Chapter 7 Valuation Discounts and Premiums

• Jurisdiction: United States

Chapter 7: Valuation Discounts and Premiums

A. Measuring the Discount for Lack of Marketability in Debtor Company Business valuations

Analysts are often asked to value a debtor company's business or business ownership interests for bankruptcy-related purposes. Often, the valuation subject is a controlling (or even 100 percent) ownership interest in the closely held (i.e., not publicly traded) debtor company.

Depending on (1) the business valuation approaches and methods applied and (2) the benchmark valuation data used, the analyst may initially conclude the value of an ownership interest in the closely held debtor company on a marketable basis; that is, the analyst applied the valuation approaches or methods (or relied on valuation variables) that concluded the value of the debtor company as if the company was publicly traded on an organized stock exchange. However, in this instance, the debtor company is not publicly traded. It is a closely held company. Unless the initial value indication is adjusted for this lack of investment marketability, the analysis will overstate the value of the closely held debtor company.

In such a debtor company valuation, the analyst might have to apply a discount for lack of marketability (DLOM) valuation adjustment to the initial value indication in order to conclude the fair market value of the debtor company's ownership interest. The difference in the price that an investor is willing to pay for a liquid investment compared to an otherwise comparable but illiquid investment may be material. In the valuation vocabulary, this price difference is commonly referred to as the DLOM.

The DLOM measures the difference in the expected price between:

1. a liquid asset (the benchmark price measure); and
2. an otherwise comparable illiquid asset (typically, the subject closely held debtor company).

This section summarizes the following topics:

1. the considerations of investment liquidity and illiquidity;
2. the various empirical and theoretical models that analysts may use to estimate the controlling interest DLOM;
3. the application of the DLOM to the valuation of a closely held debtor company controlling ownership interest; and
4. the factors that analysts consider in the selection of the appropriate measure of the controlling interest DLOM.

Consideration of Investment Liquidity

The terms "marketability" and "liquidity" are sometimes used interchangeably, but there are differences between the two terms. Barron's Dictionary of Business Terms defines "marketability" and "liquidity" as follows:

Marketability. Speed and ease with which a particular security may be bought and sold. A stock that has a large amount of shares outstanding and is actively traded is highly marketable and also liquid. In common use, marketability is interchangeable with liquidity, but liquidity implies the preservation of value when a security is bought or sold.¹⁴

The investment attribute of marketability is not an either/or proposition; there are varying degrees of investment marketability. In fact, there is a continuous spectrum of marketability, ranging from fully marketable to fully nonmarketable.

An ownership interest of a publicly traded security typically can be converted into cash quickly, at low cost, and with certainty of price. This is the typical investment benchmark for a fully marketable investment. At the other end of the marketability spectrum is an ownership interest in a closely held debtor company that pays no dividends or other distributions, requires capital contributions, and limits the ownership of the debtor company to certain individuals (e.g., current employees). Of course, there are a number of valuation subject-specific positions in between these two extremes in the marketability spectrum.

Typical Reasons to Apply a valuation Adjustment

In the U.S. public capital markets, a securityholder can quickly sell most publicly traded securities at or near the last public trade price. The security sale transaction typically occurs at a very small commission cost.

By contrast, the population of potential buyers for most closely held debtor company ownership interests is a small percentage of the population of potential buyers for publicly traded securities. In fact, it may be illegal for an individual or an issuer to sell closely held debtor company securities to the general public without first registering the security offering with either the Securities Exchange Commission (SEC) or the relevant state corporation commission. Such a security offering registration is an expensive and time-consuming process.

Besides the problems associated with selling a closely held debtor business ownership interest, it is also difficult to hypothecate closely held debtor company securities. That is, the value of the closely held debtor ownership interest is further affected by the unwillingness of banks and other lending institutions to accept such securities as loan collateral. Because of these differences in the ability to sell or hypothecate a closely held debtor company ownership interest (compared to publicly traded shares), empirical evidence suggests that the appropriate DLOM valuation adjustment may be significant.

Baseline from Which to Apply the DLOM

In the valuation of a closely held debtor company, the analyst typically applies one or more of the three generally accepted business valuation approaches: market approach, income approach and asset-based approach. Depending on the individual valuation variables used, these three business valuation approaches may conclude value indications on either:

1. a controlling ownership interest basis level of value; or
2. a noncontrolling ownership interest basis level of value.

In the typical application of the three business valuation approaches, the resulting value indications are typically concluded on a marketable ownership interest basis.

The amount of the DLOM depends on the facts and circumstances related to the closely held debtor company ownership interest. This section summarizes the factors that an analyst typically considers in the measurement and selection of the DLOM.

Certain engagement-specific factors may also affect the appropriate magnitude of the DLOM. One engagement-specific factor that analysts consider is the particular level of value sought in the bankruptcy valuation engagement. This section focuses on measuring the DLOM in the context of a controlling ownership interest level of value.

Illiquidity for a Controlling Ownership Interest

Controlling ownership interests suffer from illiquidity in somewhat the same way as noncontrolling ownership interests. The marketability of an ownership interest — whether controlling or noncontrolling — is determined by the ability of the owner to quickly, at low cost and with some degree of certainty, convert the ownership interest to cash.

Numerous judicial decisions have affirmed the application of a DLOM to the valuation of a controlling business ownership interest.¹⁵ This valuation adjustment is a function of both (1) the valuation methods used and the valuation variables used by the analyst, and (2) the level of value that is the objective of the subject valuation. The value of a controlling business ownership interest suffers some value decrement (compared to an otherwise comparable but readily marketable security). This value decrement is due to the absence of a ready private placement market and flotation costs (which would be incurred in achieving liquidity through a public offering).

The business owner faces the following transaction risk factors when attempting to liquidate the controlling (or even 100 percent) business ownership interest:

1. an uncertain time horizon to complete the offering or sale;
2. "make ready" accounting, legal and other costs to prepare for and execute the offering or sale;
3. risk as to the eventual sale price;
4. uncertainty as to the form (e.g., stock or cash) of transaction sale proceeds;
5. inability to hypothecate the subject equity interest; and
6. investment banker or other brokerage fees.

Risk factors one through five are summarized below. A summary of risk factor six is presented in the Cost to Obtain Liquidity Studies section.

Investment Time Horizon Uncertainty

It may take months (or even years) to complete the offering or sale of a closely held debtor company controlling ownership interest. This uncertain (but considerable) market exposure period time horizon contrasts with the principle of marketability. The principle of marketability typically implies a short ownership-interest-for-cash conversion period.

"Make Ready" Costs

As discussed below (in the Cost to Obtain Liquidity Studies section), the closely held company owner may incur substantial costs to (1) prepare the company for sale and (2) execute the company offering or sale. A study published in 2000 concluded that underwriter costs alone typically represent 7 percent of the deal size in an initial public offering (IPO).¹⁶These underwriter costs do not include:

1. related auditing and accounting fees;
2. legal costs to draft documents, clear contingent liabilities and negotiate warranties; and
3. business owner administrative costs.

In "The Cost of Going Public," Jay Ritter estimated these "other" transaction costs to be between 2.1 percent and 9.6 percent of the IPO proceeds.¹⁷

Expected Sale Price Uncertainty

The seller of the controlling ownership interest in the debtor company may not achieve the expected sale price because of many factors:

1. overstatement of the business valuation on which the expected price is based;
2. occurrence of debtor company events during the market exposure period that cause the sale price to decrease;
3. occurrence of market events during the market exposure period that cause the sale price to decrease;
4. lack of receptivity by capital markets to companies in the debtor company's subject industry; and
5. lack of receptivity by capital markets to the subject

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