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Minority Investment Discounting

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Definition of Fair Market Value (“FMV”)

For purposes of this opinion, the term, Fair Market Value, is defined as noted under the Internal Revenue Service Code [per Revenue Ruling 59-60, subsequently noted, and the American Society of Appraisers Business Valuation Standards; also, the wording is virtually identical in Reg. 1.170A- 1(c)(2) ( income tax, charitable contributions of property); see Reg. 20.2031-1(b) (second sentence) (estate tax), 25.2512-1 (second sentence) (gift tax)] as: “the amount at which property [in this case, shares of the Company’s common stock] would exchange hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and when both parties have reasonable knowledge of relevant facts. [as is the case herein presented].”

Note should also be made of the AICPA’s IAS 39, further described herein plus the new requirements under SFAS 141R, Business Combinations for disclosures (particularly paragraphs 67-73) and deal costs (paragraphs 43-46).

Valuation Considerations

Before any Method of Valuation can be selected, the valuation of closely held securities [as is the case herein] requires consideration of a number of relevant factors that may influence the market price. The primary 12 factors below are recognized by the Tax Courts, the Internal Revenue Service, and what professional investors generally consider before making an investment or purchase of the securities under investigation. Once this information has been assembled and reviewed, then one can determine what the best method of valuation might be.

These considerations are outlined and described in Revenue Ruling 59-60, 1959-1 CB 237, as modified by Revenue Ruling 65-193, 1965-2 CB 370, and Revenue Ruling 77-287, IRB 1977-33. Although Revenue Ruling 59-60 specifically addresses itself to stock valuations for gift and estate tax purposes, the principles set forth may be applied to a wide spectrum of valuation problems, including those related to stockholder buy/sell agreements, mergers and acquisitions, Employee Stock Ownership Plans, corporate reorganizations, marital dissolutions, and bankruptcy.

Valuation Method: Fair or Fair Market Value

There are four primary methods of valuation that are most used and accepted are: Asset Value; Income Value; Market Comparisons and Industry Standards. Each is described below and are considered to be an outgrowth of Revenue Ruling 59-60.

  1. Asset: This considers the business to be a collection of assets that have a marketable value to a third party in an asset sale. Asset valuations are typically used for businesses that are ceasing operation and for specific types of businesses such as holding companies and investment companies. Asset valuation methods include the book value method, the adjusted book value method, the economic balance sheet method, and the liquidation method.
  2. Income: Under this method valuations are based on the premise that the current value of a small business is a function of the future value that an investor can expect to receive from purchasing all or part of the business. Income valuations are the most widely used type of valuation. They are generally used for valuing small businesses that are expected to continue operating for the foreseeable future. Income valuation methods include: the capitalization of earnings method, the discounted future income method, the discounted cash flow method, the economic income method, plus other formula methods. Caution has to be exercised here because its use is highly dependent upon the continuation of the level of historical earnings and projected economic trends which as we know can often change during a company’s business cycle.
  3. Market Comparison: This is based upon current conditions amongst active business buyers, recent buy-sell transactions, and other fairly comparable business entities. Financial attributes of these comparable companies and the prices at which they have transferred can server as strong indicators of fair market value of the subject company. One of the best examples of this is the capitalization determinations of publicly-traded companies as expressed on the various publicly-traded market exchanges, like the NYSE or for smaller companies, the OTC Market (Over-the-Counter).
  4. Industry Standards: Often times a particular industry, like the distribution and separately a service business, is valued based on a multiple of its annual revenues. However, caution has to be used here for many companies are a composure of multiple industries and thus it is not unusual to find an appraiser using more than one valuation methods in determining the value of a business enterprise.

If all fails in assigning one of the above Methods, EMCO/Hanover then uses an unwritten standard, given its credentials in mergers and acquisition which is also used by investment bankers. It is 3x – 5x times pre-tax cash flow [based on certain analysis of a Company’s financial statements] but adjusted for any extraordinary or non-direct business expenses, to determine an investment’s fair value. EMCO/Hanover believes that such a standard is reasonable for non-publicly-traded, non-technology, based businesses, excluding real estate which has its own capitalization procedures.

One should also be cognizant of the alternative of establishing a “Fair Value” which is not a quoted price on any Stock Exchange which is the best evidence of fair value - quoted prices in an active market. However, if the market for a financial instrument is not active, then an entity can establish fair value by using valuation technique/ guidelines, as defined and referenced above particularly under the three other primary methods plus originally set out under Revenue Ruling 59-60 along with that presented under the AICPA’s IAS 39 Financial Instruments: Recognition and Measurement.. . . . A valuation technique: (a) incorporates all factors that market participants would consider in setting a price and (b) is consistent with accepted economic methodologies for pricing financial instruments.

Please also refer to the Section - - Compensation: Restricted Stock Valuation Standards on our website for valuing restricted shares issued to employees and executives plus Board Directors.

Basis of Minority and Marketability Discounts

The Minority Interest/Lack of Control/Marketability of the Interest Being Valued (Discount Composite: 48%).

In support for the application of Minority Interest/Lack of Control and Marketability Discounts, EMCO/Hanover has presented herein a cross-section of actual Case references of individual and joint discounts which were applied under varying circumstances plus examples of actual premiums (reciprocal discounts) paid in various publicly-traded corporate acquisition transactions to support its conclusion for a discount(s). In most situations EMCO/Hanover has typically applied a composite discount of forty-eight percent for lack of control and marketability when valuing one’s interest, particularly in privately-held circumstances – as determined below.
 
{.40, for lack of control + .08 [40% x 20%, for lack of marketability]} = .48 or 48%, the reciprocal of which is 52% when multiplying it against the stated value of the enterprise or asset involved}, as prior noted.
 
Various studies include analysis of selective restricted stocks and the pre-IPO transactions. The aggregate of these studies indicate average discounts of 35% and 50%, respectively. Some experts believe the Lack of Control and Marketability Discounts can aggregate discounts for as much as ninety percent of a Company's fair market value, specifically with family owned companies. However, each case must be analyzed based on the specific circumstances involved.
 
a.)    Minority Interest: lack of control (40%)
 
1.) General Background
 
The first step is to determine the value of having control. Control premium studies examine the differences in stock prices of a particular company immediately before and after a majority or the “controlling interest” of an enterprises stock or units in a partnership is tendered. Since the minority interest discount is a function of the control premium one must first examine this principle first.
   
The minority interest principle refers to the fact that ownership of less than a majority or controlling interest in an enterprise or partnership by itself cannot: (1) elect directors and the appointment of management, (2) determinate management compensation or perquisites; (3) control day-to-day or long range managerial decisions, impact future earnings, or control efforts for growth potential; (4) declare or pay dividends or distribute to interest holders; (5) the acquisition or sale of treasury shares; (6) consolidate or divest or merger; or (6) alter the Articles of Incorporation , bylaws or partnership agreement(s). Most importantly, minority shareholders/ partners do not have the right to establish executive or specific partner compensation, buy or sell major business assets, or cause the liquidation of all corporate or partnership assets. That right is invested in the majority shareholder(s).
 
Because the owner of a minority interest lacks the ability to control the business, an acquirer of a minority interest will pay less for that interest, on a pro-rata basis, than if he or she were acquiring a controlling interest in a business which is either privately-held, there are restrictions on the securities themselves, or where there is an absence of a “ready market” (See Section Sub-3, below, for definition according to the National Association of Securities Dealers, Inc.) for the liquidation of the securities once purchased. Further, in instances where the interest holder lacks the ability to exercise control over the operations of the enterprise, his or her interest might be worth “significantly less than its “liquidation” value.
 
2.) Control Premiums and Minority Interest Discount Studies
 
In the Houlihan, Lokey, Howard and Zukin’s Mergerstat Review - 2001, an annual publication that provides comprehensive statistics on control premium in over 50 industries, they analyzed the average price paid over the market price for the past 10 years in various publicly recorded, corporate transactions. They found that the premiums paid ranged from a low of 35.1% in 1991 to a high of 49.2% in 2000 - averaging 41.35% over the recent eight years analyzed and still valid today.
 
In The Perspective: The Source for Partnership Information, a publication that lists real estate limited partnerships (“RELPs”), along with an estimate of their underlying asset value, as estimated by the general partner or based on recent appraised values. The discounts were derived by comparing 1998 year-end value s as reported by the general partner with the weighted average prices at which investors purchased units in these real estate limited partnerships in the secondary market during the sixty-day period ended May 31, 1999. For “distributing” RELPs, the average discount was 29.0%; for “non-distributing “RELPs”, the average was 46.0%.
 
Numerous studies have also been undertaken by Spencer Jeffries, Messrs. Kam, Schroeder and Smith plus Messrs.. Johnson and Park where minority discounts for average returns under nine percent have caused average discounts from net asset value to be sixty to eighty percent.
 
According to Mary Boehler, Vice President and Division Manager of the Family Business Division of The Northern Trust Company, per an Internet article on Business Succession – Northern Trust in 2004: minority discounts can range from 25 to 35 percent and discounts for non-marketability from 20 to 40 percent [or thus, when taken as a composite, 49% (35% + 12%[.35 x 45%])].
   
3.) Selective Corporate Transactions involving Majority Ownership, 2007-2009
 
Supporting Ms. Boehler’s position also is the proposed 2007 merger (April 23, 2007: Reuters) between British Bank – Barclays Plc. (trading symbol: BARC.L) and ABN AMRO (trading symbol: AAH.AS) which represents a 33% premium (or conversely its reciprocal in discounting terms, a 47% discount) to ABN’s trading price before the banks announced its merger talks, which some analysts believe is too low. Further, the merger will result in the new bank becoming one of the top 10 in the World - - - - but not the largest or top three bank holding companies, where an acquisition premium would be even greater.
 
Note should also be made that probably one of the best historical examples in transaction discounting was between 1976 and 1990, where premiums averaged 41 percent, with many over 100 percent (Jensen, 1993), like when Campeau paid a 124 percent premium to acquire Federated Department Stores.
 
More recent examples include, in 2007, where Rupert Murdoch’s New Corporation acquisition of Dow Jones & Co. Inc. was at an “accepted” price of $60 per share where the initial offer was at $36 per share – a 66% premium. Also, Natro, Inc. (“NTOL”), a company in the manufacture and marketing of dietary supplements, herbal teas, and sports nutrition products with annual revenues of $74 million, was tendered by Plethico Pharmaceuticals Ltd.. in November, 2007 at $4.30, a 90% premium over its then price of $2.27 for a 90% controlling interest.
 
Brewers Carlsberg and Heineken Agreement to purchase Scottish & Newcastle (S&N) in January, 2008 - a premium of 50.7% over the closing share price on March 28, the day before speculation arose about a possible bid for S&N according to its own press release dated January 25, 2008.
 
In February, 2008 this was followed by an announcement by Microsoft – “MSFT” that it offered $44.6 billion in cash and stock for search engine operator Yahoo Inc. – “YHOO” (# 2 behind industry leader - Google). This represented a 62 percent premium (before raising by another 48% when the actual announcement was made on February 1, 2008) to Yahoo's closing stock price on January 31st.
 
This was followed in February 20, 2008 announcement that Reed Elsevier, a London-based educational publisher and parent of the LexisNexis information service, will buy ChoicePoint for $3.6 Billion in Cash - the purchase price for which amounts to $50 a share, a 49 percent premium given ChoicePoint's closing stock price of $33.66 on the 20th.
 
On July 20, 2008 Dow Chemical Co. agreed to buy its rival Rohm and Haas, whose revenues are 1/6 of Dow’s, for $78 per share or a 74 percent premium over Rohm and Haas’s closing share price of $44.83 on July 19, 2008. Further announced in July was the acquisition of Barr Pharmaceuticals by Teva Pharmaceutical for $66.50 per shares, which is a 42% premium over Barr’s closing price of $46.82 when the transaction became known.
 
Lloyds TSB, Britain's fifth-biggest bank (LSE:LLOY.L)  and HBOS Plc (LSE:HBOS.L) ranked sixth, Britain's biggest home loan lender, agreed in an all-share deal transaction by Lloyds to purchase HBOS for 232 pence per share, a 58% premium over 147.1 pence trading price on September 17, 2008 (but from an all-time low of 88p earlier in the day), valuing the transaction at over 12 billion British pounds.
 
On March 9, 2009 Merck announced that it was buying Schering-Plough in a $41.1 Billion deal (56% in stock and 44% in cash), a 44% premium over the two companies’ average closing share prices over the past 30 trading days. The transaction was structured as a reverse merger, with Schering-Plough as the surviving company, in an attempt to avoid triggering change-of-control provisions with Johnson & Johnson.
 
In December, 2009 drug-maker Sanofi-Aventis initiates a Buy for Chattem (CHTT) for $1.9 Billion, a 34 percent premium at $93.14 (December 21, 2009) over the prior closing price of $69.98 on December 18, 2009.
 
In June, 2010 Ralcorp Holdings, Inc. ((NYSE: RAH) said it will pay $53 per share for American Italian Pasta Co. (NasdaqGS: AIPC), with $589M in revenues), a 42% cash offered premium (the deal is being funded with cash on hand, an existing credit facilities and a bridge facility) based on its closing price on June 10th of $37.36 over the Kansas City pasta maker's closing price of $41.73 on June 18, 2010 in the mix of a highly volatile and recession-oriented market.
 
On June 30, 2010 Boeing's offer of $34.50 per share is a 41 percent premium to Argon SR, Inc.'s (STST) closing price on the prior day. Argon had $366 million in revenues during the 2009 fiscal year.
 
On July 12, 2010 insurance broker Aon Corp., who is also engaged in consulting and outsourcing operations, agreed to purchase Hewitt Associates (NYSE: HEW), a human resources and outsourcing company, by paying a 41% premium over Hewitt’s closing price on July 8th.
 
Playboy Enterprises Inc. said Monday, July 12, 2010, that its iconic founder Hugh Hefner is offering to buy the remaining, minority and non-voting shares of the media empire, taking the company private, in a deal that values the company at $185 million or a 51% premium offer over market based on the number of shares outstanding on April 30th.
 
ATC Technology Corp. (NasdaqGS Symbol: ATAC, with annual revenues of $476M) said Monday it has agreed to be acquired by privately held Genco Distribution System Inc., an engineering and supply chain logistics firm, for $512.6 million in cash, a 64% percent premium over the company's closing price ($15.28) on July 6, 2010.
  
4.) National Association of Securities Dealers, Inc.’s Definition of “Ready Market”
 
The key Guideline is according to the National Association of Securities Dealers, Inc. Manual dated July, 1997 where on Page 8113 it refers to Non-Marketable Securities and Rule 15c3-1[c][2][vii] and states:
 
“Deducting 100 percent of the carrying value in the case of securities or evidence of indebtedness in the proprietary or other accounts of the broker or dealer, for which there is no ready market, as defined in subparagraph [c][11] of this section . . . [can be justified]”.
 
On Page 8122, it further defines “Ready Market” under Section [11], sub Section (i): “the term ‘ready market’ shall include a recognized established securities market in which there exists independent bona fide offers to buy and sell so that a price reasonably related to the last sales price or current bona fide competitive bid and offer quotations can be determined for a particular security almost instantaneously and where payment will be received in settlement of a sale at such a price within a relatively short time conforming to trade custom.”
 
5.) An Industry Cross-section of Current Premiums (or conversely Minority Discounts) being paid in second-half 2010 through calendar 2011 for U.S. Publicly-traded Acquisition Transactions
 
When, in August 2010, The Blackstone Group said  that it would take power company Dynegy Inc. private in a deal valued at $4.7 billion, including debt, shares of Dynegy (NYSE: DYN) gained 62.9%.
 
Allis-Chemical Energy, Inc. (NYSE: ALY, with revenues of $547 million) jumped 68% to $3.87 a share even the transaction is valued at $4.50 ($2.30 on August 12, 2010 – a 96% premium) after the Houston-based oil field equipment firm agreed to be bought by Norway-listed Seawell in a deal valued at $890 million, including debt.
 
August 12, 2010: announcement of the acquisition of Trubion (NasdaqGM: TRBN, with reported annual revenues of $19.3 million), a Seattle-based developer of autoimmune disorder and cancer treatments, by Emergent BioSolutions Inc. (NYSE: EBS) which caused Trubion shares to rise from $1.51 to $4.50, the calculated cash/ stock value of the transaction offer (198% premium).
 
August 13, 2010: International Business Machines Corp. said Friday that it will pay $480 million to acquire Unica Corp. (Nasdaq: UNCA), with revenues of $100 million for Fiscal 2009 (down from $120 million in 2008), which is a firm that helps technology companies market their products. The all-cash offer of $21 a share is more than double (a premium of 120%) over Unica's prior closing price of $9.55 a share.
 
August 16, 2010: Dell Inc. announced to purchase data-storage company 3Par Inc. (annual revenues: $204 million and negative earnings of $3.2 million) for about $1.15 billion in cash. Dell will pay $18 a share for 3Par (NYSE: PAR), an 87% premium to 3Par's prior closing price of $9.65.
   
August 17, 2010: Medtronic Inc. (NYSE: MDT) said it will buy Osteotech Inc. (NQ: OSTE), with annual revenues of $96 million and negative earnings of $2.5 million, for about $123 million. Medtronic, the medical-devices maker, will pay $6.50 for each share for Osteotech (a provider of human bone and bone connective tissue used in transplants), a 65% premium to the August 16th closing price.
 
August 18, 2010 Intel Corp. (NasdaqGS: INTC) said Thursday it is buying computer-security software maker McAfee Inc. (NYSE: MFE) for $48-per-share price which represents a 60% premium over McAfee's August 16th’s closing price of $29.93.
 
October 12, 2010: Pfizer Inc. (NYSE: PFE), the world's largest pharmaceutical company by revenue, said it will buy pain drug maker King Pharmaceuticals Inc. (NYSE: KG) for $14.25 per share for King. That's a premium of 40 percent to the stock's Monday closing price of $10.15 or a 57% premium over the September 1, 2010 closing price.
 
October 17, 2010: St. Jude Medical Inc. (NYSE: STJ) said Monday it is buying rival heart device maker AGA Medical Holdings Inc. (NasdaqGS: AGAM), with annual revenues of $209 million, for $20.80 per share, a premium of 41% compared to AGA's latest closing price, or 49% premium over its October 1st closing price.
 
October 27, 2010: CommScope Inc. (NYSE: CTV), the maker of telecommunications equipment, agreed to be purchased by the leveraged-buyout firm Carlyle Group for $31.50 per share, a premium of 36 percent to the closing price on Oct. 22, the last trading day before CommScope said it was in talks to be acquired by Washington- based Carlyle or a 45%  premium to the October 7th closing price when the stock’s trading volume suddenly increase by 256% from 1.1 million shares being traded on the prior day to 2.85 million on October 7th.
 
November 2, 2010: Business software maker Oracle Corp. (NasdaqGS: ORCL) said Tuesday it has agreed to acquire Art Technology Group, Inc. (NasdaqGM: ARTZ) for $6 a share for the company, which makes software that helps businesses manage their customer relations. The transaction is a 46% premium to ASTG’s prior day’s closing price.  
 
On March 24, 2011 , the last trading day before Vanguard Natural Resources LLC announced its initial proposal to acquire all of the common units of Encore owned by the public and an approximately 51% premium over the December 31, 2010 purchase price Vanguard paid to Denbury Resources, Inc. for 45.6% of the Encore common units.
 
On May 24, 2011 it was announced that Varian Semiconductor Equipment Associates (Nasdaq: VSEA)  has agreed to an acquisition by Applied Materials of the Silicon Valley in a deal that will pay Varian stockholders $63 a share, or nearly $5 billion. The premium on Tuesday's closing price paid for Varian stock to get the leading supplier of implant technology, wowed investors who sent Varian stock soaring on the NASDAQ exchange. The company's stock climbing by 20.81 points or — 51.32 percent — to 61.36, an all-time high. This further rose to $62.97, which was a 70.2% premium for 2011 on November 9th.
 
On August 15, 2011 Google just announced that it is acquiring Motorola Mobility. The search and online advertising company is buying the company for approximately $12.5 billion (or $40 per share), in cash. The price represents a premium of 63 percent to the closing price of Motorola Mobility shares the past Friday.
 
In December, 2011 Tokio Marine Holdings Inc. stated that it agreed to pay a 71 percent premium in its $2.7 billion cash bid for the U.S.’s Delphi Financial Group Inc. (NYSE: DFG) as Japanese insurers face waning demand from an aging population at home. Tokyo-based Tokio Marine will pay $43.875 for each of Delphi’s Class A shares and $52.875 for every Class B share, the two insurers said in a statement yesterday. Delphi shareholders will also receive $1 in cash through a special dividend, according to the statement.. The purchase value marks a premium of 71 percent, based on the 20-day average price of Delphi’s publicly traded Class A shares and accounting for the one-time payout to existing Delphi investors after the deal closes, according to data compiled by Bloomberg. Tokio Marine paid a 81 percent premium for Philadelphia Consolidated Holding Corp. in 2008, according to the data.
 
On December 15, 2011 SonoSite, Inc. (NasdaqGS: SONO), the publicly traded ultrasound device company headquartered near Seattle, announced that it will be acquired by Tokyo-based Fujifilm Holdings Corp. for $995 million. At $54 per share, the deal works out to a 50 percent premium over SonoSite’s share price over the past three months

6.) Court Cases Involving Minority Interest and Marketability Discounts

Numerous court cases, some of which have been outlined below,  have upheld the application of minority discounts. In so doing, the Tax Court has allowed discounts for minority interests, which were approved by the IRS in Revenue Ruling 93-12. This in turn  revoked Rev. Rul. 81-253, 1981-2 C.B. 187 . Sometimes it has been difficult or impossible to determine whether the discount was allowed because the shares represented a minority interest, were unmarketable, or both. A survey of selected decisions shows minority discounts in the 10% to 40% range, marketability discounts also in the 10% to 40% range, and combined discounts, where the Court only gave a single number, in the 15% to 65% range.
Source: Control Premiums, Minority Discounts, and Marketability Discounts   Saunders, Jr., Ph.D.
In addition,  numerous  Court cases have upheld the application of minority discounts. These include: a.) Estate of Bright v. United States, 658 F. 2d 999 (5th Cir. 1981) and valued at 27% of the total public value of the decedent's stock; b.) Estate of Newhouse v. Commissioner, 94 T.C. at 249 where a 35% discount was Court approved; and c.) Samuel J. LeFrak and Ethel LeFrak v. Commissioner. United States Tax Court (66 T.C.M. 1297 (1993), T.C. Memo. 1993-526), filed November 16, 1993 where a  30% combined discount was approved by the Court.

Several other notable cases support the application of minority interest discounts of more than 50%. Important cases include: Martin v. Commissioner, TCM 1985-24, supporting the application of a 70.0% discount; Estate of Little, TCM 1982-26, supporting a 60.0% discount; and Gallum v. Commissioner, TCM 1974-284, supporting a 55.0% discount.

In the case of the Estate of Baird, Petitioner, vs. Commissioner, (Docket Nos. 8656-99, 8657-99. filed September 28, 2001) the Court found that a 60% discount was reasonable and supported. Further, in the Estate of Van Loben Sels v. Commissioner of Internal Revenue, T.C. Memo 1986-501, the Tax Court accepted a combined 60% discount.

Although several of the Court cases cited above in support of minority discounts , the application of minority interest discounts to partnership interests has also been supported in: the John R. Moore and Viola K. Moore v. Commissioner,62 T.C.M. 1128 (1991) allowing a 35% discount for minority interest, the Court ruled:

“although these cases deal with minority interest in closely-held corporations, we see no reason for a different rule for valuing partnership interests in this case” . . . “The critical factor is lack of control, be it as a minority partner or as a minority shareholder”; and (2) also see Harwood v. Commissioner, 82 TC 239 (1984), where the Court ruled in valuing gifts of minority interests in a family partnership a combined discount of 50% to be applicable for an 8.89% equity interest.

In marketability discounts (usually referred as DLOM - discount for lack of marketability and referenced under IRS Revenue Ruling 77-287), notable cases include: (1) In Dailey Estate v. Commissioner, T.C. Memo 2001-263, a 40% discount was allowed for lack of marketability; 2) In Estate of Helen Smith, 78 T.C. Memo 745 (1999), a 76% discount for lack of marketability and minority interest was allowed; (3) in Etta H. Weinberg, 79 T.C. Memo 1507 (2000), a 45% discount for lack of marketability discount was allowed and (4) in United States Tax Court Case: Donald J. Janda, Petitioner v. Commissioner of Internal Revenue, Respondent and Dorothy M. Janda, Petitioner v. Commissioner of Internal Revenue, Respondent Docket Nos. 5100-99, 5101-99, T.C. Memo. 2001-24, the Court applied a discount of 40 percent both for lack of control and marketability to the pre-discount fair market value of the Company stock.

Noteworthy also is the decision in the Kelley case (Estate of Kelley v. The Commissioner, T.C. Memo. 2005-235, October 11, 2005) where the Tax Court endorsed the application of lack of control and lack of marketability discounts for entities holding only cash. In Kelley, the answer was a resounding yes to the tune of a combined discount of 32% based solely on cash assets. In Anastos v. Sable, 443 Mass. 146, 819 N.E.2d 587 (Supreme Judicial Ct. of Mass. 2004) the Court affirmed a minority discount of 40%.  Further, the U. S.Tax Court, in a recent supplemental opinion, Pierre v. Commissioner, T. C. Memo. 2010-106 (May 13, 2010), concurred with an overall 35.6% valuation discount for a 50% interest in a family LLC. The discount was applied for the purpose of determining gift tax and generation-skipping transfer tax.

In Murphy v. U.S., 2009 WL 3366099 (W.D. Ark.) (Oct. 2, 2009) the Court allowed a composite discount of 42% discount ($135M gross value of company x 95% interest = $128M value assigned to 95% interest; $74.5M (estate value as determined by the Tax Court) divided by $128M = 58% for which the reciprocal is 42%) for lack of marketability and lack of control.

In the Estate of Marjorie deGreeff Litchfield, Deceased, George B. Snell and Peter deGreeff Jacobi, Coexecutors vs. Commissioner of Internal Revenue Service, Respondent, T.C. Memo 2009-21, January 29, 2009 the “gross discount” after all three discounts (re: lack of control – DLOC, lack of marketability – DLOM, and
built-in capital gains were applied in this situation was 47.8% for LRC and 46.2% for LSC.  In the U. S. Tax Court, in Pierre v. Commissioner, T. C. Memo. 2010-106 (May 13, 2010), the Court concurred with an overall 35.6% valuation discount for a 50% interest in a family LLC.

In  Mandalbaum v. Commissioner,  Docket Nos. 20517-92, 20678-92, 20687-92, 20688-92, 20689-92, 12749-94, 12750-94, 12751-94, 12752-94, 12753-94, 12754-94, 12755-94, 12756-94, 12757-94, 12758-94, 12759-94, 12760-94, 12761-94, 12762-94, 12763-94., 69 T.C.M. 2852 (1995), T.C. Memo. 1995-255, the Court
found that a 30-percent marketability discount was appropriate.

In the Estate of Webster E. Kelley v. Commissioner, T.C. Memo. 2005-235. The partnership in this case consisted solely of cash and certificates of deposit and the court allowed a combined discount of 32% for lack of marketability and minority interests. The same was true in McCord v. Commissioner, 120 T.C. 358 (2003).

EMCO/ Hanover has also acted as an expert in two separate cases involving two publicly-traded companies (ETAK in 2008/9 and CTIX in 2013), where EMCO/ Hanover used a 60% combined minority interest/ lack of marketability discount. Both satisfied/ met both the SEC and IRS's justification and acceptance.

Further, sources of pre-IPO studies include:  Willamette Management Associates' Valuation Advisors' Lack of Marketability Discount Study and those developed by John D. Emory of Emory & Co. have shown a discount for lack of marketability of up to 59% -- higher than in restricted stock studies.

7.) Revenue Ruling 93-12
 
This ruling is also important which the Internal Revenue Service issued, superseding Revenue Ruling 81-25. Prior to this Ruling the IRS held that individual family interests in corporate stock in the absence of family discord would have to be pooled together to determine if a minority interest discount was proper.
 
In this ruling, the IRS has now agreed with the Courts that absolute aggregation of voting power of family interests is not to be assumed.
 
8.) Discount Selected (40%)
 
Under the Asset Valuation Method applied herein, EMCO/Hanover has decided to remain conservative at forty percent (40%) and stay in proximity to the guidelines used in the Houlihan, Lokey, Howard and Zukin’s Mergerstat Review 2001, a period when the stock market was experiencing flatness and decline, which indicated an average recent discount of thirty-three percent (33%) for minority interest: lack of control. Conversely, the average premium for control positions was forty-nine point two percent (49.2%).
 
Mergerstat compiles data regarding publicly announced mergers, acquisitions and divestitures involving 10% or more of the equity interests in public companies, where the purchase price is $1 million or more and at least one of the parties to the transaction is a U.S. entity <http://en.wikipedia.org/wiki/United_States_entity> . Mergerstat defines the “control premium” as the percentage difference between the acquisition price and the share price of the freely-traded public shares five days prior to the announcement of the M&A transaction. While it is not without valid criticism, Mergerstat control premium data (and the minority interest discount derived therefrom) is widely accepted within the valuation profession and has been published annually since 1972.
 
b.) Lack of Marketability (20%)
 
1.) General Background
 
The lack of marketability principle is well documented and is based on the fact that stock in a closely-held business enterprise is less attractive and more difficult to sell than publicly-traded stock where there is an active market, with restriction under Rule 144, to accommodate such selling. Where an active trading market does not exist, other factors may be used as valuation benchmarks, and the lack of a marketability discount becomes operative and applicable. Lack of marketability discounts relate to the inherent lack of flexibility (i.e. restrictions on transfer, lack of prior transfers, number of shareholders, size of block, access to capital markets – to name just a few) in getting in and out of investments with no ready market (i.e. share trading activity – see prior definition for “Ready Market.”).
 
2.) Marketability Discount (“DLOM”) Studies of Minority Interest Positions
 
There have been various restricted stock studies regarding pre-IPO studies, an analysis of real estate limited partnerships, and other relevant facts and circumstances impacting themarketability of such a shareholder ownership percentage position. These would include studies undertaken by:
 
· The SEC Institutional Investor Study (1971), where the overall average discount was 25.8% for reporting companies, while the average discount for non-reporting OTC companies was 32.6%;
· Milton Gelman, who in 1972 evaluated 89 transactions of four closed-end investment specializing in restricted securities investments, where the overall mean discount was 33.0%;
· Robert R. Trout (1977), who studied 60 purchases of restricted company stock transactions from 1968 to 1972 and developed a regression model which resulted in a discount of 33.5%;
· Robert E. Moroney in the March, 1973 issue of Taxes, which published the results of his study of 146 handled by ten registered investment companies where the discounts ranged from 3.0% to 90.0%, with the average being 35..6%;
· J. Michael Maher, who published a later study in the September of Taxes, which evaluated the sale of restricted stock from 1969 to 1973 – calculating the average discount at 35.4%;
· Standard Research Consultants (published in 1983) studied 28 private placements of restricted company stock from 1978 to 1982, where the mean discount was 45.0%;
· Williamette Management Associates, Inc. conducted a series of studies from 1977 to 1989 which showed discounts ranging from 41.7% to 74.4%;
· In the March, 1994 issue of Business Valuation Review, John D. Emory published a summary of six, eighteen studies between 1980 and 1993, which showed that the mean discount of the private sale price to its subsequent public offering price derived from these studies ranged from 42.0% to 60%, with the average of these six means being 47.0%; and
· In a study on real estate limited partnership interest discounts in The Partnership Spectrum in its May/June 1998 edition, the net asset value discounts for “Partnership Non-distributing Equity” averaged 43%.
 
Lastly, on June 1, 2010 the Colorado Supreme Court handed down its long awaited ruling on In re Marriage of Thornhill, Case No. 08SC777 where it concurred with the Trial and the Appellate Courts in the use of Marketability Discount of 33% in an oil and gas service company, started by the husband, but was not publicly traded.
 
3.) Court Cases Involving Marketability Interest Discounts
 
In the Estate of Van Loben Sels v. Commissioner of Internal Revenue, T.C. Memo 1986-501, the Tax Court accepted a 60% discount. The court noted that there were various disabilities associated with the undivided interest, including lack of marketability, lack of management, lack of general control, lack of liquidity and potential partition expenses. The Court noted that one expert believed the discount could be as high as 78%.
 
A key case in this area is the Estate of Bernard Mandelbaum v. Commissioner, TC Memo, 1995-255, which involved the size of a discount for lack of marketability on gifts of privately-owned stock in a corporation involved in the retail women’s apparel industry, where the Tax Count established a benchmark marketability discount range of 35% to 45% and stated that the magnitude of the marketability discount should be based on the following:

In Peter S. Peracchio v. Commissioner of Internal Revenue, filed on September 25, 2003, involving a “plain vanilla” Family Limited Partnership, owning only marketable securities and cash (roughly 44% domestic equities, 5% foreign equities, 7% fixed income and 44% cash), the Court allowed a 25% marketability discount. Second, the Service abandoned its “no economic substance”, Section 2703 and Section 2704 arguments before trial.
 
4.) Discount Selected (20%)
 
Under the Asset Valuation Method applied herein, EMCO/Hanover selected conservatively twenty percent (20%), as applicable to the interest being valued, which is even below the overall discount of 32.6% reported in the Study by the Securities and Exchange Commission – as noted above.
 
5.) Other Cases: Discounts

In the case of The SUPREME COURT OF THE UNITED STATES, No. 96-1580: Edward A. Shay, et al., Petitioners v. Newman Howard, et al., Respondents where the The American Academy of Actuaries submitted a brief as amicus curiae, pursuant to Rule 37 of the Rules of the Supreme Court of the United States, in support of the petition for certiorari, the Court confirmed a 50% discount where the stock being purchased represented a 38% interest from an ESOP (Pacific Architects and Engineers, Inc. – a former EMCO/Hanover client) by a shareholder who owned 62% of the then stock outstanding.
 
In the 2005-Ohio-4493 Case: Elvina V. Caldas, Plaintiff-Appellant, v. Carlos M. Caldas, Defendant-Appellee, C.A. No. 20691. - Court of Appeals of Ohio, Second District, Montgomery County, rendered a decision on August 19, 2005 a 75% stock discount used in a marital dissolution case was correct.
 
6.) Tier Discounts
 
Tier Discounts were allowed for substantial lack of control and marketability for Parent and Subsidiary real estate partnerships. Specific reference should be made to: Astleford v. Commissioner, T.C. Memo. 2008-128 <http://www.ustaxcourt.gov/InOpHistoric/astleford.TCM.WPD.pdf>.
 
In this case, an FLP (Family Limited Partnership) owned a 50% interest in a real estate general partnership and various other real estate tracts. Here, an approximate 20% absorption discount was allowed for valuing a 1,187 acre tract in the General Partnership. The FLP’s 50% interest in the General Partnership was valued as a Partnership Interest rather than as an Assignee Interest. Even so, a 30% combined discount for lack of control and marketability was allowed for the 50% interest in the General Partnership. Further, an approximate 17% lack of control and 22% lack of marketability discount (for a seriatim discount of about 35%) was allowed for valuing gifts of 90% of the limited partnership interests (three 30% gifts in 1996 and 1997).
 
7.) Distress Financial Condition Discounting
 
In March, 2008 purchase of Bear Stearns, not the Industry Leader nor Number Two but the Fifth in size, by JP Morgan Chase was for $236.2 million — or $2 a share, a 93.3 percent discount to Bear Stearns' market capitalization as of its March 7th transaction price, and roughly a 98.8 percent discount to its book value as of Feb. 29, 2008 - thus, taking into consideration future operating loses.
 
In October, 2008 Wachovia agreed to be acquired by San Francisco-based Wells Fargo & Co. in a $15.1 billion all-stock deal, a nearly 80 percent premium over the stock's prior day closing price of $3.91 on October 2, 2008.
 

General Note: The Sections above, Definition of Fair Market Value (“FMV”) through The Minority Interest/Lackof Control/Marketability of the Interest Being Valued (Discount Composite: 48%) have been copyrighted and thus any duplication thereof must be done with the permission of The EMCO/ Hanover Group. Further any use thereof in support of such discounting must be accompanied by an appraiser's qualification and experience which is critical in the proof of one's use of the above referenced use and discounting.

© 2012 The EMCO/Hanover Group. All rights reserved.