It seems to me that healthy dialogue among practitioners is a useful tool in facilitating our growth as a profession. It is in that spirit that I wish to respond to my colleague, Chris Mercer�s recent article,[Citation Omitted] wherein he asserts that my misunderstanding of his Quantitative Marketability Discount Model (QMDM) explains the disparity in my results and his in calculating the discount for lack of marketability (DLOM). Accordingly, in this article I will:
This article consists of five sections, including this introduction. In Section 2, I explain the theoretical (and some empirical) basis of the ECM. In Section 3, I provide an empirical test of the two models with restricted stock data. In Section 4, I discuss inconsistencies in the QMDM, and Section 5 is my conclusion.
2. Economic Components Model (ECM)[Citation Ommitted]
A complete presentation of ECM is too lengthy for and is outside of the scope of this article. For that, I must refer readers to Chapters 7�9 of my book, Quantitative Business Valuation: A Mathematical Approach for Today�s Professionals (QBV). However, in a few pages, I can explain the logic of ECM and some of the key research that comprise its theoretical and empirical underpinnings.
It is important to understand that Section 2, almost half of the length of this article, is optional reading. While this entire section provides additional background that will enrich the reader�s understanding of the debate between Mr. Mercer and myself, it is not necessary material and can be skipped. Those who wish to do so can safely skip to Section 3, the Empirical Test of the Two Models. That being said, let�s move on.
The ECM contains four components that act as "building blocks" in calculating DLOM. We will discuss each of the components in its own section, although we treat the last two components together in one section.
Component #1: Delay to Sale
The base component in the ECM is one that measures the economic disadvantage of being illiquid for a material amount of time.
Psychology of Illiquidity
Before immediately jumping into the measurement of the Delay to Sale, in QBV, page 250, I cite a chapter from another book[Citation Omitted] that discussed the Ellsberg Paradox, developed by Dr. Daniel Ellsberg, later of Pentagon Papers fame. Ellsberg demonstrated that even if people are given the choice between two gambles of equal expected value, they still strongly prefer to take the gamble that is well defined than the one that is ill defined. The authors defined ambiguity as a secondorder uncertainty, i.e., uncertainty about uncertainties.
It is my opinion that this psychological point drives much of the phenomena of control and marketability. Control affects the degree of clarity of the environment and security, on one hand, or ambiguity and lack of security, on the other, that shareholders experience, depending on the degree of their control.[Citation Omitted] How many minority shareholders are booted out of their firms by control shareholders after long years of service? I have testified in a number of such cases, and it is likely that many of the readers of this journal have done so, too.
In ECM, control affects marketability in each of the different components. Compared to control interests, private minority interests differ in the following ways:
- They should take longer to sell, as they are less desirable. That exposes the minority shareholder who wants to sell to negative (or positive) changes in value for a longer period than the control shareholder.
- There are fewer buyers for minority interests. As a practical matter in most privately held firms, the control shareholder is often the only feasible buyer for minority interests. Even if one can find an interested buyer for a minority interest, that potential buyer is in a much stronger negotiating position than the potential buyers for a control interest and is likely to drive down the price due to lack of competition among buyers.
- Transactions costs of selling minority interests in private firms usually should be higher than the transactions costs of selling control interests, as the former are less desirable interests and there are no organized markets in which to sell them.
Thus, while this is an article on DLOM, we cannot ignore the issue of control, as control affects all components of marketability. Before diving into the calculation of DLOM, we will discuss the different levels of value charts that have been proposed and described in the literature.
The Levels of Value Charts
There are essentially three different levels of value charts. The (Modified) Traditional Levels of Value Chart appears in Figure 1. It is a single column. It is important to note that Chris Mercer�s position is that control interests in private firms do not receive a discount for lack of marketability. His primary reason for that is that the control shareholder enjoys the full benefit of cash flows during the time to marketability, although he has other reasons for that conclusion.[Citation Omitted] I disagree with Mr. Mercer�s conclusion, although a well-managed firm can do much to minimize the impact of DLOM.
Jay Abrams, ASA, CPA, MBA, founder and head of Abrams Valuation Group (AVG), is one of those rare individuals who integrates theory and practice. He has valued businesses and consulted on mergers and acquisitions in a wide range of industries, provided valuations and discounts for fractional interests and restricted stock, and conducted independent statistical and mathematical research regarding problems facing businesses. During his 25 years of accounting and valuation experience, he has made, and continues to make, significant contributions to the science of valuing businesses. Mr. Abrams' book, Quantitative Business Valuation: A Mathematical Approach For Today's Professionals (McGraw-Hill, 2001) shows how to integrate advanced scientific methods into real-world valuation analysis.
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