Discounts for Lack of Marketability and Mandelbaum Factors
by Greg Caruso,
We have done a number of business valuations for clients who want to gift part or all of their business interest. These valuations require a discount for lack of marketability because they are generally considered less marketable than if that person was selling their business interest.
One of the best ways to estimate a marketability discount for small businesses is through use of the Mandelbaum Factors. There are other techniques to estimate a marketability discount, but most of them require quantitative data beyond what many small companies have. Mandelbaum is qualitative–namely more fact pattern specific.
What is the discount for lack of marketability (DLOM)?
Discounts for lack of marketability can come into play anytime an interest being valued will take time to sell when using the fair market value standard of value. Keep in mind that an interest may be a whole company, a majority but not whole company stock position, a small stock position of less than 1% ownership, or even debt such as a note. Each of these interests is different and may take different lengths of time to sell. During the time required to turn the interest into cash, many things can happen that may reduce the value of the interest. With small businesses it can be as simple as the sickness or death of the owner/manager. Larger competitors undercutting on pricing or perhaps changes in customer behavior. This risk can be estimated through the marketability discount.
What are the Mandelbaum Factors?
The Mandelbaum Factors were specified in the ruling Mandelbaum v. Commissioner of Internal Revenue T.C. Member 1995-255. (Click download below to read the decision.)
In the ruling, Judge Laro determined the marketability discount by looking at specific factors that impact value and weighing them. Usually, these factors are then compared to Restricted Stock Studies findings in order to estimate a result. To simplify, Restricted Stock Studies tend to show marketability discounts from 10% to 70% with a middle ground of about 35%. Restricted Stock Studies are often based on start-ups that are quite risky because those firms often issue restricted stock. Restricted Stock is stock that can only be sold publicly after a holding period which depending on the study may have been from 6 months to 2 years. The discount that was accepted by the seller in selling the restricted interest is used to estimate marketability discounts.
Below are Mandelbaum factors and a few other related factors that influence marketability. Some of these factors are mentioned in IRS Discount for Lack of Marketability Job Aid issued September 25, 2009.
History and outlook for business and industry; Financial factors such as revenues, earnings, ratios; Management; Likely holding period of interest; Redemption policy; Transfer of control; Restrictions on transfer of control; Cash distribution policy; Competitive position, nature of industry, risk of maintaining growth; Cost of public offering.
Click Here and download an example of one way to present these factors in a chart format.
The overall trend indicates a need for the adjustment for the marketability as this interest is much less marketable than a 100% control interest.
The commonly used fair market value standard assumes that the interest being sold is sold for cash or cash equivalents quickly. Public stocks and bonds have this type of marketability but most private companies do not. This means that in many cases a discount needs to be estimated.
The Internal Revenue Service will review the business valuation and DLOMs for tax purposes, so it is important to make these valuations supportable and all calculations accurate. As always, determining a business’s value is not just a strict science based on Mandlebaum Factors, but an art too that takes Mandlebaum and other discounts (if needed) into account.
Contact Greg today for exit and estate planning business valuations.