By: Nestor Cruz
In past issues of this publication, we published a three-part article on the valuation of closely-held businesses. We used as illustration the recent Tax Court valuation case Estate of Gallagher v. Commissioner of Internal Revenue, TCM 2011-148 (2011). In this article we will discuss the marketability discounts which might be applied once the value of a company has been ascertained. Preliminarily, in the valuation of closely held businesses, two types of marketability discounts apply: a minority discount and a lack of marketability discount. Although similar, there is a discernible difference between the two.
The minority discount is designed to reflect the decreased value of shares which do not convey control of the company. The lack of manageability discount, on the other hand, is designed to reflect that there is no ready market for shares in closely-held business. The values are multiplied, not added. Although the court stated the minority discount is applied first, followed by the lack of marketability discount, it really does not make a difference since in multiplication order of the factors does not make a difference since in multiplication the order of the factors does not alter the product. For example, assume a minority discount of 20% and a lack of marketability discount of 25% are applicable. The resulting combined discount is 40% (1-0.80 x 0.75). If one simply added the discounts the result would be 45%. In general, by multiplying the discounts the resulting total discount is smaller than by simply adding them.
In Gallagher Thomson, the Internal Revenue Service’s (IRS) expert, proposed a 17% minority discount based on studies of control premiums. He argued the inverse of control premium “equates to a minority interest discount.” He then proposed a 31% discount for lack of marketability. He found a minority discount unnecessary because under his discounted cash flow analysis, the cash flows would accrue pro rata to all shareholders and, therefore there was no need for “further adjustment” to reflect a minority interest value.
To calculate the minority interest discount after concluding it is the mathematical inverse of a control premium, Thomson, the IRS expert, reviewed statistics on control premiums in mergers and acquisitions. He found the median premiums for all industries to be 34.4% in 2002 and 31.6% in 2003; where the purchase price was between $100 million and $500 million 30.3% and 27.4%. On the basis of these statistics, Thomson concluded a 20% control premium was reasonable. Such a premium translates into a 17% discount (1 – 1.0/1.2).
The court agreed with Thomson’s general approach but disagreed with his figure. The premium Thomson proposed was about 10 percentage points below the premiums in the studies cited. For example, if one were to average the four control premiums cited in the prior paragraph, one would come up with a figure of 30.9% control premium. Since Thomson did not justify his low control premium, the court determined a 30% control premium was applicable, resulting in a minority discount of 23% (1 – 1.0/1.3).
Thomson determined a 31% lack of marketability discount after reviewing seven independent restricted stock studies which showed an average discount of 32.1%. May, taxpayer’s expert, computed a 30% lack of marketability discount based on the same seven studies and two additional pre-initial public offering studies. The court was hesitant to rely on the studies since the holding periods in the studies differed from the presumed holding period in the case before it. Nevertheless, noting both experts’ reliance on the studies, the court accepted them as benchmark figures and found a discount of 31% for lack of marketability.
Thus, the combined discount found by the court was 47% (1 – 0.77 x 0.69) , which seems fair but perhaps not that easy to obtain short litigation. For example, the court found a 23% minority discount. Some historical studies have found data points with discounts lower than 10%. The court found a 31% lack of marketability discount, yet there are historical studies with data points lower than 13%. Al of us, of course, would be quite happy if 47% combined discounts became standard without the necessity of litigation or other expense. Regrettably, every discount proposed to the IRS by a taxpayer must be substantiated without any guarantee of acceptance, as illustrated by the protracted litigation in this case.