The debate on discounts for lack of marketability (DLOM) continues
Last week, the BVWire™ included a follow-up to a Letter to the Editor authored by Ronald Seaman, FASA, of Tampa, Florida’s Southland Business Group. In his letter Seaman noted, “The costs of Long-Term Equity Anticipation Securities (LEAPS) put options are an excellent proxy for the discount for lack of marketability because the costs of LEAPS include most of the Mandelbaum factors and are obviously market-based. Because LEAPS are valuation-date specific and industry specific, the question about reduced liquidity can easily be answered by a study of their costs on whatever beginning and ending dates one chooses and for whatever industries or companies one chooses.”
Yet another ‘Wire reader, IRS analyst Harry Fuhrman, AVA, followed up with his thoughts on Seaman’s premise and took exception to his use of LEAPs in developing a discount for lack of marketability. What follows, are Fuhrman’s comments, which he offers solely as his own and not in the context of his position as a valuation analyst for the IRS. Indeed, he stresses that his opinions are not those of the Service in general. Fuhrman’s perspective:
“On Seaman’s Web site, [he] states, LEAPS can prove a significant DLOM. I believe Seaman’s comments are misleading and significantly overstate the range of discounts for the lack of marketability. [The] calculations exclude one-half of the equation, and by calculating only the cost for a put option (to “eliminate downside risk”), [he] disregards the related upside potential in an underlying security [to] which a hypothetical investor would have access. To ‘lock-in’ a security’s price today, an investor would undertake two courses of action: 1) purchase a put option to protect against any downside risk (as Seaman’s calculations do) or 2) have the ability to sell a call option related to any upside potential in the stock. The netting of the put-expense with the call-income would truly demonstrate the relevant position an investor would be confronted with when attempting to ‘lock-in’ the current security price. As a result, by including only the expense related with maintaining the current security price, the conclusions Seaman arrives at are overstated and cannot be used as anything more than the ceiling for potential discounts for lack of marketability.”
Fuhrman offers the following example: “AT&T closed at $25.02 on 1/20/2009. A January 2010 put at a $25.00 strike price traded for $5.00, and a January 2010 put, also at a $25.00 strike price, traded for $6.90. Based on these put options, the Seaman calculation would estimate discounts for lack of marketability ranging from 20-28 percent. This estimate would be significantly overstated as a holder of AT&T, in addition to purchasing a put to secure the downside risk, would also have the right to sell call options for 2010 and 2011, which were trading (for the same strike price) at $4.00 and $5.00, respectively. Taking into consideration the income from the sale of the call options, the vast majority of the cost of the put options would be offset. Rather the true ‘cost’ for securing the current AT&T stock price would be the net of the put cost and the call income, which would equate to a range for the discount of lack of marketability between 4.0 and 7.6 percent, significantly lower than the results based on Seaman’s calculations. Of course this would be a baseline indication reflecting the volatility inherent in the security over the time to market and would need to be adjusted for the specific interest at hand.”
Ronald Seaman’s response: "I understand Mr. Fuhrman’s arithmetic, but I don't understand his logic. A discount for lack of marketability does not attempt to 'lock-in a security’s price today,' which Mr. Fuhrman states as the objective in his example. A DLOM simply attempts to measure the investor's risk, a major part of which is the risk of loss in value over time. That is precisely the risk measured in an analysis using LEAPS put options. As an investor, I am interested in minimizing my risk and leaving open my opportunity for gain. If I could buy a put option on my stock at the value at which I bought it, I would be protected from downside risk. There is no loss of ‘upside potential’ because I can simply not exercise the option. Thus, there is no reason for me to purchase a call option.”
What do you think? Readers who want to join the discussion can drop us a line.
Are there lessons for BV analysts in the PCAOB’s Fair Value alert for auditors and CFOs?
Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists, a recent Staff Audit Practice Alert on the audit of fair value measurements in financial statements issued from the Public Company Accounting Oversight Board (PCAOB), addresses the “challenges presented by the subprime credit situation and its effects on the markets and fair value measurements, and certain issues that might arise in the transition to Statement of Financial Accounting Standards No. 157,” according to Marty Baumann, Director of the PCAOB Office of Research and Analysis. While the alert does not create any new auditing requirements, it does outline auditing and related accounting standards that are particularly relevant at this moment.
BV experts looking for hands-on insights should know that leaders from the PCAOB, the Federal Accounting Standards Board, and the Securities and Exchange Commission will deliver the opening address at our 2nd Annual Summit on Fair Value for Financial Reporting on February 2-3 in New York City—the only event to offer a joint appearance of leaders from the three financial reporting agencies. It is not too late to register for this informative and much-anticipated event.
IRS continues outreach efforts with BV while gearing up for 409A oversight
“I want to outreach with you and my colleagues want to outreach with you,” Michael Gregory, an IRS Territory Engineer, told some 1400 attendees at the 2008 AICPA/ASA National Business Valuation Conference in Las Vegas. Important: Gregory offered his own opinions, not those of the IRS. To fulfill these efforts, the IRS is currently beefing up its team of engineers and appraisers, adding two territory managers in the west and two more in the east. The managers network every month, according to Gregory, talking about “what we can do to strengthen our partnerships with the private sector.” If [the IRS isn’t doing its] job, then “you need to come and tell us that we’re not.”
What about appraisers who may not be doing their jobs? The IRS continues to use the penalty provisions in IRC Sec. 6695A as a key enforcement tool to curb appraisal abuses. In addition, as of the conference date, the Service had asserted 146 penalties in the estate and gift arena, charitable deductions, conservation easements, and pension fund (ESOP). Review of Sec. 409A is another area where the IRS is reportedly beefing up its oversight. Gregory chairs the team on 409A appraisals, who will be “off and running” in the spring of 2009. (At the meeting, Gregory suggested that appraisers refer to the AICPA’s practice guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation.)
In his AICPA/ASA presentation, which we’ve outlined in an article in the January 2009 Business Valuation Update™, Gregory also offered suggestions on how to avoid the top valuation-related missteps—including the valuator’s use of aged data, improper discount and cap rates, and inappropriate discounts for lack of marketability and minority interests. Overall, Gregory suggested making sure that your valuation conclusion passes the “common sense” test. Ask yourself: Would I be willing to pay that amount if I had the money to buy this company?” For a full accounting, you can access a Free Download of the article, “22 Ways to Avoid Appraisal Missteps.”
IFRS implementation and SEC Roadmap continues to veer off track
Mary Schapiro, just confirmed as the new SEC chairperson, noted plans to re-examine the commission’s proposed “Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards (IFRS)” during her confirmation hearings. Then last week, the Financial Executives International (FEI) sent a comment letter formally asking the SEC to consider extending the comment period on its proposed “Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards.” The FEI request asks the SEC to consider a formal 45-day extension of the comment period, which closes on February 19.
Is IFRS dying or dead? For a compelling perspective, consider the views reported in the January 2009 issue of CFO Magazine. Interestingly, the piece notes that, “Among those mounting a grassroots movement to slow the rush to IFRS are Analyst's Accounting Observer newsletter editor Jack Ciesielski, former FASB member Ed Trott, and Bowling Green State University professor David Albrecht. Among their arguments: “preliminary research from Europe shows that the international ‘standards’ in fact afford investors little comparability among financial statements, one of the key reasons given for U.S. convergence. Niemeier [Charles Niemeier is a member of the PCAOB oversight and a leading critic of the current time line] is also leery of letting the International Accounting Standards Board (IASB) be the standards-setter for the world, given its recent capitulation to pressure from European Union authorities to loosen fair-value accounting for banks.” Stay tuned…
Emerging trends in healthcare valuation: key information for BV experts
The valuation of healthcare companies is an increasingly tricky task, made even more so by the ever changing legal regulations. Changes in revenue streams, regulatory measures, and business arrangements alone present a daunting task to those charged with valuing the healthcare industry’s constituent parts. Analysts in need of information can gain invaluable insights at BVR’s Teleconference Series on Healthcare Valuation, a program for business appraisers tasked with valuing any aspect of this industry. This week’s must-attend teleconference—taking place on January 30 at 10 am Pacific/1 pm Eastern—is the first of a three part series on healthcare valuation.
Jim Pinna, Alan Simons, and Todd Sorensen—contributors to the recently released BVR’s Guide to Healthcare Valuation—will join moderator and Guide co-editor Mark Dietrich for presentations and discussion of the Stark Law and anti-kickback statutes, home health care agencies, long-term care facilities, ambulatory surgical centers, and more. (You can listen to Mark Dietrich describe this distinguished panel and their presentations in a podcast here.)
Parts 2 and 3 of this series, featuring other Guide contributors, will cover topics such as physician compensation, imaging centers, physician practices, joint ventures, co-management agreements, and more. Best of all: Attendees of Part 1 and/or Part 2 will receive $50 off the next Healthcare teleconference they choose to attend. Those who attend Part 1 of the teleconference will receive $100 off the teleconference price by purchasing BVR’s Guide to Healthcare Valuation—co-edited by Cindy Eddins Collier and Dietrich—when you register. Note: This $100 off is only available to registrants of Part 1. Attendees will earn 2 CPE and/or 1.5 CLE credits.