Business Valuation. Discounts. and. Premiums SECOND EDITION. Shannon P. Pratt

Transcription

1 Business Valuation Discounts and Premiums SECOND EDITION Shannon P. Pratt

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3 Business Valuation Discounts and Premiums

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5 Business Valuation Discounts and Premiums Second Edition SHANNON P. PRATT John Wiley & Sons, Inc.

6 This book is printed on acid-free paper. 1 Copyright # 2009 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, , fax , or on the web at Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, , fax , or online at Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at , outside the United States at or fax Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our Web site at Library of Congress Cataloging-in-Publication Data: Pratt, Shannon P. Business valuation discounts and premiums / Shannon P. Pratt. 2nd ed. p. cm. Includes bibliographical references. ISBN (cloth) 1. Business enterprises Valuation. I. Title. HG4028.V3P dc Printed in the United States of America

7 To the Appraisal Foundation and the Appraisal Standards Board publishers of the Uniform Standards of Professional Appraisal Practice (USPAP) which has done much to improve consistency in the appraisal profession.

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9 Contents List of Exhibits xv About the Author xix About the Contributing Authors xxi Foreword Preface xxv xxvii Acknowledgments xxix 1 Overview of Business Valuation Discounts and Premiums and the Bases to Which They Are Applied 1 Discounts and Premiums Are Big-Money Issues 2 Entity Level versus Shareholder Level Discounts and Premiums 3 How the Valuation Approaches Used Affect the Level of Value 8 Use of Public Company Data to Quantify Discounts and Premiums 9 How the Standard of Value Affects Discounts and Premiums 10 American Society of Appraisers Business Valuation Standard VII: Valuation Discounts and Premiums 12 Summary 13 2 Minority Discounts and Control Premiums 15 Relevant Definitions 16 Basic Minority/Control Value Relationship 16 Prerogatives of Control 17 Factors Affecting Degree of Control 18 How the Valuation Methodology Affects the Minority Discount or Control Premium 25 Do Publicly Traded Minority Stock Prices Reflect Control Value? 29 Treatment of Control Premiums in the Delaware Courts 35 How the Purpose of the Valuation Affects Minority Discounts or Control Premiums 37 Summary 38 3 Empirical Data Regarding Minority Discounts and Control Premiums 41 Premiums Paid in Acquisitions 41 Identifying Industries with Higher or Lower Control Premiums 62 Caveats Regarding Use of Control Premium Data 63 Are Control Premiums Too High? 65 vii

10 viii Contents Percentage Discounts from Net Asset Value 66 Summary 66 4 Minority Discounts and Control Premiums in the Courts 68 Gift, Estate, and Income Tax Cases 70 Discounts for Lack of Control in Employee Stock Ownership Plan Cases 74 Dissenting Shareholder Cases 75 Shareholder Oppression Cases 80 Marital Dissolution Cases 80 Bankruptcy Case 82 Summary 82 5 Discounts for Lack of Marketability for Minority Interests: Concept and Evidence 86 Public Market Benchmark for Marketability 86 Empirical Evidence to Quantify Discounts for Lack of Marketability 87 Restricted Stock Studies 88 Pre Initial Public Offering Discount for Lack of Marketability Studies 90 Courts Aversion to Benchmarking 91 Regulatory and Court Recognition of Empirical Marketability Discount Studies 92 Summary 92 6 Synopsis of Restricted Stock Studies 95 Securities and Exchange Commission Institutional Investor Study 96 Gelman Study 100 Trout Study 100 Moroney Study 101 Maher Study 101 Standard Research Consultants Study 101 Silber Study 101 FMV Opinions Study 103 Management Planning Study 104 Johnson Study 110 Columbia Financial Advisors Study 110 LiquiStat Database 111 Summary LiquiStat Database (Restricted Stocks, Options, Warrants, and Convertible Securities) 113 Restricted Stock as a Basis 114 Biases Beyond Illiquidity in Traditional Restricted Stock Studies 114 How LiquiStat Is Different 115 Options and Warrants in LiquiStat 116 Convertible Securities in LiquiStat 117 Summary 117

11 Contents ix 8 Blockage Discounts 118 Blockage Is Distinct from Restricted Stock 119 Factors to Analyze in Quantifying Blockage Discounts 119 Must Consider Ways of Selling Stock 122 Price Pressure and Market Exposure 122 Block Buyer Could Ameliorate Blockage Discount 122 Blockage Discounts Recognized in Estate and Gift Tax Regulations 123 Blockage Discounts in U.S. Tax Court 123 Financial Accounting Standards That May Affect Blockage Discounts 126 Blockage Discounts Used to Estimate Illiquidity Discounts 126 Summary John Emory Pre Initial Public Offering Discount for Lack of Marketability Studies Complete Underlying Data 128 Study #1: Adjusted Study, January 1980 June Study #2: Adjusted Study, January 1985 June Study #3: Adjusted Study, August 1987 January Study #4: Adjusted Study, February 1989 July Study #5: Adjusted Study, August 1990 January Study #6: Adjusted Study, February 1992 July Study #7: Adjusted Study, January 1994 June Study #8: Adjusted Study, November 1995 April Study #9: Adjusted Study, Dot-Com Companies, May 1997 March Study #10: Adjusted Expanded Study, May 1997 December Summary Valuation Advisors Discount for Lack of Marketability Study 182 Description of Study 182 Results of Study 184 Summary Factors Affecting Discounts for Lack of Marketability for Minority Interests 186 Size of Distributions 187 Prospects for Liquidity 191 Pool of Potential Buyers 193 Risk Factors 194 Summary Discounts for Lack of Marketability for Controlling Interests 200 Discounts for Lack of Marketability for Controlling Interests: A Controversial Concept 202 Control, Marketable Is an Oxymoron 202

12 x Contents Bases from Which Controlling Interest Discounts for Lack of Marketability May Be Deducted 202 Factors Affecting Controlling Interest Discounts for Lack of Marketability 204 Public versus Private Company Acquisition Multiples 207 Court Treatment of Controlling Interest Discounts for Lack of Marketability 210 Summary The Quantitative Marketability Discount Model: A Shareholder Level DCF Model 213 Introduction 213 The Structure of the Shareholder Level DCF Model 214 A Visual Representation of the Shareholder Level DCF Model 217 Factors Contributing to Marketability Discounts 218 Summary Marketability Discounts in the Courts Minority Interests 225 Gift and Estate Tax Cases 227 Employee Stock Ownership Plan Case 231 Dissenting Shareholder Cases 232 Minority Oppression Cases 234 Marital Dissolution Cases 234 Summary Marketability Discounts in the Courts Controlling Interests 241 Gift and Estate Tax Cases 241 Marital Dissolution Cases 243 Summary Voting versus Nonvoting Stock 245 Voting versus Nonvoting Stock Scenarios 245 Empirical Studies Show Little Differential for Small Minority Interests 246 Transactions Involving Premiums for Control Blocks 251 Court Cases Involving Voting versus Nonvoting Stock 251 Summary Key Person Discounts and Premiums 260 Empirical Evidence Supports Key Person Discount 261 Internal Revenue Service Recognizes Key Person Discount 263 Factors to Consider in Analyzing the Key Person Discount 264 Quantifying the Magnitude of the Key Person Discount 265 U.S. Tax Court Cases Involving Key Person Discounts 266 Key Person Discounts in Marital Dissolutions 270 Key Person Discounts in Other Types of Cases 272 Summary 274

13 Contents xi 18 Discounts for Trapped-In Capital Gains Taxes 276 Rationale for Trapped-In Capital Gains Tax Discount 277 General Utilities Doctrine 277 Tax Court Recognizes Trapped-In Capital Gains 278 Internal Revenue Service Acquiesces to Trapped-In Capital Gains Discount 279 Subsequent Tax Cases Regularly Recognize Trapped-In Capital Gains Tax Discount 280 Trapped-In Capital Gains in Dissenting Stockholder Actions 282 Trapped-In Capital Gains in Bankruptcy Court 283 Trapped-In Capital Gains Taxes in Marital Dissolutions 283 Treatment of Capital Gains Tax Liability 286 Treatment of Capital Gains Tax Liability in S Corporations 288 Summary Nonhomogeneous Assets ( Portfolio ) Discounts 291 Portfolio Discount Principle 291 Empirical Evidence Supporting Portfolio Discounts 292 How to Value Companies with Disparate Portfolios 294 Quantifying the Portfolio Discount 295 Portfolio Discounts in the Courts 295 Summary Discounts for Environmental, Litigation, and Other Contingent Liabilities 300 Concept of the Contingent Liability Discount 300 Financial Accounting Standard #5 May Provide Guidance in Quantifying Contingent Liabilities 301 Treatment of Contingencies in the U.S. Tax Court 301 Treatment of Contingencies in Marital Dissolution 304 Summary Discount Adjustments for Limited Partnership Interests and Other Asset Management Entities 305 Introduction 307 Partnership Features 307 Other State Law and Regulatory Issues 308 Compliance with Federal Income Tax Regulations 308 Compliance with Federal Transfer Tax Regulations 309 Analysis of Ownership and Classes of Interests 309 Analysis of Underlying Adjusted Net Asset Value 310 Analysis of Income Capacity Value 310 Valuation of Noncontrolling Entity Interests 311 Discounts for Lack of Control and Marketability 313 Court Cases Regarding Limited Partnership Values 315 Summary 321

14 xii Contents 22 Adjusting Values for Differences in Size 323 Income Approach 323 Market Approach 325 Criticisms of the Size Premium 329 Court Cases Involving the Size Premium 329 Summary 334 Sources of Additional Data Discounts and Premiums in ESOP Valuations 337 ESOP Definition, Types, and Benefits 337 Adequate Consideration for ESOP Valuation Purposes 338 Control Premiums in ESOP Valuations 339 Discounts for Lack of Marketability in ESOP Valuations 339 ESOP Court Cases 340 Summary Discounts and Premiums in Divorce Disputes 345 Control Premiums in Divorce 345 Discounts for Lack of Marketability in Divorce 345 Discounts for Lack of Voting Rights in Divorce 346 Key Person Discounts in Divorce 346 The Effective Discount for Personal Goodwill in Divorce 346 Active versus Passive Appreciation 347 Summary Discounts and Premiums in Corporate and Partnership Dissolution and Oppression Cases 349 Dissolution for Shareholder (Partner) Oppression 349 Discounts 351 California Oppression Cases 357 Delaware s Approach 359 Summary Discounts and Premiums in Fair Value for Financial Reporting 362 Introduction 362 Fair Value of Reporting Units 363 Fair Value of Share-Based Compensation 369 Summary 371 Additional Reading Premium and Discount Issues in Undivided Interest Valuations 372 Description and Characteristics of Undivided Interests 373 Appraisal of Assets in Fee-Simple Interest 376 Factors Affecting the Value of an Undivided Interest 379

15 Contents xiii Valuation Adjustments for Undivided Interests 381 Court Decisions Related to Undivided Interest Discounts 389 Summary Common Errors in Applying Discounts and Premiums 397 Using Synergistic Acquisition Premiums to Quantify Premiums for Control 398 Assuming That the Discounted Cash Flow Valuation Method Always Produces a Minority Value 398 Assuming That the Guideline Public Company Method Always Produces a Minority Value 398 Valuing Underlying Assets Rather Than Stock or Partnership Interests 399 Using Minority Interest Marketability Discount Data to Quantify Marketability Discounts for Controlling Interests 399 Using Only Restricted Stock Studies (and Not Pre Initial Public Offering Studies) as Benchmark for Discounts for Lack of Marketability 399 Inadequate Analysis of Relevant Factors 400 Indiscriminate Use of Average Discounts or Premiums 400 Applying (or Omitting) a Premium or Discount Inappropriately for the Legal Context 400 Applying Discounts or Premiums to the Entire Capital Structure Rather than Only to Equity 401 Quantifying Discounts or Premiums Based on Past Court Cases 401 Using an Asset Appraiser to Quantify Discounts or Premiums for Stock or Partnership Interests 401 Summary 401 Appendix A Bibliography 403 Books 403 Articles 404 Periodicals 407 Appendix B Data Resources 410 Control Premiums/Minority Discounts 410 Discounts for Lack of Marketability 410 Discounts from Net Asset Value for Limited Partnership Interests 412 Discounts from Net Asset Value for REITs and REOCs 413 Discounts from Net Asset Value for Closed-End Investment Funds 413 Discount and Capitalization Rates 414 Appendix C How Much Can Marketability Affect Security Values? 416 I. The Framework 417 II. The Upper Bound 418 III. A Comparison 420 IV. Conclusion 422 References 422

16 xiv Contents Appendix D Internal Revenue Service Revenue Ruling Section 1. Purpose 424 Sec. 2. Nature of the Problem 424 Sec. 3. Background and Definitions 424 Sec. 4. Securities Industry Practice in Valuing Restricted Securities 425 Sec. 5. Facts and Circumstances Material to Valuation of Restricted Securities 427 Sec. 6. Weighing Facts and Circumstances Material to Restricted Stock Valuation 428 Sec. 7. Effect on Other Documents 429 Appendix E Securities and Exchange Commission Rules 144 and 144A 430 History 442 Appendix F Table of Cases 448 Index 455

17 List of Exhibits 1.1 Estate of Weinberg v. Commissioner Experts and Court s Discounts from Net Asset Value Levels of Value in Terms of Characteristics of Ownership Levels of Value in Private Companies Based on Owners Options for Exit or Liquidity American Society of Appraisers Business Valuation Standard VII, Valuation Discounts and Premiums Definitions Relating to Minority Discounts and Control Premiums A Summary of State Voting Requirements for Approval of Sale of Assets as Business Combination B Summary of State Voting Requirements for Approval of Merger and Share Exchange Simple Two-Attribute Model Tradeoff between Liquidity and Control Schematic Relationship of Stock Market and M&A Market Articles and Conference Presentations Dealing with the Debate over the Question Do Publicly Traded Minority Stock Prices Reflect Control Value? Summary of How the Valuation Methodology Affects the Resulting Value Definitions of Terms Announce and Closing Dates, Total Deal Value Purchase Price/Share Mergerstat Unaffected Price ($) Mergerstat Control Premium Control Premiums by Industry Company Descriptions Target Financials (M$) Target Multiples Industry Premiums (Percent Premium Offered) Summary of Restricted Stock Transaction Studies Discounts on Purchase Price of Restricted Common Stock Classified by Trading Market Discounts on Purchase Price of Restricted Common Stock Classified by Institutional Purchaser Discounts on Purchase Price of Restricted Common Stock Classified by Size of Transaction and Sales of Issuer Average Discounts on Purchase Price of Restricted Common Stock Classified by Sales of Issuer by Year Discounts on Purchase Price of Restricted Common Stock Classified by Earnings of Issuer 99 xv

18 xvi List of Exhibits 6.6 Average Discounts on Purchase Price of Restricted Common Stock Classified by Earnings of Issuer by Year Distribution of Discounts in Gelman Study Original Purchase Discounts, Moroney Study (Discounts from the quoted market value of the same corporation s free stock of the same class) Analysis of Private Sales of Unregistered Common Stock, Management Planning Study Relationship between Revenues and Discount, Management Planning Study Relationship between Earnings and Discount, Management Planning Study Johnson Study LiquiStat Discounts for Restricted Stocks Restricted Stock Discounts from LiquiStat Warrant Discounts from LiquiStat Definitions of Blockage and Blockage Discount Summary of Selected Tax Cases Involving Blockage Discounts Fair Market Value Transactions That Occurred within Five Months Prior to an Initial Public Offering as Disclosed in the Prospectus, January 1, 1980 June 30, 1981; Adjusted: October 19, Fair Market Value Transactions That Occurred within Five Months Prior to an Initial Public Offering as Disclosed in the Prospectus, January 1, 1985 June 30, 1986; Adjusted: October 19, Fair Market Value Transactions That Occurred within Five Months Prior to an Initial Public Offering as Disclosed in the Prospectus, August 1987 January 1989; Adjusted: October 19, Fair Market Value Transactions That Occurred within Five Months Prior to an Initial Public Offering as Disclosed in the Prospectus, August 1987 January 1989; Adjusted: October 19, Fair Market Value Transactions That Occurred within Five Months Prior to an Initial Public Offering as Disclosed in the Prospectus, August 1990 January 1992; Adjusted: October 19, Fair Market Value Transactions That Occurred within Five Months Prior to an Initial Public Offering as Disclosed in the Prospectus, February 1992 July 1993; Adjusted: October 19, Fair Market Value Transactions That Occurred within Five Months Prior to an Initial Public Offering as Disclosed in the Prospectus, January 1994 June 1995; Adjusted: October 19, A Fair Market Value Transactions That Occurred within Five Months Prior to an Initial Public Offering as Disclosed in the Prospectus, November 1995 April 1997; Adjusted: October 19, B Discounts for Lack of Marketability Arising from Sales Transactions, November 1995 April 1997; Adjusted: October 19, A Pre-IPO Dot-Com Discount Study, May 1997 March 2000; Adjusted: October 19, B Discounts by SIC Code, Pre-IPO Dot-Com Discount Study, May 1997 March 2000; Adjusted: October 19,

19 List of Exhibits xvii 9.9C Supplementary Schedule, Pre-IPO Dot-Com Discount Study; Adjusted: October 19, D Footnote Summary, Pre-IPO Dot-Com Discount Study; Adjusted: October 19, Pre-IPO Discount Study, May 1997 December 2000; Adjusted: October 19, Emory Studies (after 2002 revision) Emory Studies (after 2002 revision) Sales vs. Option Transactions Emory Studies (after 2002 revision) Broken Down by Time before IPO Valuation Advisors Lack of Marketability Discount Study Transaction Report Legend for Valuation Advisors Lack of Marketability Discount Study Data Valuation Advisors Lack of Marketability Discount Study Transaction Summary Results by Year from The Partnership Re-Sale Discount Study Results Relationship between Quarters to Sell Block (Based on Trading Volume) and Discount, Management Planning Study Standard Research Consultants Study Management Planning Study Stability of Earnings Management Planning Study Level of Earnings Johnson Study Net Income Management Planning Study Level of Revenues Johnson Study Sales Levels of Value in Terms of Characteristics of Ownership Median P/E Offered: Public versus Private, Descriptive Statistics of Sample Domestic Transactions (Koeplin et al. Study) Private Company Discounts (Koeplin et al. Study) Descriptive Statistics of Sample Transactions (Officer Study) Private Company Discounts (Officer Study) Descriptive Statistics of Sample Transactions (De Franco et al. Study) Private Company Discounts (De Franco et al. Study) Enterprise and Shareholder Level DCF Assumptions The Two-Stage Enterprise DCF Model The Two-Stage Shareholder DCF Model The Marketability Discount Visual Representation of the QMDM The QMDM with No Agency Costs or Incremental Risks The QMDM with Agency Costs The QMDM with Incremental Risks Impact of Agency Costs and Incremental Risk on Marketability Discount Houlihan Lokey Howard & Zukin Study of Premiums Paid for Voting Rights A Transactions since 1993 in Which Premiums Were Paid for High-Vote Shares 252

20 xviii List of Exhibits 16.2B Analysis of Premiums Paid for High-Vote Shares since Portfolio Discounts Implied by AT&T and ITT Breakups Companies Classified as Conglomerates by Yahoo! Estimated Breakup Values of Existing Conglomerates Discounts Indicated in The Partnership Spectrum Study Long-Term Returns in Excess of CAPM with S&P 500 Benchmark Duff & Phelps Size Study for Use in CAPM Examples of the Size Premium in the CAPM Example of Adjusting for Size from Guideline Public Companies Dissolution Statutes Example Goodwill Impairment Calculation Summary of How the Valuation Methodology Affects the Resulting Value Definitions Related to Undivided Ownership Interests The Partnership Re-Sale Discount Studies, Tax Court s Calculations in Estate of Busch v. Commissioner Tax Court s Calculations in Estate of Williams v. Commissioner Tax Court s Calculations in Estate of Barge v. Commissioner 392

21 About the Author Shannon P. Pratt, CFA, FASA, ARM, MCBA, MCBC, CM&AA, is a well-known authority in the field of business valuation and has written numerous books that articulate many of the concepts used in modern business valuation around the world. Shannon Pratt is Chairman and CEO of Shannon Pratt Valuations, Inc., a business valuation firm headquartered in Portland, Oregon. He is also a member of the board of directors of Paulson Capital Corporation, an investment banking firm that specializes in small cap IPOs. Over the last 40 years, he has performed valuation engagements for mergers and acquisitions, employee stock ownership plans (ESOPs), fairness opinions, gift and estate taxes, incentive stock options, buy-sell agreements, corporate and partnership dissolutions, dissenting stockholder actions, damages, marital dissolutions, and many other business valuation purposes. He has testified in a wide variety of federal and state courts across the country and frequently participates in arbitration and mediation proceedings. He holds an undergraduate degree in business administration from the University of Washington and a doctorate in business administration, majoring in finance, from Indiana University. He is a Fellow of the American Society of Appraisers, a Master Certified Business Appraiser, a Chartered Financial Analyst, a Master Certified Business Counselor, and is certified in mergers and acquisitions. Dr. Pratt s professional recognitions include being designated a life member of the Business Valuation Committee of the American Society of Appraisers, a life member of the American Society of Appraisers, past chairman and a life member of the ESOP Association Advisory Committee on Valuation, a life member of the Institute of Business Appraisers, the Magna Cum Laude in Business Appraisal award from the National Association of Certified Valuation Analysts, and the distinguished service award of the Portland Society of Financial Analysts. He recently completed two three-year terms as trustee-at-large of the Appraisal Foundation. Dr. Pratt also is certified by the American Society of Appraisers in Appraisal Review and Management (ARM), enabling him to conduct multi-disciplinary valuation reviews. Dr. Pratt is the author of Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th edition, published by McGraw-Hill, the co-author with Roger Grabowski of Cost of Capital: Applications and Examples, 3rd edition, the co-author with Jay Fishman and William Morrison of Standards of Value, author of The Market Approach to Valuing Businesses, 2nd edition, Business Valuation Body of Knowledge, Business Valuation Discounts and Premiums, and co-author with the Honorable David Laro of Business Valuation and Taxes: Procedure, Law and Perspective, all published by John Wiley & Sons, and the co-author with Alina Niculita of The Lawyer s Business Valuation Handbook, 2nd edition, published by the American Bar Association. He is also co-author of Guide to Business Valuations, 19th edition, published by Practitioners Publishing Company, and is the co-author of Valuing Small Businesses and Professional Practices, 3rd edition, published by McGraw-Hill. He is publisher emeritus of a monthly newsletter, Business Valuation Update (primarily for the professional appraisal community). xix

22 xx About the Author Dr. Pratt develops and teaches business valuation courses for the American Society of Appraisers and the American Institute of Certified Public Accountants, and frequently speaks on business valuation at national legal, professional, and trade association meetings. He also developed and often teaches a full-day seminar (sometimes divided into two partial days) on business valuation for judges and lawyers.

23 About the Contributing Authors Frances (Xudong) Fan is a financial analyst at Shannon Pratt Valuations, Inc., in Portland, Oregon. She passed the Chartered Financial Analyst (CFA) Level I test and is a non-accredited member of the American Society of Appraisers. At Shannon Pratt Valuations, Ms. Fan works on the essential aspects of business valuation, such as economic analysis, financial statement analysis, discount rate development, and report writing. She also assisted in researching, editing, and contributing to The Lawyer s Business Valuation Handbook, 2nd edition. Ms. Fan holds an MBA with an emphasis in Finance from Portland State University, and a MS with major in Material Science and Engineering from Tsinghua University, China. She also received a BS with double major in Material Science and Computer Science from Zhejiang University, China. Noah J. Gordon, Esq., is Legal Counsel for Shannon Pratt Valuations, Inc., in Portland, Oregon, where he is regularly involved with business valuations. He has served as a contributing author and editor of several legal treatises and publications, and regularly contributes to various business valuation publications. Most recently, he has contributed to Guide to Business Valuations, 19th edition (2009), The Lawyer s Business Valuation Handbook, 2nd edition (2009), BVR s Guide to Personal v. Enterprise Goodwill (2009), BVR s Annual Guide to Fair Value in Dissent, Oppression and Marital Dissolution (2008), Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th edition (2008), Standards of Value (2006), and The Market Approach to Valuing a Business (2005), 2nd edition. He also maintains a freelance editorial business. Mr. Gordon is admitted to the bars of Oregon, New York, New Jersey, the District of Columbia, and the United States Supreme Court. Roger J. Grabowski, ASA, is a Managing Director at Duff & Phelps LLC. He was formerly Managing Director of the Standard & Poor s Corporate Value Consulting practice, a partner of PricewaterhouseCoopers LLP and one of its predecessor firms, Price Waterhouse (where he founded its U.S. Valuation Services practice and managed the real estate appraisal practice). He has directed valuations of businesses, interests in businesses, intellectual property, intangible assets, real property, and machinery and equipment. Roger has testified in court as an expert witness on the value of closely held businesses and business interests, matters of solvency, valuation and amortization of intangible assets and other valuation issues. His testimony in U.S. District Court was referenced in the U.S. Supreme Court opinion decided in his client s favor in the landmark Newark Morning Ledger case. Roger co-authors the annual Duff & Phelps Risk Premium Report and is co-author with Shannon Pratt of Cost of Capital: Applications and Examples 3rd edition (Wiley). Roger teaches courses for the American Society of Appraisers, including Cost of Capital, part of the curriculum of the Center for Advanced Valuation Studies, a course he co-developed. Travis W. Harms, CPA/ABV, CFA, is a senior vice president of Mercer Capital. Travis s practice is primarily concentrated in valuation for financial reporting (compliance with SFAS 123, 141, and 142). He is experienced in the valuation of various intangible assets, employee options, restricted stock, and assets subject to specific contractual restrictions. He is the co-author of Business Valuation: An Integrated Theory Second Edition (John Wiley & Sons, 2008) with Z. Christopher Mercer, ASA, CFA and xxi

24 xxii About the Contributing Authors a co-author of Valuation for Impairment Testing (Peabody Publishing, LP, 2001). He is a senior member of the Financial Reporting Valuation Group. Travis is a sought-after speaker on many different business valuation topics. Curtis R. Kimball, CFA, ASA, is a managing director of Willamette Management Associates and is director of WMA s Atlanta regional office. He is a Chartered Financial Analyst (CFA) of the CFA Institute, an Accredited Senior Appraiser (ASA) of the American Society of Appraisers in business valuation, and a member of the Institute of Business Appraisers. Kimberly Linebarger is a Financial Analyst with Shannon Pratt Valuations, Inc., in Portland, Oregon. She is a contributor to Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th edition, and Guide to Business Valuations, 19th edition, and has assisted in researching and editing Cost of Capital: Applications and Examples 3rd edition. She holds a Bachelor of Science in Business Administration, with an emphasis in Finance, from Portland State University. Angelina McKedy is a senior analyst for Shannon Pratt Valuations, Inc., in Portland, Oregon. She has assisted in performing valuation assignments for litigation support and dispute resolution (including dissenting stockholder suits and marital dissolution cases), solvency opinions, and fairness opinions. In addition to her business valuations work, she also provides stock portfolio management. She has contributed to many of Shannon Pratt s books, and regularly contributes to Guide to Business Valuations. She holds a Bachelor of Science, Business Administration with an emphasis in Finance, Portland State University, and is a Candidate Member of the American Society of Appraisers. Z. Christopher Mercer, ASA, CFA, is founder and chief executive officer of Mercer Capital, a business valuation and investment banking firm serving a national and international clientele. He began his valuation career in the late 1970s. He has prepared, overseen, or contributed to hundreds, if not thousands, of valuations for purposes related to M&A, litigation, and tax, among others. He is a prolific author on valuation-related topics and one of the most sought after speakers on business valuation issues for national professional associations and other business and professional groups. Chris is the sole author of six books, including Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions? (Peabody Publishing, LP, 2007), Valuing Shareholder Cash Flows: Quantifying Marketability Discounts (Peabody Publishing, LP, 2005), Valuing Enterprise and Shareholder Cash Flows: The Integrated Theory of Business Valuation (Peabody Publishing, LP, 2004), Quantifying Marketability Discounts (Peabody Publishing, LP, 2001, & 1997), and Valuing Financial Institutions (Business One Irwin, 1992), and is a contributing author to Valuation for Impairment Testing (Peabody Publishing, LP, 2001). He has also published scores of articles and given numerous speeches on topics related to business valuation and investment banking. His latest book is Business Valuation: An Integrated Theory, Second Edition, which he co-authored with Travis Harms (John Wiley & Sons, 2008). Alina V. Niculita, CFA, MBA, is president and COO of Shannon Pratt Valuations, Inc., in Portland, Oregon. She is a Chartered Financial Analyst and a candidate for the ASA designation in business valuation. She is also a member of the CFA Institute, the American Society of Appraisers, and the Licensing Executives Society. At Shannon Pratt Valuations, Ms. Niculita works on all aspects of case management, including the fundamental aspects of business valuation and economic analysis and report writing. Ms. Niculita has been involved in business valuation engagements for various purposes, such as transactions in company stock, estate and gift taxes, and litigation support.

25 About the Contributing Authors xxiii Ms. Niculita has also worked on valuations of intangible assets and fairness and solvency opinions. Ms. Niculita is the assistant author of Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th edition, and the co-author of Business Valuation Body of Knowledge Workbook, 2nd edition, the Cost of Capital Workbook, and The Lawyer s Business Valuation Handbook, 2nd edition. She is also a contributor to BVR s Guide to Personal v. Enterprise Goodwill (2009). Espen Robak, CFA, is the founder and President of Pluris Valuation Advisors LLC and a nationally recognized expert on illiquid debt instruments, including auction-rate securities, FAS 157, valuations for alternative investment managers, and discounts for lack of liquidity; and a prolific author on valuation, accounting, and taxation topics. Recent articles include fair value of illiquid securities, auction-rate securities valuation, PIPE (private investment in public equity) valuations, amendments to Rule 144, illiquidity discounts, valuation of stock options, M&A arbitrage data, and restricted stock marketability discounts. Mr. Robak s expert commentary has been featured in the Wall Street Journal, Financial Times, Forbes, CFO Magazine, Bloomberg, Absolute Return, American Banker, The Deal, Compliance Week, Inside Market Data, Opalesque, Accredited Investor, andhedge Fund Manager Week. He is a columnist for Wealth Strategies Journal. Daniel R. Van Vleet, ASA, CBA, is a Managing Director in the Valuation & Financial Opinions Group at Stout Risius Ross, Inc. Prior to joining Stout Risius Ross, Inc., Mr. Van Vleet was a Managing Director with Duff & Phelps, LLC in its Valuation Advisory Services Group. Mr. Van Vleet is a contributing author to numerous business valuation textbooks and has lectured extensively on advanced subjects in the areas of business valuation, pass-through entity valuation, controversy, and corporate transactions. Mr. Van Vleet sits on the International Board of Governors of the American Society of Appraisers representing the business valuation profession. He also sits on the Board of Directors of the Business Valuation Association of Chicago, is a Past President of the Chicago Chapter of the American Society of Appraisers, and is a member of the valuation editorial review board for Trusts & Estates magazine. Mr. Van Vleet has served as an adjunct professor of finance at DePaul University and Northwestern University. He also serves as a business valuation instructor for the American Society of Appraisers.

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27 Foreword Jay E. Fishman I can t think of a more propitious time for Shannon Pratt to update his 2001 work on discounts and premiums. The confluence of difficult economic times, Congressional inquiry into the use of discounts in family limited partnerships, and the progression continuing toward fair value accounting for financial reporting has made a careful and comprehensive study of discounts and premiums more relevant than ever. We all know that the application of discounts and premiums depends upon the base from which the value has been developed. In other words, for discounts and premiums to be relevant, one must consider the characteristics of the property that is the subject of the valuation and the base from which discounts and premiums are applied. This invaluable resource provides valuation practitioners and users of appraisal services alike with a thorough understanding of the basis for the various discounts and premium. This update builds upon the 2001 work and provides the reader with a rigorously researched baseline of knowledge from which to apply relevant discounts and premiums in a defensible manner. One cannot discuss discounts and premiums without addressing the commonly accepted concept of Levels of Value. As an early developer of this concept, I have been pleased by its reception and the debate it has sparked. Its critics may be surprised to learn that it was never intended to be the sole prism from which the applications of discounts and premiums should be viewed. As readers may remember from the first edition of this book, the work of Nath, Bolotsky, Lee, and Matthews is discussed and their points of view explained. Each point of view has merit, but it should be noted that the traditional view is not static and the reader will see how it has changed over the years. But this edition contains so much more! Not only have the tables and references been updated but there is a considerable amount of new material. A plethora of new court cases have been added, changes to Rule 144 and 144A are discussed, and Chris Mercer and Travis Harms have completely rewritten the chapter on Quantitative Marketability Discount Model (QMDM). Most importantly, Shannon has added seven new chapters. New chapters such as Discounts and Premiums in Fair Value for Financial Reporting, The LiquiStat Database (Restricted Stock, Warrants and Convertibles), and Discounts and Premiums in ESOP Valuations are particularly timely. Like me, the reader may not agree with every position taken but will be impressed with the breadth and depth of the discussions on these various issues. One of the things that I admire most about Shannon is his boundless energy and steely determination to continue to add to the foundation of the body of knowledge that is the business valuation profession. This book is no exception. Shannon and I have taught, written, and lectured many times over the years, and I truly was honored when he asked me to write this foreword. Like me, all practitioners owe him a debt of gratitude for his continuing efforts. It has been said of Alexander the Great that upon learning he had conquered what he knew as the world, he cried as there were no new worlds to conquer. It will be interesting to see where Shannon directs his efforts in the future. Jay E. Fishman February 2009 xxv

28 xxvi Foreword Jay E. Fishman, FASA, is a Managing Director of Financial Research Associates and has been actively engaged in the appraisal profession since He specializes in the valuations of business enterprises and their intangible. Mr. Fishman has co-authored several books, including the recently released Standards of Value: Theory and Applications and the highly acclaimed Guide to Business Valuations (both with Shannon Pratt), and written numerous articles on business valuation as well as qualifying as an expert witness and providing testimony in twelve states. He has taught courses on business valuation to the Internal Revenue Service, the National Judicial College, and the Hong Kong Society of Accountants, on behalf of the World Bank in St. Petersburg, Russia, and most recently in Moscow, Russia. He holds a bachelor s and master s degree from Temple University, as well as an M. B.A. from LaSalle University. Mr. Fishman is a Fellow of the American Society of Appraisers, a former Chairman of the Business Valuation Committee of the American Society of Appraisers, Editor of the Business Valuation Review, Chair of ASA s Government Relations Committee, a former Trustee of the Appraisal Foundation, Chair of its Task Force on Best Practices for Financial Reporting, and was appointed to the Internal Revenue Service Advisory Committee in He was recently appointed to the Appraisal Standards Board of the Appraisal Foundation, publishers of the Uniform Standards of Professional Appraisal Practice (USPAP).

29 Preface In most business valuation disputes, the largest differences between the parties involve discounts and/or premiums. That is why this book is so important. The focus of this book is on: Understanding the basis for the various discounts and premiums Understanding when each of the discounts and/or premiums is or is not applicable under the facts and circumstances at hand How to defensibly quantify the magnitudes of the various discounts and premiums Courts treatments of the various discounts and premiums in various contexts. This knowledge will assist the preparer of the valuation to document a defensible conclusion the first time. Perhaps even more importantly, it will assist the reviewers of appraisal reports to identifyerrors,shortcomings,andstrengthsbothinappraisalscommissionedbythem and also in appraisal reports prepared on behalf of the opposition. The book addresses discounts and premiums in the following contexts: Gift, estate, and income taxes Marital dissolutions Corporate and partnership dissenting stockholder (partner) and oppression suits Fair value for financial reporting Undivided interest valuations ESOP valuations Bankruptcy reorganizations The outcome of valuation disputes usually is determined on the quality of evidence submitted by experts. In the hundreds of reports reviewed by me and my company, rarely does the report submitted for any of the above purposes thoroughly cover the issues of discounts and premiums. Moreover, in most of the cases that do end up in court, rebuttal evidence is weak on one or both sides. Discounts and premiums addressed in this book fall into two categories: Company level (those that apply to all owners): Key person Contingent liability or asset (e.g., environmental or lawsuit) Portfolio (nonhomogeneous assets) Trapped-in capital gains Shareholder level (those that apply to one or a specified group of owners): Lack of marketability Minority (lack of control) Voting versus nonvoting interests Blockage xxvii

30 xxviii Preface The first edition of this book was published in A lot has changed since then! We have updated all the tables and references. We have included many illustrative court cases decided in the last eight years. Other updates include: Rule 144 and 144A through October 2008 Chris Mercer and Travis Harms have completely rewritten the chapter on the Quantitative Marketability Discount Model (QMDM) We have added seven completely new chapters: Discounts and Premiums in Fair Value for Financial Reporting Adjusting the Values for Differences in Size The LiquiStat Database (Restricted Stock, Warrants, and Convertibles) Valuation Advisors Discount for Lack of Marketability Database Discounts and Premiums in Divorce Disputes Discounts and Premiums in Corporate and Partnership Dissolutions Discounts and Premiums in ESOP Valuations We have written this book both as a primer for those unfamiliar with business valuation discounts and premiums and as a well-indexed reference for the experienced. We believe that it will be useful to the following audiences: Business appraisers Attorneys dealing with business valuations Judges Corporate officers, especially CEOs and CFOs Fiduciaries, such as trustees and directors Government appraisers and reviewers of appraisals CPAs Investors Academicians and students of finance My staff at Shannon Pratt Valuations and I sincerely hope that this book will contribute to sounder and more thoroughly documented valuations that will stand up to critical scrutiny and ultimately carry the day. Shannon P. Pratt Shannon Pratt Valuations, Inc S.W. Beaverton-Hillsdale Highway, Suite 432 Portland, Oregon Phone: (503) shannon@shannonpratt.com Fax: (503) Web site: