If a careful analysis has been done in determining freely traded value (marketable
minority interest value), a great deal about the security should already have been
"baked in". Whether the equity security being valued represents an indirect
interest in financial assets or operating assets is “baked in” to the freely
traded value. In determining DLOM we are attempting to find the diminution in value due to
the lack of a public market for a particular security. We continue to believe that our
restricted stock study yields the best objective measure of this value differential.
What We Are Doing
We are updating our restricted stock study. We have reviewed over 2,500 private placements
and have screened for securities which match our established criteria. Our updated
study will be online by mid-year 2008.
We are keeping abreast of changes to SEC Rule 144 and the shortened holding period just
enacted. We continue to point out that declining liquidity discounts associated with
reduced holding periods are largely due to the relaxation of restrictions rather than the
timing of the transactions. In our opinion closely held stock is just as illiquid today as
it would have been during the pre-1990 era of Rule 144 restrictions.
Accordingly, the S corporation benefit is dependent on and positively correlated with
(1) the distribution policy of the S corporation, (2) the dividend tax rates, (3) the
differential in personal and corporate tax rates and (4) the holding period. We combine
the value of the C corporation equivalent value with the specific benefit of the S
corporation calculation to arrive at the value for the S corporation. In some cases the S
corporation benefit can be quite significant. In other cases it is negligible.
The Federal District Court for the Northern District of California decided that the
estate tax value of a one-half undivided interest in a collection of nineteen paintings
should be reduced by only a 5% discount for the costs and delay in pursuing a partition
action. The IRS conceded 5% while the estate was at 44%. The estate’s expert used a
28% discount rate (later reduced to 20%) and a 3% paintings’ annual appreciation rate
in its present value analysis. The Court said:
“an investor seeking a 20% or 28% return would not choose to invest in art that is
expected to return only a fraction of those percentages. . . . Plaintiffs have failed to
provide any basis on which this Court could arrive at a reasonable expected rate of return
for individuals who invest in art other than the 3% at which Plaintiffs assert art
generally appreciates each year.”
COMMENT: The discount rate would seem to be substantially higher than 3% if
the opportunity costs of investing in other assets (i.e. bonds, marketable securities) are
considered.
On May 25, 2000 Reliance Steel, a public company, announced it would continue a stock
repurchase plan originated in 1994. Georgina Gimbel, the widow of Reliance’s former
Chairman, died June 5, 2000 owning 3.6 million restricted shares of the company’s
stock. Following a series of discussions among the estate’s representatives, Reliance
management and an investment banking firm, Reliance repurchased 2.27 million (63%) of the
estate’s shares at a modest discount (7%) from the stock’s trading price on
October 30, 2000.
Subsequent post-death events relating to valuation are disregarded unless they would be
reasonably foreseeable on the valuation date. The estate’s two valuation experts
ignored the repurchase in concluding overall discounts of 20.7% and 17% to reflect SEC
Rule 144 public resale restrictions. The IRS trial expert said it was reasonably
foreseeable that Reliance would purchase 50% of the estate’s shares in arriving at a
9% discount. Judge Swift cited the repurchase plan’s long track record but also noted
its history of smaller block transactions and the fact that Reliance would need
substantial cash and credit to complete a potential acquisition of a large company. The
Judge’s conclusion of a 14.2% discount was based primarily on a Rule 144 dribble-out
analysis but did consider repurchase pricing for 20% of the estate’s shares.
The Litmans and Dieners sold their internet travel service business (later called
Hotels.com) to HRN, a wholly owned subsidiary of USA Networks. Pursuant to an asset
purchase agreement, they were issued 10 million restricted shares of HRN stock at the time
of HRN’s IPO in February 2000. The shares could not be sold in a private placement,
had to be sold over a one to four year period and were subject to SEC Rule 144 resale
restrictions. The shares were reported for income tax purposes at a weighted average
marketability discount of just under 72% from the $16.00 estimated IPO price. HRN, seeking
to maximize good will amortization deductions, reported the shares at the $16.00 price but
at trial applied a flat 20% discount to each of the four tranches. The IRS used a 20.3%
weighted average discount in valuing the shares.
Valuation experts varied considerably in their approaches to measure lack of
marketability. Federal Court of Claims Judge Miller was most impressed with the
Litmans’ and Dieners’ appraiser, Mark Mitchell, whose discounts ranged from
49.5% for the one year block of shares to 79.0% for the four year block. Unlike appraisers
for HRN and the IRS who relied on restricted stock studies, Mr. Mitchell constructed
option and capital asset pricing models designed to capture the volatile, frenzied
internet stock environment during the two year period prior to the first quarter of 2000:
“Anybody would have to ask themselves am I at the top, how can I see an index that
has increased 500 percent in a matter of five years, how can I see that index do the same
thing, continue to go up and up and up? And that risk has to impact any analysis
associated with a restriction on marketability because you don’t have a chance to
sell those shares at any point during a contractual restriction period...if the price goes
up, you can’t sell, and if the price goes down, you start to worry that the bubble is
bursting and you can’t sell.”
By relying on these models, he was able “to better emphasize the factors that are
most important in determining discounts, and that would include risk in terms of
volatility as the primary measure of risk, and then the time related to the restrictions
period.”
Judge Miller’s final decision was to reduce Mr. Mitchell’s discounts to a
weighted average of 43.2% (vs. 72%) to account for weaknesses in his analysis.
COMMENT: If stock in a public company is discounted 20.3% by the IRS because
it is not freely tradable for one to four years, what about a minority interest in a
private company that may never see the public marketplace?
A majority decision by the Eleventh Circuit reversed the Tax Court* and directed it to
deduct the full amount of potential capital gains taxes in determining the value of the
decedent’s 6.44% interest in a C corp with marketable securities. The Tax Court had
previously ruled such taxes must be reduced to their present value. There is heavy
reliance on the Fifth Circuit Dunn case** (threshold assumption of immediate liquidation)
despite the fact that it involved a 62.96% interest.
A persuasive dissenting opinion said the majority’s “arbitrary
assumption” of a tax-triggering liquidation on the date of death of the owner of a
noncontrolling interest is “preposterous.” Judge Carnes said his colleagues took
“the easy way out” to avoid the “judicial effort” to make a “more
realistic calculation.”
*T.C. Memo. 2005-131.
**301 F.3d 339 (5th Cir. 2002).
