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–or less financial-ratio and detailed-finance specific and 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. 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 is a chart showing Mandelbaum 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, Outlook, and Attractiveness of Business||The subject business is attractive with a good location. Yet sales and profits have stagnated.||X|
|Attractiveness of Industry||The industry is stable and even anti-cyclical.||X|
|Availability of Information||Information is limited and generally unavailable. This would increase the discount.||X|
|Financial Factors, Revenues, Earnings, ratios,||The financial condition of the subject Company is stable. Financial results have been suitable. This compares favorably to the restricted securities which are often from unprofitable firms and some distressed firms.||X|
|Management||The Company is easy to run and convey. Management in this size store is less important compared to some other industries.||X|
|Business Risk||The business has no continuing contracts but does have a proven location.||X|
|Laws and Regulation||This is a highly regulated industry which has historically protected profitability and transferability. There are strong efforts to remove these protections at this time.||X|
|General Economic Condition||The general economy has been quite good. The industry is projected to continue growing.||X|
|Transfer of Control / Holding Period|
|Restriction on Transfer||There are no known restrictions on transfer. Yet it is very difficult to transfer non-control interests.||X|
|Cash Distribution / Dividend Policy||There have been little profits to distribute.||X|
|Ownership Concentration||Multiple shareholders, the other two being brothers. This decreases marketability.||X|
|Redemption Policy||No known redemption. State law would require a sale or dissolution.||X|
|Cost of Public Offering||Not applicable||X|
|No of Potential Buyers||Limited as discussed above||X|
|Size of Business||Small business, increasing marketability risk||X|
|Volume of Comparable Private Transactions||Current market is strong. But an industry with few transactions considering the number of companies. This is neutral at this time do to current market||X|
|Attributes of controlling shareholder, shareholder restrictions||Transfer of shares within a family.||X|
The overall trend indicates a need for the adjustment for the marketability as this interest is much less marketable than a 100% control interest. Reviewing all the factors and the Restricted Stock Studies in my judgment a 15% marketability discount is appropriate.
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 accurate. As always, determine a business’s value is not a strict science based on Mandlebaum Factors, but an art that takes Mandlebaum and other discounts (if needed) into account.
Contact Greg today for exit and estate planning business valuations.