Zero in on Discounts for Lack of Marketability in Family Law

Business appraisal is a mixing bowl of art and science.

I recently attended a financial conference for family law professionals.  One can easily observe expanding complexity in financial matters in family law.  A significant driver is the increased sophistication of experts, lawyers, and triers of fact.  Another driver of course is the increasing complexity of people’s financial affairs when viewed in relation to state statute and emerging case law.

Sophistication has not been lost on Discounts for Lack of Marketability (DLOM)!  As a general concept, appraisal professionals have increasingly identified two broad concepts in DLOM – a lack of liquidity (including the general absence of a ready market), and a transactional cost.  Although DLOM was historically more art than science, we now have tools that directly aid in the quantification of the discount.

The transactional cost is fairly easy.  A detailed study conducted by business school professors over 10 years ago dissected observed “discounts for lack of marketability”.  Their work suggested that the observed levels were due to several other factors, including liquidity, and that the element of the discount ascribable to a legal inability to sell the stock in a public market was roughly 7.23%.^[1]   That 7-8% cost is used by appraisal professionals today as a built-in transactional cost.  All other studies that appraisers rely upon tend to quantify the cost of illiquidity.

We often see the Mandelbaum case (Mandelbaum v. Comm. TC Memo 1995-255 (1995)) used as a guide to document a DLOM overall of 30-45%. The topics used by the Court to consider marketability are on the money, but the discount range suggested in the case is both wide and not an absolute limit.  And the Mandelbaum case really only provides a framework to generally assess liquidity issues.  Mandelbaum offers no fine tuning.

But there are ways to quantify the cost of liquidity using methods that are demanded in other appraisal areas, including the IRS related valuations.  One is Chris Mercer’s Quantitative Marketability Discount Model[2] (QMDM) which considers a number of quantitative factors – the cost of capital, growth rates, dividend expectations, and time to the date of liquidity – to mathematically compute the cost of illiquidity.

Another key approach is the protective put.  A put option answers the question “what would I need to pay someone to assure that they will buy a security from me at a specific price and date?”  Once again, there are several mathematical formulas (Black Scholes is but one of them), albeit complex, available to compute the value of a put, each applicable to a specific assumption about the rights of the put holder.  The value of any put is the cost of illiquidity.

Both QMDM and the protective put calculations require some inputs subject to judgment, including the estimated time required to market a security.  But the qualitative variables can be described, discussed, and vetted.  And although there are differences in results for each quantitative method, the relationships between the results of each formula tend to be predictive.

Keep in mind that these results measure the cost of illiquidity.  To determine the total DLOM, you need to add the 7-8% transactional cost.

DLOM, where applicable, can now be largely quantified, eliminating the mystifying, undocumented, and unexplainable DLOM percentages of the past that can materially misstate value in equitable distribution.

[1] Bajaj, Denis, Farris and Sarin, “Firm Value and Marketability Discounts,” (February 26, 2001). Available at SSRN: http://ssrn.com/abstract=262198 or DOI: 10.2139/ssrn.262198.

[2] Developed by Chris Mercer; available from www.MercerCapital.com.

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