Page 45 - Business Valuation for Estates & Gift Taxes

It is important to note that the Mandelbaum case analysis was written prior to the reduction of the Rule
144 holding period to less than two years. Studies subsequent to those reductions (Columbia, Trugman,
and Stout, Risius, Ross) have all shown material declines in median and mean observed discounts from
the 35 percent to 45 percent serving as the Mandelbaum benchmark, emphasizing the critical nature of
the term of the trading impairment on the magnitude of the discount. Furthermore, the dispersion of the
results of most of the larger studies suggests that multiple factors, as identified in Mandelbaum, affect
the observed discount. fn 6

Quantitative Tools for Estimating a DLOM

In 1997, Chris Mercer published Quantifying Marketability Discounts. In the book, he introduced the
quantitative marketability discount method (QMDM). The QMDM expanded upon the previous work of
John C. Harper and J. Peter Lindquist, which suggested that a discount for lack of marketability could be
calculated using the relationship between the value of a company based on enterprise-level cash flows
versus shareholder-level cash flows.

Valuation analysts also use various option-based models to estimate DLOMs. The most commonly used
model is a simple Black-Scholes option pricing model used to estimate the value of European-style op-
tions. The result of the option model calculation is the price that the theoretical holder of the security
would pay to buy protection against a price decline during the term of an anticipated holding period. fn 7

Other models have come into common use since Black-Scholes. One of the most often-referenced is the
Longstaff Upper Bound Lookback put option model. Published in 1995, fn 8 the Longstaff model as-
sumes the holder of the option has perfect hindsight and therefore would exercise the option at the opti-
mal point during the term of the option. The value of a look-back option is greater than a regular option,
so it will cost more leading to a higher DLOM. For a hypothetical investor, the Longstaff model repre-
sents a logical upper bound to the DLOM.

Following Longstaff, an Asian look-back put option model (Finnerty model) developed by Professor
John Finnerty of Fordham University fn 9 has had significant support, especially from audit professionals
who focus on compliance with FASB Accounting Standards Codification (ASC) Topic 718, Stock Based
Compensation. The Finnerty model produces a value based upon the average underlying value during
the term of the option. Like the Longstaff model, the Finnerty model can produce indicated discounts in

fn 6 A complementary model of subjective factors targeted at holding companies (such as Family Limited Partnerships or LLCs which
operate as holding companies) was developed by Charles Elliot, CFA, ASA, and published in his article "Valuing Family Limited
Partnerships." That article is quoted at length in Robert Reilly’s and Robert Schweihs’ The Handbook of Advanced Business Valua-
tion, (New York: McGraw Hill, 2000,) pages 155–173.

fn 7 The European Option is exercisable only at the end of the option life. The original 1993 publication by David Chaffe was based
upon the European Option. David B. Chaffe, III "Option Pricing as a Proxy for Discount for Lack of Marketability in Private Compa-
ny Valuations," Business Valuation Review (December 1993).

fn 8
Francis A. Longstaff "How Much Can Marketability Affect Security Values?" Journal of Finance, December 1995, Vol. 50 No.
5, pages 1767–1774.
fn 9
John Finnerty, "The Impact of Transfer Restrictions on Stock Prices" (October 2002). AFA 2003 Washington, D.C. Meetings.
Paper critiqued by Stillian Ghaiderov of Grant Thornton in September 2009 in "Analysis and Critique of Average Strike Put Option
Marketability Discount Model." Finnerty model modified in response as of October 2009.

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