Example - Marketability Discounts and Control Premium

Estate of William J. Desmond, v. IRS
[full text] [excerpted]
T.C. Memo 1999-76 (U.S. Tax Court 1999).

William Desmond died holding 136,000 shares (81.93%) of Deft Corporation, a small closely held company that manufactures industrial paint for military and commercial uses. The IRS claimed that Desmond's estate tax return underreported the value of Desmond's interest in Deft and accordingly determined a deficiency and assessed a large penalty. The key issue before the court, therefore, was to determine the fair market value of Desmond's interest in Deft.

Both Desmond's estate and the IRS submitted expert valuation reports to the court. The estate valued Deft using three methods: Asset method, income method, and market method. It averaged the results obtained under the three methods and then applied a 25% lack of marketability discount. THe IRS's expert did not address the fundamental ("unadjusted") value of the company, focusing solely on the appropriate lack of marketability discount instead.

The court adopted Desmond's conclusion under the income and market methods, and rejected the asset method results as "vague and generally unhelpful." Under the income method, Desmond's experts projected the future cash flows of Deft and then discounted these projections using a discount rate determined by the Capital Asset Pricing Model (CAPM), applying a beta derived from the betas of eight similar publicly-traded paint finishing companies. The court averaged the valuation obtained under both methods. To this amount, the court applied discounts for lack of marketability and pending environmental liabilities Deft was facing.

Marketability discount. On the question of marketability discounts, the court concluded:

• Deft's potential environmental liability affected the value of the company's stock
• The environmental risk properly resulted in discounting under the income method, but not the market method.
• The betas of 8 comparable companies used to determine the discount rate under the income method were not shown to be "higher than normal due to potential environmental liabilities faced by these companies."
• The price-earnings ratio for two similar companies "already include the potential environmental problems faced by the similar companies" and thus the price-earnings ratio used under the market method "took into account the potential environmental liabilities of the comparable companies."

The court found the following factors "favor a high lack of marketability discount":

• There was no public market for Deft's stock
• Deft's profit margins were below the industry average
• All stock in Deft was subject to a restrictive share agreement which provided that a shareholder could transfer his or her stock to a non shareholder only after the shareholder offered the shares to the remaining shareholders
• Given the size and low profitability of Deft, a public offering of the stock was unlikely in the future
• The size of the interest is so large that it may be hard to find potential buyers in the future who could finance such a purchase
• Deft has large potential environmental liabilities.

The court concluded, without explanation, that a 30% lack of marketability discount was appropriate for the Deft stock. Of this 30% discount, 10% was attributed to Deft's potential environmental liabilities - again, without explanation. The court applied the 30% discount to the value determined under the income method. The court applied only a 20% discount to the value determined under the market method.

Control premium. The court then turned to whether the 82% interest held by Desmond warranted a control premium. As the court explained, a "control premium may be necessary when valuing an interest which gives its holder unilateral power to direct corporate action, select management, decide the amount of distributions, rearrange the corporation's capital structure, and decide whether to liquidate, merge or sell assets."

The court concluded that whether a control premium is appropriate depends on the valuation method. The income method, the court stated, "assumed the continuation of Deft's present policies and did not account for a change in control." It thus produced an unadjusted value based on a minority interest, making it proper to apply a control premium. The market method, based on comparisons with publicly traded stocks, also produces an unadjusted value based on a minority interest, making a control premium proper.

Court decision:

Some questions:

• Why isn't the potential environmental risk already impounded in the discount rate implicit in both the betas of comparable companies and their price-earnings ratios?
• Can you explain why a company's beta does not reflect environmental risks, but its market valuation would?
• Can there be individual shareholders risks that are beyond the general company risks, reflected in comparable P/E ratios and CAPM discounts?
• Why is a buyer willing to pay more, on a relative basis, for an 82% interest than a an 8.2% interest in the same company?
• Is there any reason to believe that new management is more effective in increasing corporate returns than existing management?
• Should the market value of an asset (here a company) depend on the value placed on it by a buyer, because of changes that will happen in the future?