In the realm of estate and gift tax valuation, the concept of Discount for Lack of Marketability (DLOM) plays a crucial role in determining the fair market value of closely held business interests. The DLOM reflects the reduced value of such interests due to their limited marketability compared to readily tradable securities like publicly traded stocks.
Originally developed to assist Internal Revenue Service (IRS) engineers, the DLOM Job Aid is also used by appraisers and valuation professionals in navigating the complexities of DLOM determination. This guide provides valuable insights into the factors that influence DLOM and offers guidance on applying the DLOM to various valuation approaches.
Understanding the IRS Job Aid for DLOM
The IRS Job Aid for DLOM outlines nine key factors to consider when evaluating the DLOM for a closely held business interest. These factors include:
Financial statement analysis: The financial health of the company plays a crucial role in its marketability.
Dividend history and policy: A consistent dividend history and policy enhances the attractiveness of the shares to potential investors.
Nature of the company: Factors like industry, track record, and market position influence marketability.
Company management: The experience and reputation of the management team affect marketability.
Amount of control in the transferred shares: Controlling interests are more marketable than minority interests.
Restrictions on transferability: Restrictions like buy-sell agreements reduce marketability.
Holding period for the stock: Longer holding periods may warrant a higher DLOM.
Subject company’s redemption policy: The frequency and terms of redemptions affect marketability.
Costs associated with a public offering: The costs of taking the company public reduce the net proceeds to shareholders.
Discounting serves as a valuable tool for determining fair market value for tax or estate planning purposes.
Applying the IRS Job Aid to Estate and Gift Tax Valuation
Thorough Familiarization: Begin by thoroughly reviewing the IRS Job Aid to gain a comprehensive understanding of the DLOM concept, the factors that influence DLOM, and the various methodologies for applying DLOM.
Valuation Approach Selection: Identify the appropriate valuation approach for the specific business being valued. Common approaches include Discounted Cash Flow (DCF) Analysis, Comparable Transaction Analysis, Guideline Public Company, and Capitalization of Income Approach.
DLOM Factor Analysis: Apply the nine DLOM factors outlined in the IRS Job Aid to the specific business being valued. This involves evaluating each factor and documenting its impact on marketability.
DLOM Quantification: Based on the analysis of the DLOM factors, quantify the appropriate DLOM percentage to be applied to the valuation. This may involve utilizing comparable DLOMs from similar businesses identified through qualitative evaluation such as Mandelbaum Analysis or applying valuation models including quantitative methods and Options Models that incorporate DLOM adjustments.
DLOM Integration: Integrate the quantified DLOM into the chosen valuation approach. For instance, in DCF analysis, the discount rate could be adjusted to reflect the DLOM.
Documentation: Thoroughly document the DLOM analysis, including the identification of relevant factors, the rationale for quantifying the DLOM, and the application of the DLOM to the valuation approach.
The IRS Job Aid for DLOM serves as an invaluable resource for appraisers and valuation professionals involved in estate and gift tax valuations of closely held businesses. By carefully considering the DLOM factors and applying the guidance provided in the Job Aid, appraisers can ensure that their valuations are well-supported, defensible, and compliant with IRS guidelines.
Valuing small business using financial statement evaluation and ratio analysis (quantitative analysis) can be difficult because companies do not tend to follow industry or GAAP standards. Even when cash flows are correct, other financial information may not compare well with available data. This means the business valuator must put more emphasis on understanding how the business really works beyond the numbers (qualitative analysis). This way, the valuator can determine if the business has resilience. Resilience allows the company to survive and thrive when roadblocks appear. This means that the business is more likely to meet financial forecasts, reducing risk. Here are a few soft factors that business valuators can review as part of proper qualitative analysis when quantitative analysis is not available.
What are the components to business valuation?
There are two main components to valuing a business. The first is forecasting future cash flow. Then, we determine the risks and likelihood that the risks will reduce the expected cash flow. We address risk using the discount or capitalization rate or the multiplier. The two components, cash flow and risk, are somewhat inseparable. For example, if we forecast a very high cash flow for a company, the risk of meeting the cash flow automatically goes up to some degree. In every business valuation the factors that should be reviewed and the impact on risk to the company can vary.
What are the qualitative or soft factors to review in business valuation?
What are the cash flow trends over time?
High margins and growth usually portend more good things.
What is the management structure and the size of the company?
Owner/operators who do everything create risk. If something happens to them, the business might be in a lot of trouble. Furthermore, most buyers do not want to stock shelves if the stock person does not show up.
What are the concentrations?
As I have said many times, concentrations kill. Yet small businesses are always going to have some. Concentrations can include geography (New York City was a much worse place to have a sit down restaurant in 2020 than most of Texas), management, suppliers, referrers, keywords (many an internet company lost profitability when keywords got too expensive), suppliers, referrers, customers, etc. For a small business, each of these create more risk than with larger companies in the same industry. They might even be way beyond what the typical small company comparable might have. For instance, we would have to adjust for more risk when comparing a commercial landscaper with only a few large clients to the typical landscaper with large number of smaller clients.
How well is the company organized?
Organized companies with standardized processes that work every time are much stronger and deserve high business valuations than when a few people make all decisions shooting from the hip. Remember what my dad said: “Great systems exist when average people get extraordinary results every time.”
What is the workforce and employee base like?
Traditionally, many industries have placed an emphasis on management. However, having a loyal, well-trained workforce increasingly brings strong value. In a technical world, ramp-up time and training costs can be significant. This can be reduced if a qualified workforce is in place.
What is the company culture like?
Company culture can be very hard to assess. But some companies have a culture of overcoming problems and obstacles, which can be an asset. This is an important asset. A motivated can-do company culture greatly reduces risk. But be aware, it can change as management changes.
Most of these quantitative factors in business valuation are hard to assess and translate into numerical risk assessments. (Eventually we do have to work it into our quantitative analysis.) Unfortunately, much of it will never get beyond the claim of professional judgement. In fact, it is why professional judgement is more important in small business valuation than many other accounting and finance functions. Sometimes it is easy to see the advantage, but hard to assess an exact increase or decrease due to the complex interplay of factors. For instance, problems that might be a small bump in a fast growing economy could be the kiss of death in a recession.
This is why I say that business valuation is an art and a science. If you have questions about business valuation for SBA loans or planning and exit or succession, estate and gift tax, or ESOP’s contact me today.
Gregory R. Caruso, Partner, Harvest Business, LLC t/a The Art of Business Valuation.
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.
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.
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.
When we are assessing a company in a business valuation, we look at a number of future risks, some of which I’ve discussed in previous blog posts. Discounts and premiums are adjustments we make to the estimate of value in business valuation based on risk and depending on modeling and comparisons to known sample sets. Today I want to talk about the marketability discount, which is based on both the time value of money and the risk that the value will decrease–or even disappear.
What is the marketability discount?
The Business Valuation Glossary defines marketability as “the ability to quickly convert property to cash at minimal cost.” Basically, can an owner in the business sell their interest quickly and with certainty about the final sales price? The marketability discount in business valuation is a discount calculated based on risk during the time involved to find a buyer and get to closing.
How does the discount for lack of marketability (DLOM) apply to valuations?
In many ways, this discount is magnified with small and very small businesses because they tend to have limited product offerings in limited geographic markets. This limitation means situations beyond their control can very quickly cause a large loss of value. These situations might include the loss of a major client, the illness of an owner, calling of a line of credit, a loss or disruption in supplies, or the loss of a franchise or license agreement, to name a few. You might know that these are a possibility, but they are not usually foreseeable during day-to-day operations, and usually don’t apply for a valuation that takes place at a specific time (before that risk becomes reality). If larger businesses are being valued for estate or gift tax more detailed analysis and review should be applied.
How does risk relate to marketability?
Many risks increase over time and are very tied to marketability. One of the harder issues is that sometimes risks are all-or-nothing risks. For example, a company that has essentially one contract (and few easy replacements) which can be terminated at will has a business concentration risk. This situation would justify a large discount for marketability, even if it may have a high cash flow that continues for a long time.
An example of this is a valuation of a business during a divorce where the business owner has a contract with a local school system that brings in $2,000,000 of revenues and the SDE cash flow is $500,000. But, the contract is at-will of the school administration, which tends to change every two or three years. While the revenue is good and may continue for a number of years, it could also disappear if the school administration chooses another vendor. This company has a risk that will make selling more difficult than most competitors, making a marketability discount appropriate even for a control owner. Fact patterns such as this require additional background, experience, and professional judgment.
What are the methods used to estimate the discount for lack of marketability?
Currently, the primary methods used to estimate the discount for lack of marketability (DLOM) in business valuation are the quantitative approach, the qualitative approach, and the option pricing models. Quantitative approaches use databases and data to attempt to quantify the DLOM. They are used for larger businesses that have clear financials and meaningful business ratios, and data can be compared carefully to database data and converted into a discount rate. Qualitative approaches provide a more general framework to compare the subject company to the databases, since detailed financial analysis is often impossible. Option pricing models such as Longstaff, Finnerty, and Chaffe each attempt to “model” the discount based on statistics and available option pricing formulas.
As I always say, business valuation is not a strict science, but an art and a science. This is especially true with the marketability discount, where there are many factors and risks that have to be taken into account. Contact me today to learn more about my professional business valuation services.
Business, Institutional, or Corporate goodwill and Personal Goodwill can be an important breakdown of the intangible value of the micro or small business. The brief video above explains the differences quite clearly.
A summary of key distinctions are below.
For most small businesses goodwill is the classification used on the balance sheet to show intangible asset value. The intangible asset value formula is below.
Value of the Business – Value of Tangible Assets = Goodwill or Intangible Asset Value
Tangible assets are cash, equipment and plant, accounts receivable, and other tangible things or assets. Intangible assets is the value created by the cash flows that are above the value of the tangible assets.
Goodwill is broken down into two broad classifications. Business, Corporate, or Institutional and Personal Goodwill. The concept is that the goodwill that a business has can be solely attached to the business or it can be attached to a key person, usually an owner.
This is typically determined by a weighting of attributes that indicate who really owns or controls the relationship. Extreme examples are a McDonald’s restaurant where no one cares about the franchise owner, the franchise system has all the goodwill. That is all corporate goodwill. The other extreme is an exceptional surgeon where everyone only wants her even if she is in a large practice. That is personal goodwill. Many small businesses have a mix of the two goodwills.
Personal goodwill can further be broken down into transferable goodwill which will transfer with non-compete agreements and a transition plan and pure personal goodwill that is really not transferable at all.
Personal goodwill is important in many states in business valuations for divorce as often the personal goodwill is not part of the marital estate. It also has application in estate and gift tax matters and other Federal Tax or IRS situations.
Clearly, business valuation is quite technical. To learn a little more, download the e-book “7 Things to Know About Business Valuation“ – and then connect with Greg if you have any questions about a business valuation for you or your clients
