Jan 29th, 2008
A New Landmark Along Cases Considering Restricted Stock Discounts
Litman v. United States, 2007 U.S. Claims LEXIS 273 (August 22, 2007)
Not since the Estate of Gimbel v. Commissioner (2006) [usual format] has a federal court taken such a close and comprehensive look at the calculation of marketability discounts for large blocks of restricted stock. But in Gimbel, the issuer’s repurchasing option played a significant role in reducing the risk and the applicable discount for a 13% block of shares in a publicly traded, steel and aluminum company. By contrast, Litman considered an emerging Internet company’s transfer of nearly 10 million shares to insiders (about 33% more than the public float) on the eve of its IPO, with the stock subject to considerable contractual and non-contractual (SEC) restrictions, as well as market, industry, and company risk.
Entrepreneurs in the hotel industry
Two business partners, Litman and Diener, began Hotel Reservations Network (HRN), growing it through the advent of the Internet until 1998, when USA Networks bought 90% of the company for $150 million. The partners remained in key executive roles; the buyout permitted them to sell their residual 10% interest over five years, with the price of the “earn outs” dependent on HRN’s future performance. The agreement also allowed HRN to amortize the purchase price over a certain period of time, recapturing some of its costs through tax benefits (the “tax shield”).
As lifelong entrepreneurs, the partners soon chafed under HRN’s control. Their incentive to maximize the earnouts, paid as a multiple of EBITDA cash flow, clashed with the new owners’ efforts to grow the company. The travel industry was growing rapidly due to the Internet, and the company authorized an IPO only seven months after the sale. To align their interests, the parties agreed to convert the founders’ earn out rights to equity.
An amended purchase agreement entitled the former owners to receive 9,999,900 shares when HRN “consummated” the IPO, subject to four years of restrictions: 40% transferable after the first anniversary of the IPO, 10% after each of the second and third anniversaries, and all remaining stock after the fourth. On February 24, 2000, the IPO price was set at $16 per share, and HRN issued nearly 10 million shares to the former owners. The IPO of 6.21 million shares closed on March 1, 2000. at $26.25 per share.
Taxpayer and issuer at odds, IRS ‘whipsawed’ in the middle
In connection with their 2000 personal income tax returns, the former owners retained an accredited financial analyst to value the HRN stock. The expert began with the $16 IPO price and then applied a discount for lack of marketability (DLOM) for each restricted “tranche,” ranging from 49.5% in year one to 79% in year four—for an average weighted value of $4.54 per share.
On its 2000 corporate income tax return, however, HRN valued the same 9.99 million shares at $16 per without applying discounts, resulting in a goodwill value of nearly $160 million, amortized in 2000 at $9.5 million. The tax gap between the individual and corporate taxpayers amounted to approximately $115 million, according to the IRS, which complained of being “whipsawed” by the disparate valuations. Based on its own assessment, the IRS claimed a total of $5.7 million against the former owners (Litman and Diener) on their individual returns and $3.2 million against HRN. By its notices of deficiency, the IRS also sought the “consistent and proper taxation of the transfer of the HRN restricted stock.”
Key issues: valuation date and discounts
The cases were consolidated in the U.S. Court of Claims, which first considered the appropriate valuation date. The IRS agreed with Litman and Diener that the appropriate date was February 24, 2000, when the IPO price was set (at $16 per share) and the issuer transferred the stock. HRN argued that the March 1 closing date of the IPO should control; or, alternatively, the stock should be valued on February 25, when some finalization of the stock issuance took place—and the stock “popped” to $26 per share–very close to the $26.25 price at closing.
But in its original claim for a refund and court pleadings, HRN had conceded issuing the stock certificates on February 24, and the Court found this language controlling. As to the fair market value of the 9.9 million shares of restricted stock, only HRN disputed the $16 price as the starting point for the valuation, and all parties disagreed over the appropriate determination of discounts.
1. IRS. The IRS expert reviewed three restricted stock studies to establish a preliminary discount range from 16% to 22%, adjusted to 20% to 26% to account for the four-year restrictions. He also considered a “hypothetical equity option collar transaction,” which encompassed four years of theoretical borrowing costs adjusted to present value. After adjustments to account for a “key person” discount, the IRS expert determined discounts for each tranche of shares, ranging from approximately 17% to 21%. He then compared both methods to reach a final weighted average DLOM of 20.3%.
2. Corporate taxpayer. The company’s expert believed that HRN stock was worth $23 per share at the IPO, taking into account the “pre-open bid and offer prices.” To calculate the DLOM, he relied on a restricted stock study and a pre-IPO study and compared the length of HRN restrictions against large blocks of publicly traded restricted shares, using the latter’s discounts as benchmarks. Ultimately, he concluded that a 20% DLOM was appropriate.
3. Individual taxpayers. Their expert began with the $16 IPO price and reviewed the IRS Revenue Ruling 59-60 factors specific to valuation of restricted securities, concluding that the key “drivers” of marketability discounts were the substantial restrictions and the associated opportunity costs. Not only was the HRN stock restricted for twice as long as the more typical two-year holding period, but additional contractual limitations precluded private placement. The 9.9 million block of shares was also larger than the public “float” of 6.2 million shares, further impacting the stockholders’ ability to sell. The “frenzy” over Internet stocks was a final factor; during the two years prior to 2000, the return on public equity in the dotcom sector was over 1000%.
To quantify these variables, the expert applied: (1) the Black-Scholes option-pricing model; (2) a capital asset pricing model (CAPM); and (3) a number of empirical studies. The latter gave rise to a range of DLOM from 31% in year one to nearly 70% in year four. Given the atypical restrictions and risk, the expert put greater weight on the pricing models to determine a final DLOM range of 49.5% to 79%.
Court reviews restricted stock studies
The studies relied on by the individual taxpayers’ expert helped support the conclusion that a “wide range of…marketability discounts” applied in this case, the Court said. “Also, these studies reinforce the concept that one of the components driving the determination of a marketability discount is a quantifiable risk associated with purchasing a restricted stock.”
But empirical studies that primarily examine discounts in the context of comparable earnings and revenues may ignore factors such as block-size, holding period, number of weeks to sell, and trading volume. Much of the data are aged, and any reliance on published averages in the studies—without accounting for the underlying data points—“channels” the analysis to yield an average result rather than a wide range.
Moreover, in his reliance on just two studies, the expert for the corporate taxpayers did not take into account the “severe” restrictions imposed on HRN stock, which—unlike the stock in the studies—could not be easily “collared” or sold in private placement. He also did not factor the effect of a block sale by the former owners, which would likely depress the market. “Thus [his] opinions that everything evens out and the appropriate [marketability discount] is 20% are incongruent in the factual context.”
Quantitative methods must be ‘real world’
The IRS criticized the taxpayers’ use of the Black-Scholes model for being “one-sided,” insuring against only the downside risk, whereas its “option collar” accounted for not only the cost of a put but also a call option. While the theoretical approach had some merit, the Court found that “the size of the HRN restricted stock, as compared to the public float, [renders] such a transaction impossible as a practical matter.” (Interestingly, the IRS expert in Gimbel v. Comm’r also used an option collar approach—and the Tax Court likewise found that the approach failed for lack of “real world” availability.)
Moreover, in an internal memorandum discussing the taxpayers’ audit, the IRS valuation agent used an option-discount methodology. This was “the most persuasive real world factor” supporting the taxpayer’s methodology,” the Court said, finding the option-pricing model an “accepted method within the appraisal community of valuing restricted shares.” The model effectively valued marketability or “the right to sell,” which is one of the more valuable rights available to the holder of securities.
While the Court credited all experts, it generally approved of the quantitative approaches used by the individual taxpayers’ experts, with some exceptions—for instance, his failure to consider items the parties specifically negotiated in their purchase agreement, such as the early lifting of restrictions. To account for the omission of these “real world” variables, the Court subtracted 25% from the lower range of the taxpayers’ marketability discounts, concluding a range from 22% to 50% in years one through four. Applying these discounts, it reached a final fair market value for the stock of $12.48 in year one, $10.24 in year two, $9.92 in year three, and $8.00 in year four.
