Example - Marketability
Discounts and Control Premium
Estate of William J. Desmond,
T.C. Memo 1999-76 (U.S. Tax Court 1999).
William Desmond died holding 136,000
shares (81.93%) of Deft Corporation, a small closely
held company that manufactures industrial paint
for military and commercial uses. The IRS claimed
that Desmond's estate tax return underreported
the value of Desmond's interest in Deft and accordingly
determined a deficiency and assessed a large penalty.
The key issue before the court, therefore, was
to determine the fair market value of Desmond's
interest in Deft.
Both Desmond's estate and the IRS
submitted expert valuation reports to the court.
The estate valued Deft using three methods: Asset
method, income method, and market method. It averaged
the results obtained under the three methods and
then applied a 25% lack of marketability discount.
THe IRS's expert did not address the fundamental
("unadjusted") value of the company,
focusing solely on the appropriate lack of marketability
The court adopted Desmond's conclusion under
the income and market methods, and rejected the
asset method results as "vague and generally
unhelpful." Under the income method, Desmond's
experts projected the future cash flows of Deft
and then discounted these projections using a
discount rate determined by the Capital Asset
Pricing Model (CAPM), applying a beta derived
from the betas of eight similar publicly-traded
paint finishing companies. The court averaged
the valuation obtained under both methods. To
this amount, the court applied discounts for lack
of marketability and pending environmental liabilities
Deft was facing.
Marketability discount. On the
question of marketability discounts, the court
- Deft's potential environmental liability affected
the value of the company's stock
- The environmental risk properly resulted in
discounting under the income method, but not
the market method.
- The betas of 8 comparable companies
used to determine the discount rate under the
income method were not shown to be "higher
than normal due to potential environmental liabilities
faced by these companies."
- The price-earnings ratio for two similar companies
"already include the potential environmental
problems faced by the similar companies"
and thus the price-earnings ratio used under
the market method "took into account the
potential environmental liabilities of the comparable
The court found the following factors "favor
a high lack of marketability discount":
- There was no public market for Deft's stock
- Deft's profit margins were below the industry
- All stock in Deft was subject to a restrictive
share agreement which provided that a shareholder
could transfer his or her stock to a non shareholder
only after the shareholder offered the shares
to the remaining shareholders
- Given the size and low profitability of Deft,
a public offering of the stock was unlikely
in the future
- The size of the interest is so large that
it may be hard to find potential buyers in the
future who could finance such a purchase
- Deft has large potential environmental liabilities.
The court concluded, without explanation, that
a 30% lack of marketability discount was appropriate
for the Deft stock. Of this 30% discount, 10%
was attributed to Deft's potential environmental
liabilities - again, without explanation. The
court applied the 30% discount to the value determined
under the income method. The court applied only
a 20% discount to the value determined under the
Control premium. The court then
turned to whether the 82% interest held by Desmond
warranted a control premium. As the court explained,
a "control premium may be necessary when
valuing an interest which gives its holder unilateral
power to direct corporate action, select management,
decide the amount of distributions, rearrange
the corporation's capital structure, and decide
whether to liquidate, merge or sell assets."
The court concluded that whether a control premium
is appropriate depends on the valuation method.
The income method, the court stated, "assumed
the continuation of Deft's present policies and
did not account for a change in control."
It thus produced an unadjusted value based on
a minority interest, making it proper to apply
a control premium. The market method, based on
comparisons with publicly traded stocks, also
produces an unadjusted value based on a minority
interest, making a control premium proper.
Accepting the estate's expert's 25% control premium,
the court applied it to the the market method, but
not market method since the expert had already .
We find HML's determination reasonable, and we conclude
that a control premium of 25 percent is appropriate.
We shall apply this premium to the unadjusted value
we determined under the income method.
(based on expert's report)
Less Marketability Discount:
Add Control Premium (already
included in expert's report for market method)
Fair Market Value of
- Why isn't the potential environmental risk
already impounded in the discount rate implicit
in both the betas of comparable companies and
their price-earnings ratios?
- Can you explain why a company's beta does
not reflect environmental risks, but its market
- Can there be individual shareholders risks
that are beyond the general company risks, reflected
in comparable P/E ratios and CAPM discounts?
- Why is a buyer willing to pay more, on a relative
basis, for an 82% interest than a an 8.2% interest
in the same company?
- Is there any reason to believe that new management
is more effective in increasing corporate returns
than existing management?
- Should the market value of an asset (here
a company) depend on the value placed on it
by a buyer, because of changes that will happen
in the future?