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Valuation discounts for lack of marketability

By Robert James Cimasi.

When the time arrives to consider a change with your practice, either selling or adding a partner or acquiring or merging with another practice, you will need to know the value of the practice(s) involved. Since most medical practices are closely-held (i.e., not publicly traded on a stock market) the relative marketability of the interest(s) being transferred in the transaction is an important consideration in arriving at its value. However, a basic understanding of the business valuation process is essential before considering the level of marketability.

The choice of approach(es) or method(s) from within the numerous generally accepted health care valuation approaches, methods and procedures, depends primarily upon the purpose of the valuation report and the specific characteristics of both the subject entity and the subject interest. The objective and purpose of the valuation engagement, the standard of value (answers the question, “Value to whom?, e.g., Fair Market Value), the premise of value (value-in-use as a going concern – or – value-in-exchange by orderly disposition or liquidation of assets), and the availability and reliability of data must also be considered by the business appraiser in the selection of applicable approaches and methods.

The three general classifications of business valuation approaches are:

·Income Approach” based methods measure the present value of anticipated future economic benefits that will accrue to the owner of the subject interest.

·Market Approach” based methods are premised on the foundation that actual transactions of similar entities provide guidance to value.

·Asset/Cost based Approach” methods seek an indication of value by determining the cost of reproducing or replacing an asset.

Following careful consideration of the value standard and premise sought, the purpose of the engagement and, importantly, the available data, the business appraiser selects the methods appropriate to employ given the specific facts and circumstances of the valuation. With each method utilized, certain adjustments should be considered based upon the specific requirements of each engagement and the inherent indication of value sought, i.e., the “level of value” that results from each method, e.g., the level of value for privately held entities is represented at a “closely-held” level (in contrast to “freely traded,” “marketable,” or “publicly traded” level).

The issue of marketability in business valuation derives from the consideration of the inherent risks and costs relative to the liquidity of investments in closely held, non-public companies that may not be relevant to the freely-traded investment in companies whose shares are publicly traded. Investors in closely-held companies do not have the same availability to dispose of an invested interest quickly if the situation is called for, e.g., forecasted unfavorable industry conditions or the investor’s personal immediate need for cash. This relative lack of liquidity of ownership in a closely held company is also accompanied by certain risks, delays and costs associated with the selling of an interest in such a company, i.e., locating a buyer, negotiation of terms, advisor/broker fees, risk of exposure to the market, etc. In contrast, investors in the stock market are most often able to sell their interest in a publicly traded company within hours and receive cash proceeds in a few days. Thus, a discount to the value of a closely held company due to the inherent illiquidity of the investment may be indicated. Such a discount is commonly referred to as a “discount for lack of marketability” (DLOM).

As a guidance for business appraisers, there have been several empirical studies performed over the years that attempt to quantify a DLOM on a minority basis, typically in three (3) categories: (1) transactions involving restricted stock of publicly traded companies; (2) private transactions of companies prior to their initial public offering (IPO); and (3) an analysis and comparison of the price-to-earnings (P/E) ratios of acquisitions of public and private companies respectively published in the “Mergerstat Review Study.”

It should be noted that publicly traded companies may sell unregistered securities through a private placement. These “restricted” stocks are very similar to the shares of stock of the same company that are publicly traded in the market except that restricted stocks are prohibited from trading for a designated period of time. Because of the risk associated with holding such an illiquid investment, purchasers of restricted stock typically require a discount from the price of the publicly traded price of the shares.

Several tables in Shannon Pratt’s 2001 Business Valuation Discounts and Premiums indicated that the average of 14 restricted stock studies (i.e., SEC Overall Average, SEC Nonreporting OTC Companies, Milton Gelman Study, Robert E. Moroney Study, Robert R. Trout Study, J. Michael Maher Study, Standard Research Consultants, Willamette Management Associates, William L. Silber Study, FMV Options, Inc., Management Planning, Inc., Johnson Study, Columbia Financial Advisors, Columbia Financial Advisors) revealed a range of indicated DLOM of 13.0 to 45.0 percent with an average discount of approximately 28 percent. Since 1997, when the SEC Rule 144 requiring a two year “holding period” before restricted stocks could be freely traded, was reduced to one year, there has been only one restricted stock study published. This study, by Columbia Financial Advisors, found an average DLOM of only 13 percent. The business appraiser should keep in mind that registered shares are not necessarily liquid. A shareholder, in combination with related parties, who owns greater than ten percent of a public company’s outstanding shares is subject to the sale restrictions under SEC rule 144. Failure to take this into consideration has been a criticism of the often cited Bajaj study (as cited in Gross v. Commissioner) [Hall, L., “Counteracting the New and Winning IRS Approach to Determine Discounts for Lack of Marketability,” 2004 March/April Valuation Strategies, Pgs. 16-19].

Two of the significant studies relating to the discounts of the price of private transactions and their subsequent IPOs are: (1) The Emory Studies, which had a range of 34 to 59 percent and an average of 46.3 percent [http://www.emorybizval.com/1980_2000_Underlying_Data.xls]; and, (2) Willamette Management Associates Studies, which had a range of 18.0 to 55.6 percent and an average of 37.3 percent [http://www.willamette.com/research/research-discount.html]. These empirical studies measured the difference in price of arm’s-length transactions involving private companies and the price of their stock at a subsequent IPO. However, there are indications that the Willamette Management Associates Studies 1999 and 2000 data may be skewed due to the dot.com “bubble” [Reilly, R., “Pre-IPO Study from Willamette Management Associates shows higher DLOM figures post dot.com boom,” January 2006 BV Update]. Each year, the “Mergerstat Review Study” looks at the variance of price to earnings (P/E) ratios of transactions involving the acquisition of public companies vs. transactions involving the acquisition of private companies. Transactions over the past ten years have resulted in a range of 8.38 to 33.33 percent and an average of 18.06 percent [Mergerstat Review 2007 (2006 data)].

Recent research and case law has confirmed that the business appraiser should not simply utilize the average discount from the various studies when considering the appropriate level of a DLOM adjustment. When valuing a minority interest, the business appraiser should review the restricted stock studies, pre-IPO studies and the Mergerstat Review studies discussed above, and when appropriate, consider them as a starting point in researching the level of a DLOM for the valuation. However, the appraiser should consider how (and to what extent) the subject interest differs from the average of the studies, as is suggested in Mandelbaum v. Commissioner [Chandler, W., “Business Valuation Recent Cases, Rulings and Interpretations,” BVR’s Guide to Discounts for Lack of Marketability, 2007, Pg. 6-52]. Other factors, to be considered in the determination of a DLOM specific to the subject entity may include, but are not limited to: the prospect of a pending or anticipated public offering; the level of value sought; the financial performance and position of the subject entity in comparison to its industry as a whole; the circumstances of the transactional marketplace; the existence or expectation of the payment of cash dividends; the comparative strength of management; the existence of key man risk; and, the nature and strength of the subject entity’s customer base [McLaughlin, D., “A Robust Approach for Justifying the Discount for Lack of Marketability in Business Appraisal Reports,” Winter 2006/2007 Business Appraisal Practices, Pgs. 22-30].

Valuation case law typically supports allowance of a DLOM when valuing a controlling interest. In Estate of Andrews v. Commissioner, the court stated that “even controlling shares in a nonpublic corporation suffer from lack of marketability because of the absence of a ready private placement market and the fact that flotation costs would have to be incurred if the corporation were to publicly offer its stock.” Further, most business appraisers agree that the application of a DLOM to a controlling interest is still appropriate [Pratt, S., Business Valuation Discounts and Premiums, 2001, Pg. 167]. However, currently there is a lack of empirical studies quantifying lack of marketability for controlling interests. Specific consideration in the determination of a DLOM on a control basis should include factors related to the operating structure and financial attributes of the subject entity in addition to costs that may be incurred by the subject entity in preparation for a sale include: accounting costs; legal costs; appraisal costs; management time; and, transactional costs [Pratt, S., Business Valuation Discounts and Premiums, 2001, Pgs. 171-172].

The careful consideration of an adjustment reflecting a DLOM in the valuation of a health care enterprise is especially important in light of significant regulatory restrictions on the transfer of closely held interests which are unique to health care, e.g., physician licensing, specialty board certification and credentialing requirements, corporate practice of medicine laws, certificate of need (CON) limitations, and medical staff privileges. In all cases, physicians seeking an appraisal of their practice, clinic or health care enterprise, should engage a competent, professional appraiser, certified in business valuation, and experienced in the appraisal of health care enterprises to conduct the process of considering any DLOM.

Robert James Cimasi, MHA, ASA, CBA, AVA, CM&AA, CMP, is President of Health Capital Consultants, in St. Louis, MO, with a professional focus on the financial and economic aspects of the health care industry.

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