BUSINESSVALUATION

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Shannon Pratts

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A Business Valuation Resources publication

Excerpt from Vol. 10, No. 2, February 2004

Guest Article:

By Lance S. Hall, ASA*

The discount for lack of marketability: an examination of Dr. Bajaj's approach

Bajaj's arguments is first to look at his article, "Firm Value and Marketability Discounts"5 to examine how he uses his research to determine discounts for privately held entities. Dr. Bajaj's research and findings The initial premise of Dr. Bajaj's research is that the observed discount between a freely traded company stock and its restricted counterpart may represent more than just a discount for lack of marketability. Dr. Bajaj hypothesizes that the observed discount in restricted stock transactions, in addition to reflecting the investment's lack of liquidity, may also reflect a return to compensate the buyer for: a) assessing the investment; b) monitoring the investment; c) advising management; and d) a promise of future investments. Dr. Bajaj then sets out to separate the discount by examining a group of 40 restricted and 38 registered private placement transactions. Implicit in Dr. Bajaj's cross-sectional analysis are the following underlying assumptions about the data: a) All unregistered shares are equally illiquid; and b) All registered shares are liquid. In his analysis of the registered and unregistered private placements, Dr. Bajaj found that the median discount for the registered shares was 14.5 percent, and the median discount for the unregistered shares was 26.47 percent. Given the underlying assumptions, Dr. Bajaj notes that because registered private placements are sold at a discount and the shares are fully liquid, the registered stock discount cannot be for a lack of liquidity. Therefore, the discount for lack of marketability cannot exceed the difference between the discounts for registered private placements and unregistered private placements. Moreover, because of significant differences in the characteristics of the companies in registered and unregistered private placements, the discount for lack of marketability may, in fact, be less than the 16.62 percent discount differential between the two groups. Dr. Bajaj further notes that part of the discount differential may be attributed to: a) Assessment difficulty (as represented by): a. Growth-oriented (Percentage Block) b. Higher Risk (Volatility) c. Financial Distress (Z-Score) b) Increased Monitoring (as represented by): a. Growth-oriented (Percentage Block) Continued to next page...

The IRS's winning discount for lack of marketability analyses in Gross1, McCord2, and Lappo 3 have set the valuation community abuzz. This new discount approach has Lance Hall been developed by litigation expert, Dr. Mukesh Bajaj, as an outgrowth of his research into restricted stock transactions.4 Clearly, Dr. Bajaj's arguments have resonated with the Tax Court, which has deemed them superior to the opposing experts' analyses. However, before the valuation community, the IRS, and the courts jump on the "Bajaj Approach" bandwagon, a closer examination of his underlying arguments and supporting data is required. Perhaps the best way to examine Dr. * Lance S. Hall is a Managing Director at FMV Opinions, Inc., a national business and real estate valuation firm (fmv.com). Mr. Hall manages FMV's estate and gift tax practice. 1 Gross v. Commissioner, 272 F.3d 333 (6th Cir. November 19, 2001). 2 McCord v. Commissioner 120 T.C. No. 13 (May 14, 2003). 3 Lappo v. Commissioner T.C. Memo 2003-258 (September 3, 2003). 4 Dr. Bajaj is the Managing Director of Finance and Damages Practices of LECG, LLC, which is an international consulting firm. Dr. Bajaj received his Ph.D. in finance from the University of California, Berkeley, where he teaches part-time. 5 Mukesh Bajaj, David J. Denis, Stephen P. Ferris, and Atulya Sarin, Journal of Corporation Law, Fall 2001.

Reprinted with permission from Business Valuation Resources, LLC

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Shannon Pratts

ALU TION BUSINESS VALUATION

Publisher & Editor-in-Chief: Managing Editor: Associate Editor: Legal and Court Case Editor: Production: Staff Writer: Director of Marketing: Customer Service:

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Shannon Pratt Alina Niculita Tanya Hanson Linda Kruschke Laurie Morrisey Paul Heidt Rihab Hamze Angelina Mckedy Kyla Westfall Doug Berger Pam Pittock

The discount for lack of marketability: an examination of Dr. Bajaj's approach

...continued from front page b. Higher Risk (Volatility) c. Financial Distress (Z-Score)
ever, Rule 144's dribble-out provision limits what we can sell in any given quarter, after the holding period. Under Rule 144's dribble-out provision, we are allowed to sell every quarter the greater of (a) one percent of the total shares outstanding, or (b) the average weekly trading volume over the prior four-week period. Accordingly, as I have a 30 percent block, the most I can sell in any quarter is one percent. Therefore, my total holding period is 8.5 years compared with your one-year holding period. In other words, my 30 percent block is 8.5 times as illiquid as your one percent block. Dr. Bajaj's analysis makes the implicit assumption that a one-percent restricted stock block and a 30-percent restricted stock block in the same public company would have the same discount. That assumption defies logic and is contrary to the dribble-out provisions of Rule 144. The discount accorded these two private placements must reflect the differences in their relative lack of liquidity. While the Bajaj Approach attributes the higher discount associated with larger percentage blocks to assessment and monitoring difficulty, the more likely explanation for the higher discounts observed in larger block transactions is that larger blocks are more illiquid than smaller blocks. Dr. Bajaj also notes that the greater the volatility of stock price returns, the larger the discounts. Dr. Bajaj claims this is consistent with his hypothesis, as companies with volatile stock prices are more difficult to assess, require more monitoring, have a greater need for future investment, and need management advice. However, the better explanation for the relationship between volatility and the magnitude of the observed discount Continued to next page...

c) Economies of Scale (as represented by): a. High Dollar Placements In his analysis, Dr. Bajaj found that the greater the percentage block in a private placement, the higher the discount. According to Dr. Bajaj, "This is consistent with the speculation that firms with ambitious growth plans require closer scrutiny by investors prior to the consummation of the placement and greater monitoring subsequent to it." Moreover, Dr. Bajaj found that the greater the volatility of a company's returns, the higher the discount. Dr. Bajaj also found that financially distressed companies had higher discounts than did financially healthy firms. These findings also supported Dr. Bajaj's thesis that such companies required greater assessment, monitoring, advice, and future funding. However, Dr. Bajaj found that higher dollar placements did not significantly affect the discount. The first fatal flawall restricted stock is equally illiquid Dr. Bajaj's study, however, is fatally flawed, as the foundational assumptions of the study are wrong. The first erroneous assumption underlying the Bajaj Approach is that all restricted stock is equally illiquid. This is not true. Consider the following: Suppose you and I hold restricted stock in the same publicly traded company. However, your restricted stock block represents only one percent of the company's total shares outstanding, whereas my block represents 30 percent of the company's total shares outstanding. Under the Securities and Exchange Commission's (SEC) Rule 144, we each have a one-year holding period, after which we can sell our shares on the open marketplace. How-

Editorial Advisory Board

MEL H. ABRAHAM, CPA/ABV, CVA, ASA
Kaplan, Abraham, Burkert & Co.Wood Ranch, Calif.

RONALD D. AUCUTT, Esq.

McGuireWoods LLPMcLean, Va.

JOHN A. BOGDANSKI, JD
Lewis & Clark Law SchoolPortland, Ore.

HON. WILLIAM A. CHRISTIAN

N.C. 11th Judicial District CourtSanford, N.C.

S. STACY EASTLAND, Esq.

The Goldman Sachs Group, Inc.Houston, Texas

BARNES H. ELLIS, Esq.

Stoel Rives LLPPortland, Ore.

JAY E. FISHMAN, ASA, CBA

Kroll Lindquist AveyPhiladelphia, Pa.

OWEN G. FIORE, JD, CPA

Fiore-Ramsbacher LLPSan Jose, Calif.

LARRY WELDON GIBBS, JD

Gibbs Professional CorporationSan Antonio, Texas

LYNNE Z. GOLD-BIKIN, Esq.

Wolf, Block, Schorr & Solis-Cohen, LLPNorristown, Pa.

LANCE S. HALL
FMV Opinions, Inc.Irvine, Calif.

JARED KAPLAN, Esq.

McDermott, Will & EmeryChicago, Ill.

MAURICE KUTNER, Esq.

Maurice Jay Kutner & Associates, P.A.Miami, Fla.

GILBERT E. MATTHEWS, CFA

Sutter Securities IncorporatedSan Francisco, Calif.

JAMES J. PODELL, Esq.

Podell & PodellMilwaukee, Wis.

JOHN W. PORTER
Baker & Botts, LLPHouston, Texas

JAMES S. RIGBY, ASA, CPA/ABV

Financial Valuation GroupLos Angeles, Calif.

ARTHUR D. SEDERBAUM, Esq.

Patterson, Belknap, Webb & TylerNew York, N.Y.

DONALD S. SHANNON, Ph.D., CPA

School of Accountancy, DePaul UniversityChicago, Ill.

BRUCE SILVERSTEIN, Esq.

Young, Conaway, Stargatt & Taylor, LLPWilmington, Del.

GEORGE S. STERN, Esq.

Stern & EdlinAtlanta, Ga.

Shannon Pratts Business Valuation Update (ISSN 1088-4882) is published monthly by Business Valuation Resources, L.L.C., for $249 a year. Please call or write for multiple-subscription rates. Periodicals postage paid at Portland, Oregon. POSTMASTER: Send address changes to Business Valuation Resources, L.L.C., 7412 S.W. Beaverton-Hillsdale Hwy., Suite 106, Portland, OR 97225, phone (503) 291-7963 or (888) 287-8258, fax (503) 291-7955, e-mail: CustomerService@BVResources.com, Web page: www.BVResources.com. Editorial office and subscription requests should go to the above address. Please note that by submitting material to Shannon Pratts Business Valuation Update, you are granting permission for the newsletter to republish your material in electronic form. Although the information in this newsletter has been obtained from sources that Business Valuation Resources believes to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This newsletter is intended for information purposes only, and it is not intended as financial, investment, legal, or consulting advice. Copyright 2004, Business Valuation Resources, L.L.C. (BVR). All rights reserved. No part of this newsletter may be reproduced without express written consent from BVR.

Reprinted with permission from Business Valuation Resources, LLC

Shannon Pratts Business Valuation Update February 2004

The discount for lack of marketability: an examination of Dr. Bajaj's approach

...continued is in Revenue Ruling 77-287, which governs valuations of restricted stock for estate and gift tax purposes. Revenue Ruling 77-287 states that the discounts observed in restricted stock transactions are attributable to:
1) "The risk that the underlying value of the stock will change in a way that, absent the restrictive provisions, would have prompted a decision to sell," and 2) "The risk that the contemplated means of legally disposing of the stock may not materialize." Clearly, the greater the volatility of the underlying stock, the more likely things will "change." Volatility also may impact the stock's trading volume, possibly preventing the restricted shareholder (once the restrictions are lifted) from selling as many shares as originally anticipated. Dr. Bajaj also cites the higher discounts observed for financially distressed companies (as measured by the Z-Score) as support for his thesis of higher assessment costs, a greater need for monitoring, the promise of future investment, and the greater need for management advice. However, companies in severe financial distress are more likely to experience highly volatile stock prices. Moreover, a restricted shareholder is under an even greater disadvantage than the public shareholder, because the company could go bankrupt during the restricted period. At least the public shareholder has an opportunity to liquidate his or her investment early. In other words, liquidity has value, and the lack of liquidity in financially risky companies diminishes value. The second fatal flawall registered stock is liquid The second fatal assumption underlying the Bajaj Approach is that all registered stock is freely marketable. This assumption also does not withstand scrutiny. All shareholders owning over 10 percent of a publicly traded company are deemed to be "affiliates" and are restricted under the dribble-out provisions of the SEC's Rule 144. That is to say, an investor holding registered stock representing over 10 percent of a public company's outstanding stock can only sell, per quarter, the greater of (a) one percent of the total stock outstanding, or (b) the average weekly trading volume over the prior four weeks. An examination of Dr. Bajaj's data shows that the average (median) size block of the registered shares was 13.1 percent. In other words, on average, Dr. Bajaj's registered shares were not freely tradable. Rather, these registered shares were restricted under Rule 144's dribble-out provisions. Moreover, even if public trading in the registered shares were unrestricted, low trading volume in the underlying stock could prevent the registered shareholder from liquidating his or her investment in a timely manner. In other words, low trading volume results in a lack of liquidity (normally referred to as "blockage") for the registered shares. Dr. Bajaj's study does not examine the impact of trading volume on liquidity. The foundational premise of Dr. Bajaj's study is that the discount for lack of marketability cannot exceed the differential between registered shares and unregistered shares, because registered shares are liquid. As we have shown, the registered shares in Dr. Bajaj's study were restricted under Rule 144 and, therefore, were not liquid. Accordingly, all of Dr. Bajaj's conclusions on the determination of discounts for lack of liquidity (marketability) must be discarded. Misinterpretations of the Bajaj Approach If the Bajaj Approach assumptions are wrong, how does one explain a firm's need for monitoring and management advice? According to Dr. Bajaj, one reason discounts exist is that an investor must make a return on his or her cost of monitoring the investment. Moreover, this need for monitoring is equally true for registered and restricted private placements. The greater the growth, the higher the volatility, and the more financial distress experienced by a company, the greater the need for, and costs associated with, monitoring. Where Dr. Bajaj's argument breaks down lies in the question, "Why do investors monitor their investments?" An investor monitors his or her investments to assess if he or she should (a) maintain the investment, (b) make additional investments, or (c) reduce the investment. Clearly, an illiquid investment can't be sold, regardless of the results of monitoring, so the very act of monitoring an illiquid investment has less value to an investor. However, monitoring may be very valuable for a liquid investment that could be sold. Another reason for the observed discount, according to Dr. Bajaj, is that an investor will require a return for the management advice he or she gives. The higher the growth, the greater the volatility, and the more financial distress a company operates under, the greater and more often the need for management advice. What is interesting about this conjecture is that it presupposes that the private placement buyer has influence and control over the management of the company. All the appraisal literature and court decisions (as well as empirical data) point to the fact that investors who buy influence and control over management pay a premium for their investmentnot a discounted price. The logical extension of the Bajaj Approach thesis is that there can never be a control premium, because investors must receive a return on their inContinued to next page...

Reprinted with permission from Business Valuation Resources, LLC

February 2004 Shannon Pratts Business Valuation Update 3

The discount for lack of marketability: an examination of Dr. Bajaj's approach

...continued from previous page
fluence and control derived through investing at a discounted price. Applicability to privately held companies We have demonstrated that (a) the underlying assumptions and interpretations of the data in the Bajaj Approach are flawed, and (b) better explanations for the magnitude of the discounts found in restricted stock transactions are available. Nonetheless, an investor in a privately held company must still assess and monitor the investment in a manner similar to that of a restricted stock investor. Accordingly, the Bajaj Approach, even if it were correct, would not be applicable to privately held companies. Conclusion The courts have favored the Bajaj Approach when the opposing appraisers use inferior data (discount averages) or flawed analyses. However, notwithstanding the numerous and fatal errors, the Bajaj Approach is very appealing because of the comparative nature of its analysis. Therefore, to succeed against the Bajaj Approach, the appraiser must be armed with more and better comparative data, as well as superior explanations for the observed discounts. The largest source of more and better restricted stock data is The FMV Restricted Stock Study. The FMV Study has over 10 times the restricted stock transactions of Dr. Bajaj's limited study, including post-1997 data. Moreover, instead of only four transaction and company characteristics used in the Bajaj Approach, The FMV Study has over 30 transaction and company characteristics for each private placement. This paper explains the misinterpretations and faulty assumptions underlying the Bajaj Approach. More importantly, however, this paper provides better economic rationale and interpretations of the supporting discount data that can be used to determine and defend the appropriate magnitude of a discount for lack of marketability applicable to restricted stock and to a privately held company. (The FMV data is available at BVMarketData.comsm). BVU

Reprinted with permission from Business Valuation Resources, LLC

4 Shannon Pratts Business Valuation Update February 2004