Does using pre-IPO data for DLOM double count the discount?
The use of pre-IPO studies to measure a discount for lack of marketability has gained acceptance among valuation analysts and the Tax Court. Still, though, there is some criticism over this method. One notion kicking around recently is “double counting,” meaning that some of the transactions in the pre-IPO databases are calculated with a DLOM already in them.
Not true: “Double counting of discounts is not occurring when viewed in the larger context of the transaction,” says Brian Pearson of Valuation Advisors LLC, who developed the Valuation Advisors Lack of Marketability Discount Study. This is the only online database of pre-IPO private stock and option transaction data from 1985 to the present. It recently hit the 10,000 mark in terms of the number of transactions it contains.
In a recent interview with Business Valuation Update, Pearson reacted to the idea that the discount is double counted. “While it is true that some of the transactions include a prior discount, it helps to understand the process by which this ‘discount’ was calculated,” he says. “Under the fair value standards for option and stock issuance and the AICPA’s guide to fair value, the commonly used valuation method of PWERM (probability-weighted expected return method) requires consideration of a DLOM. So if the enterprise value is $10 per share and the CPA BV professional, under the fair value guidelines, assigns a 30% discount, the reported transaction price is $7. If the company goes public at $12, in theory, you have two discounts at two different periods (30% and 20%). However, this is where the theory of multiple discounts fails, since in reality the transaction is just one transaction, from the time of investment until the time of liquidity (i.e., the IPO date).”
He continues: “Prior to the fair value standards, in an arm’s-length negotiation of the price, the same process would have occurred, except it would simply have been reported as a $7 transaction with the discount as ((12 - 7)/12), or 41.66%. Thus, the concept of “two discounts,” although implicit in the process, wasn’t being publicly reported. In fact, the same level of DLOM is occurring in both situations—it’s just that the fair value standards for pre-IPO transactions shed better light on the process of how such pre-IPO values are being arrived at now.”
Free article: Read the complete interview with Pearson in the article “Is the Lingering Criticism of Using Pre-IPO Studies for DLOM Justified?” available from BVR as a free download.