The Discount for Lack Of Marketability (DLOM)

The difference in price an investor will pay for a liquid asset compared to a comparable illiquid asset is often substantial and one of the largest components in a valuation adjustment. The measurement of the DLOM continues to be a controversial topic especially with regard to valuations performed for gift and estate tax, shareholder litigation, buy-sell agreements, and family law purposes.

There are varying degrees of marketability. In the United States public capital markets, a security owner can sell an actively traded security over the telephone or internet and typically receive the proceeds, net of a small transaction cost, within three business days. The other extreme is represented by a hypothetical private business that pays no dividends or distributions, requires periodic capital contributions, has significant risk factors related to management depth and concentrations in customers, and places restrictions on subsequent ownership transfers.

There are other characteristics of a closely held entity that further impair marketability; the population of potential buyers of a closely held entity is much smaller than the population of buyers of a publicly traded entity; a minority shareholder is unable to register closely held shares for public trading, and; banks are typically unwilling to accept closely held stock as collateral as they would accept publicly traded shares.

Empirical evidence indicates that the DLOM for closely held securities is within a range of 25% to 50% compared to publicly traded securities. However, the specific facts and characteristics of each security and the specific company will determine the magnitude of the DLOM.

In Bernard Mandelbaum v. Commissioner (T.C. Memo 1995-255, June 12, 1995) Judge Laro raised 10 key factors to be considered in determining an appropriate DLOM.

These are:

1. Private vs. public sales of the subject company stock or stock sales of similar public companies.

2. An analysis of the subject company's financial statements.

3. The subject company's dividend policy.

4. The nature of the subject company, its history, position in the market, and economic outlook.

5. The subject company's management.

6. Degree of control transferred with the block of stock to be valued.

7. Any restrictions on the transferability of the subject company stock.

8. Period of time an investor mush hold stock to realize a sufficient profit.

9. The subject company’s redemption policy.

10. Costs associated with making a public offering.

A strong valuation report presents a convincing and detailed argument of the actual factors that impact marketability and are unique to each situation.

Buy Sell Agreements and Book Value

Once again, an outdated buy-sell agreement is the cause of legal action. This case was filed on behalf of the estate of Claudia L. Cohen by its executor, Ronald Perelman, against Booth Computers (a family partnership) and Claudia’s brother, James Cohen. Superior Court of New Jersey, Appellate Division, Docket No. A-0319-09T2, on appeal from the Superior Court of New Jersey, Chancery Division, Bergen County, Docket No. C-135-08.

Booth Computers (Booth) was established in the late 1970’s by Robert Cohen and later assigned to his three children, Claudia, Michael, and James, in equal shares. Booth was a 45% limited partner in another partnership that owned an oceanfront estate in Palm Beach, Florida, in addition to two warehouse buildings. The fair market value of the real estate holdings at date of death was estimated by appraisers in excess of $40 million and Booth’s 45% ownership interest was worth approximately $18 million, before considering any discounts. Claudia and James Cohen each held a 50% ownership interest in the partnership at date of death.

The buyout provision of Booth Computers, drafted in the late 1970’s, specified the following:

Each of the Partners has considered the various factors entering into the valuation of the Partnership and has considered the value of its tangible and intangible assets and the value of any goodwill which may be present. With the foregoing in mind, each of the Partners has determined that the full and true value of the Partnership is equal to its net worth plus the sum of FIFTY THOUSAND ($50,000.00) DOLLARS. The term "net worth" has been determined to be net book value as shown on the most recent Partnership financial statement at the end of the month ending with or immediately preceding the date of valuation;

Claudia Cohen passed away on June 15, 2007. Under the buyout agreement, the estate’s 50% interest in the partnership was calculated at $178,000. The estate filed suit claiming the term “net book value” is sufficiently ambiguous to encompass fair market value.

The judge noted that the buyout provision had been invoked once before, in 1998, after the death of their brother, Michael, one of the other partners. The buyout at that time was calculated in the same manner and amounted to an entity value of only $98,000. Further, the judge noted the disparity between book value and fair value, but stated the controlling factor is the language of the partnership agreement. The judge noted that the agreement specifically states the term “net worth” is to be net book value.

On appeal, the decision supporting the buyout at net book value was affirmed. In support of his conclusion, the judge observed:

I find that the actual historical treatment of value by Booth over the years comports with the plain language of the buyout provisions: no reference to actual, market value, but rather consistent reference to standard business practices applicable to this business and most business – value pegged to book value, which, in turn, reflects costs, does not reflect increases or decreases in asset values, but does change depending upon whether additional contributions are made and/or withdrawals or distributions taken.

This is another reminder to review your buy-sell agreement annually. We are able to assist you to ensure that the valuation provision in your agreement provides the outcome you desire.

Contact us today to review your buy-sell agreement.

The Doom of Discounts

The fate of valuation discounts has been most recently challenged in a bill introduced in Congress by Representative Earl Pomeroy of N. Dakota. On January 9, 2009, Mr. Pomeroy introduced a bill HR 436 which could pave the way for the demise of valuation discounts applicable to transfers of interests in estate planning entities such as the Family Limited Partnership, if it carries non-business assets. As defined in the bill, non-business asset means any asset which is not used in the active conduct of 1 or more trades or businesses. Example of a non-business asset would be marketable securities, which are generally wrapped up in a family limited partnership. The wrapper of family limited partnership helps estate planners to reduce the taxable value of transfered interest by application of valuation discounts.

The focus of this bill is to eliminate the use of customary valuation discounts, such as the discount for lack of control and lack of marketability, in determining the value of the transferred interest. According to the bill:

"the value of any non-business assets held by the entity shall be determined as if the transferor had transferred such assets directly to the transferee (and no valuation discount shall be allowed with respect to such non-business assets)."

Additionally, the bill emphasizes that in the case of the transfer of any interest in an entity not actively traded, no discount for lack of control will be allowed if the entity is controlled by family members.

It remains to be seen if the bill will be enacted by Congress. Please contact us with any questions or if you are in need of valuation services.

FMV Definition for Healthcare Industry

Under Stark Laws the term fair market value ("FMV") is defined as follows:

Fair market value means the value in arm’s length transactions, consistent with the general market value. "General market value" means the price that an asset would bring as the result of bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party, or the compensation that would be included in a service agreement as the result of bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party, on the date of acquisition of the asset or at the time of the service agreement.