is required.”3
We also note that the survey revealed that the Stout database was the one respondents used most (75% say they use this study). The database includes the Stout Calculator, which embodies the restricted stock comparative analysis approach.
IRS DLOM Job Aid
We were surprised that one in 10 survey respondents have “never heard” of the IRS DLOM Job Aid. Over half (53%) said they use it, and over a third (36%) said they do not.
First made public in 2011, the document takes a comprehensive and sometimes acutely critical look at the most common methods. The document does not make recommendations about what method to use, but it gives the agency’s thinking about the various methods for tax purposes. Importantly, it starts with the baseline presumption that anything above a marketability discount of zero requires detailed explanation and support. The DLOM remained the No. 1 audit trigger for valuations submitted to the IRS. Although the Job Aid is over 10 years old, it is still very much relevant. You can find a copy on BVR’s free download page.
DLOM on a 100% interest
This was an interesting question because it has been a point of contention in the business valuation profession. Would you apply a DLOM to a 100% interest in a private company? One-third of respondents said “yes,” and 40% said “maybe.” About a quarter (27%) said they would not.
The book A Consensus View: Q&A Guide to Financial Valuation states: “Many analysts do not take a discount for lack of liquidity/marketability when valuing a 100% controlling interest in a company.” But our survey found that 73% either do it or might do it, so it appears that there may have been some change in thinking on this matter. Shannon Pratt (one of the authors of the Consensus book) takes marketability discounts on controlling interests, including 100% ownership, and gives arguments for both sides of the issue.
Number of methods used
The typical advice when estimating DLOM is to use multiple methods, at least as a sanity check. But we noticed in our survey results that 21% said they included only one DLOM method in their valuation reports. The use of two methods was the most cited (38%), and the use of three methods was the second most cited (25%).
While the use of just one method may be appropriate in certain cases, the advice to use more than one should be seriously considered. Many analysts make the assumption that every valuation engagement will end up in litigation, so you wouldn’t want to go in with just one method when your opponent may use two or three.
For more insights from the DLOM Survey, be sure to check out the full results of BVR’s DLOM Survey 2021. In addition, learn more about BVR’s DLOM platforms, Stout Restricted Stock Study, a thoroughly vetted, restricted stock-sourced DLOM database that provides empirical support to quantify marketability discounts and Valuation Advisors Lack of Marketability Discount Study, which includes more than 17,000 pre-IPO transactions covering 45 countries, from 1985 to the present.
1 Peracchio v. Commissioner, T.C. Memo. 2003-80 (Sept. 25, 2003).
2 Temple v. U.S., No. 9:03-CV-165 (March 10, 2006).
3 BVR’s 2011 Online Tax Summit: Part 3. Judges Roundtable: View From the Bench, Hosted by Georgetown University Law Center, Nov. 4, 2011 (sub.bvresources.com/trainingeventpast.asp?WebinarID=229).