WFU Law School
Law & Valuation
5.4.3 Minority Discounts

5.4.4 Marketability Discounts

The inability to readily sell a financial interest (whether because of a lack of willing buyers or contractual restrictions) significantly reduces its value. After all, what's so great about the empty promise of future returns if you need money now?

Valuators regularly reduce the value of an investment interest if it lacks a ready market. The size of this discount is often the crux of a valuation.

"Discounts for Lack of Marketability" Fair Value (Sep 1994).

Example

 


Estimates of marketability discount

Numerous studies have sought to estimate the effect on price caused by lack of marketability. See Bajaj, Denis, Ferris, Sarin, Firm Value and Marketability Discounts. The studies tend to focus on two comparisons:

  • prices at which publicly-traded companies issue restricted shares in private placements compared to the companies' publicly-traded stock price
  • prices at which companies go public compared to the prices at which shares were sold prior to the same companies' IPOs

Courts have relied on these studies. Mandelbaum v. Commissioner, (T.C. 1995-255, June 12 1995) (approving 30% discount after considering published market studies, as well as company-specific factors). Recent studies indicate that multipliers for valuing private companies hold across transactions involving domestic and foreign companies. Sarin, Koeplin & Shapiro, "The Private Company Discount," 12 J. Applied Corp. Fin. (Winter 2000).

An interesting question is whether marketability discounts are appropriate subjects on which valuation experts may opine. See Mercer Capital Management, Rule 702, Daubert, Kuhmo Tire Co. and the Development of Marketability Discounts. See Weinberg v. CIR, TC Memo 2000-51 (refusing to allow use of QMDM in determining marketability discount).

Study
Type of stock
Time period
Average discount
1. SEC Institutional Investor Study
Restricted stock - 398 reporting companies
1966-1969
25.8%
2. SEC Institutional Investor Study
Restricted stock - 398 non- reporting OTC companies
1966-1969
32.6%
3. Mitlon Gelman
??
1968-1970
33.0%
4. Robert R. Trout
??
1968-1972
33.5%
(median)
5. Robert E. Maroney
Restricted stock - 146 reporting companies
1969-1972
35.6%
6. J. Michael Maher
??
1969-1973
35.4%
7. Robert W. Baird & Co
Privately traded pre-IPO stock - 173 IPO companies
??
47%
8. Standard Research Consultants
??
1978-1982
45.0%
(median)
9. Willamette Management Associates (unpubl)
??
1981-1984
31.2%
(median)

Example

In Hartman v. Hartman, the trial court valued plaintiff's interest in a closely held cemetery corporation. Plaintiff owned 1,118 shares of the 2,568 outstanding shares of common stock, a 43.5% interest. Based on the testimony of the plaintiff's expert (a CPA, experienced in valuing stock of small, closely held corporations), the court found that the minority stock interest of the plaintiff had "limited marketable capacity," that the corporation had not made a dividend payment in years, and that it had experience cash-flow difficulties.

The expert felt that a discount factor of at least 50 percent should be applied, the normal discount rate in small corporations being 30-50 percent. The shares in the corporation were worth $156 each, if they could be sold as a whole.

The court elected to apply a discount rate of 36% making each share worth $100, a finding upheld on appeal as being supported by competent evidence.

Source:

Shannon Pratt, Valuing a Business / Institute of Chartered Financial Analysts, Valuation of Closely-Held Companies & Inactively Traded Securities

1, 2. "Discounts Involved in Purchases of Common Stock (1966-1969)," Institutional Investor Study Report of the Securities and Exchange Commission. H.R. No. 64, Part 5, 92d Cong., 1st Sess. 1971, pp. 2444-2456.
3. Milton Gelman, "An Economist-Financial Analyst’s Approach to Valuing Stock of a Closely Held Company," Journal of Taxation, June 1972, pp. 353-354.
4. Robert R. Trout, "Estimation of the Discount Associated with the Transfer of Restricted Securities," Taxes, June 1977, pp. 381-385.
5. Robert E. Moroney, "Most Courts Overvalue Closely Held Stocks," Taxes, March 1973, pp. 144-154.
6. J. Michael Maher, "Discounts for Lack of Marketability for Closely-Held Business Interests," Taxes, September 1976, pp. 562-571.
8. "Revenue Ruling 77-287 Revisited," SRC Quarterly Reports, Spring 1983, pp.1-3.


Restrictive covenants

Ownership interests in closely held businesses are frequently subject to agreements restricting their transfer. You can find them in:

  • corporation's Articles of Incorporation or Bylaws
  • agreements among or between the shareholders and the corporation
  • LLC operating agreements
  • partnership agreements

These restrictions affect valuation. "Partnership agreements often furnish a useful method for calculating the partnership interest's value, particularly when they do not penalize or place a premium on the holdings of a particular partner… When the terms of a partnership agreement are used, however, the value of the interest calculated is only a presumptive value, which can be attacked by either plaintiff or defendant as not reflective of true value." Weaver v. Weaver, 72 N.C. App. 409, 324 S.E.2d 915 (date). For an approved withdrawal formula for a partnership interest in an accounting practice, see Fox v. Fox, 103 N.C. App. 13, 404 S.E.2d 354 (1991).

Restrictive agreements can take many different forms:

  • Absolute prohibitions against transfer - This type of restriction in a corporation is frequently invalid as a restraint upon alienation if for an unreasonable period or limited to specific transferees.
  • Consent restraints - These involve restrictions requiring consent of the other shareholders or the corporation before a transfer can be made.
  • First Refusal Rights - This type requires that any shares proposed for sale first be offered to the corporation or to other shareholders at the proposed transfer price.
  • Options to Purchase by the Corporation or the Other Shareholders - The option price is usually a fixed price or a predetermined formula price (such as book value). The events triggering the option are usually death, termination of employment, or a proposed transfer by the shareholder.
  • Mandatory Buy-Sell Agreements - Under such an agreement, the estate of a deceased shareholder must sell, and the corporation must purchase, the decedent's shares at a fixed or pre-determined formula price.

Illustration

Restrictive agreements, normally found in incorporated medical practices, can be found in two documents:

  • Employment agreement provides, for example, for the payment of 50% of the average of the last three years W-2 income as termination pay. This formula could be used in lieu of the valuation of intangible assets, such as goodwill.
  • Stock purchase agreement that would provide for a valuation of the tangible assets at fair market value by an appraiser or, for example, at 40% of cost.

Why would parties agree to value goodwill according to a formula that may not fully reflect its value?


Answer: Text


Policy consideration in discounting

Sometimes courts have refused to consider transfer restrictions in valuing stock. For examples, in equitable distribution cases, recognizing the restrictions on control diminishes the value of the stock to a spouse seeking one half of marital property.

Example

A North Carolina court has held that intra-spousal restrictions are not binding unless specifically and expressly set forth in the stock restriction:

…The agreement requires a shareholder who wishes to sell, assign, encumber or otherwise dispose of the corporation's stock other than as expressly provided for in the agreement to obtain the written consent of the other shareholders. The agreement contains no express provision regarding the interspousal transfer of shares incident to equitable distribution. The spouse is neither joined in the agreement, nor has she waived her interest in the stock. We are not prepared to cut off the marital interest of a spouse under those circumstances. We hold that, under the rule of strict construction, a restriction on the transfer of stock which is marital property absent an express provision prohibiting such transfers is [unenforceable].

Bryan-Barber Realty, Inc. v. Fryar, 120 N.C. App. 178, 461 S.E.2d 29 (1995). What is the court's reason for disregarding the restriction? The court can award an "in-kind" division of the stock despite the stock restriction. This would leave both parties with the risk and reward of being a stockholder. N.C. Gen. Stat. § 50-20(e) has been amended to create a presumption that an in-kind division is equitable. (effective October 1, 1997)


Answer: Text


Blockage discounts

The marketability of stock may also be affected by whether the public trading market in the stock could absorb a large block of shares. So-called blockage discounts may be appropriate when holdings in a public company are so large that the shares may not be readily tradeable. For example, a discount may be appropriate if the trading volume of the shares is not large enough to absorb a large block without a major downward pressure on the price of the stock.

See

 

5.4.3 Minority Discounts

©2003 Professor Alan R. Palmiter

This page was last updated on: August 4, 2003