What’s the right marketability discount for a minority interest in a closely held company? Is it in the neighborhood of 45 percent or is it a much smaller figure?

In recent months, two experts have weighed in with their opinions, reaching very different conclusions. On one side of the debate is Shannon Pratt, founder and managing director of Willamette Management Associates (WMA). On the other side are Mukesh Bajaj, managing director of finance and damage practice at LECG and a frequent expert for the IRS; and John Kania, an IRS economist.

A complete discussion of the parties’ methodologies is beyond the scope of this article. But the debate highlights the importance, for attorneys and their valuation experts, of examining the various discount studies and being prepared to defend their positions.

Pratt’s Position
In the editor’s column of the February issue of Pratt’s Business Valuation Update (BVU), he criticizes "Fair value and Marketability Discounts," a paper written by Bajaj; David J. Denis, professor of finance at Purdue University; Stephen P. Ferris, professor of finance at the University of Missouri-Columbia; and Atulya Sarin, associate professor of finance at Santa Clara University.

Pratt asserts that Bajaj and his coauthors advocate marketability discounts for stocks of closely held companies at "a fraction of those encountered in the real world." As a result, Pratt asserts that those who rely on the paper will settle cases at a significant departure from fair Pratt goes on to cite a number of problems with the study. According to Pratt, the authors prefer the acquisitions approach to the IPO and restricted stock approaches in determining marketability, but fail to mention that the acquisitions approach relates to controlling interests while the others relate to minority interests.

Pratt points to a number of other areas in which he believes the study is flawed. The authors overlooked, for example, the risks of "lock-in" resulting from lack of marketability (such as what happened to Enron investors when the company’s  stock became worthless). Pratt also argues that the study ignores the perceived length of the holding period, which has a significant impact on the discount.  

Bajaj’s Response
Bajaj responds to Pratt’s criticisms in the March issue of BVU. He defends his study and criticizes IPO studies conducted by WMA and John Emory that support a 45 percent marketability discount. He then lists several reasons why the studies are flawed:

Large marketability discounts imply unrealistically high rates of return.

Pre-IPO buyers are usually insiders, so part of the discount in the IPO studies may reflect compensation to insiders rather than lack of marketability.

The discount on pre-IPO shares also reflects the risk of business failure.

One of Emory’s studies contained data errors that produced biased results.

Is Debate Over Semantics?
Pratt takes issue with several of Bajaj’s criticisms of the IPO studies, but he goes on to comment that, "Perhaps this discussion is merely semantic. That is, the discounts are real, but Dr. Bajaj wants to separate other factors from marketability while we recognize them as factors influencing the discount for lack of marketability."

Regardless of the debate’s outcome, it’s clear that in valuing minority interests in closely held businesses, experts must go beyond benchmark average discounts and analyze the unique characteristics of the company and the transaction. Focusing on the facts and circumstances of the subject company will help avoid any confusion over semantics.

It hardly seems likely that this will be the final word in the discussion for as Pratt notes, discounts for lack of marketability are the largest money issue in business valuation disputes.