Tax cases offering guidance on the valuation of restricted securities are few and far between. The U.S. Court of Appeals for the Ninth Circuit in its 1998 McClatchy decision¹ treated the shares of an affiliate decedent as restricted shares, regardless of the date-of-death transfer to a nonaffiliate estate, but didn’t say how to determine the size of the illiquidity discount necessitated by the restrictions. Then, right before the end of 2006, the Tax Court in Gimbel2 assumed the challenge of deciding the proper illiquidity discount, not just for a very large block of stock held by an affiliate estate, but also in a situation where there was a possible repurchase of the restricted shares.

The court rarely decides questions of fact, including most valuation issues, en banc. And a trier-of-fact’s decision is rarely better than the analysis and research presented to it. In any given case, a valuation issue might be decided differently based on which facts, research and analyses the parties present and which judge(s) is(are) on the bench. But the Tax Court’s reasoning in Gimbel is a good starting point for reviewing the evidence and theory on restricted securities and illiquidity discounts.

THE FACTS

As of her death in June 2000, Georgina Gimbel owned, directly or indirectly, about 3.6 million shares of Reliance Steel, or about 13 percent of the company’s then-outstanding shares. The decedent’s late husband, William Gimbel, had been chairman and former chief executive officer of Reliance until his death in 1998. The decedent’s son became a director upon William Gimbel’s death. 

Reliance was a successful manufacturer of metal products and as of 2000, had grown to about $1.7 billion in sales and $157 million in net income. Its stock had increased greatly in value over the years and, on the valuation date (the date of Georgina’s death), traded at a high of $21.25 and a low of $20.375, indicating a total market capitalization of $578 million. The company’s dividend also had grown and represented 5.5 cents per quarter as of the valuation date. Reliance held significant amounts of cash and had access to a $200 million line of credit.

Reliance adopted a stock repurchase plan in 1994. The plan initially allowed for the repurchase of up to 2.25 million shares, but this amount was raised to 6 million in 1998. Until the valuation date, 1.37 million shares had been repurchased in the open market under this plan. Just two weeks prior to the valuation date, the chief executive officer of Reliance reported that 1999 had been a record year and the company was considering repurchasing shares as it had in the recent past for about $19 per share. Eventually, Reliance repurchased about two-thirds of the estate’s 3.6 million shares at a modest discount from the market-trading price.

The court had to decide (1) whether it was foreseeable as of the date of Georgina’s death that Reliance would repurchase any of the estate’s shares and, if so, how many shares the estate could reasonably have been expected to sell in this fashion; and (2) the proper discounts, both for the shares to be repurchased and for the remainder of the shares left after the expected repurchase. 

AFFILIATE STATUS

Under applicable securities regulations, the liquidity of restricted shares can be affected by the identity of their holder. Securities and Exchange Commission Rule 144 covers securities acquired from the issuer without registration as well as all securities held by an issuer’s affiliate. Because the resale restrictions of the rule are much more stringent for affiliate shares than for nonaffiliate shares, the affiliate status of the decedent (or the estate) was important in determining the fair market value (FMV) of the estate’s shares. As the first step in the valuation process, then, the Gimbel court was called upon to determine whether the shares were held by an affiliate. This is not easy, for two reasons: (1) The test for whether a “person” (in the context of Rule 144) is considered an affiliate is not clear-cut; and (2) it’s also unclear in the tax code if the decedent’s or the estate’s affiliate status is the deciding factor.

Rule 144 states: “An affiliate of an issuer is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer.”³

Whether a person controls the issuer is a fact-based determination that must consider his percentage ownership of voting stock, any positions held by him in company management or on its board—or any other evidence of control. A person’s affiliate status may change as circumstances change. A person also can take steps to change his status by selling parts of his block, or otherwise “splitting” it, if the size of the block is the deciding issue. Often, 10 percent is regarded as the threshold for affiliate status. Yet it is possible to establish a person with an even greater ownership percentage as a nonaffiliate, if it can be shown that the person does not exercise any control over the issuer.⁴

The Tax Court in Gimbel did focus on the size of the decedent’s ownership, saying that “due to the large number of decedent’s Reliance shares . . . [she] was considered an ‘affiliate’ (or an affiliated person).”⁵ The court added that under Rule 144, the estate would not be allowed to sell to the public more than 277,860 of its approximately 3.6 million shares in the public market and that it would take a minimum of about three years and three months to do so.

Interestingly, the Gimbel court did not consider the estate’s affiliate status. Admittedly, the affiliate status of the decedent and the estate are likely to be the same in this case, as the decedent did not have a management position at Reliance. But the exclusive focus on the decedent’s affiliate status might indicate the Tax Court’s position on this issue has changed since McClatchy. The decedent in McClatchy was chairman, chief executive officer and editor of McClatchy Newspapers, Inc., and held a significant interest, albeit less than 10 percent. The Tax Court held that this represented one of those rare circumstances in which death alters the value of the decedent’s assets. In the Tax Court’s view, Charles McClatchy had removed the Rule 144 restrictions on his shares by passing away and thereby increased their value. Distinguishing McClatchy from Ahmanson⁶ and Land,⁷ the Ninth Circuit took a different view, noting that while “the death of a key partner can instantly decrease the value of a business,”⁸ in McClatchy, “death alone did not effect the transformation of the stock’s value. The value of the stock was transformed only because the estate was a non-affiliate. . . If the estate had been an affiliate, the securities law restrictions still would have applied. . . The affiliate or non-affiliate status of an estate depends on the status of the executor or other person who serves ‘in any similar capacity.’ The personal representatives for the estate were not issued letters testamentary until 25 days after McClatchy’s death. The restrictions therefore did not evaporate at the moment of death.”⁹

McClatchy’s estate was not an affiliate of the issuer. The Ninth Circuit clearly is of the opinion that in the “willing buyer, willing seller” valuation context—as we cannot have known for certain that the estate would be a nonaffiliate—we should consider the share’s restrictions as not having changed at death. In other words, the shares are valued “as if” in the hands of the decedent.¹⁰

REPURCHASE

The question of whether to consider a post-death event in arriving at the date-of-death value is exceedingly difficult and no clear guidance exists, other than the “reasonably foreseeable” test used in a string of cases.¹¹ Unfortunately, to say that something is reasonably foreseeable can mean almost anything and this term has been interpreted loosely. The test is meant to establish what data a buyer or seller would have considered in his transaction decisions as of the valuation date. To the Gimbel court’s credit, that is exactly how it was applied. 

Given Reliance’s long-established stock repurchase plan and management’s public statements before Georgina died, an investor in the shares would have considered a repurchase possible. But Reliance had other potential uses for its cash and line of credit so it also was possible that the repurchase would not take place. At trial, the valuation experts’ opinions were quite different: The estate’s expert concluded that it was not reasonably foreseeable that Reliance would repurchase any of the shares, while the Internal Revenue Service’s expert concluded that it was reasonably foreseeable that Reliance would repurchase 50 percent of the estate’s shares. To say that both of these possibilities were reasonably foreseeable is as correct as it is completely beside the point. The question is: how would a hypothetical investor in the shares weigh these and other possibilities? The court considered two facts in rejecting a 50 percent repurchase fraction: At the time, Reliance was negotiating a large company acquisition that, if successful, would have required significant cash and credit, thereby stretching the company’s financial capacity. Also, to buy 50 percent of the Gimbel estate’s shares, Reliance would have had to spend three times as much as it had for its largest prior stock repurchases.¹²

In other words, while it was plainly foreseeable that Reliance would repurchase some of the estate’s shares, the possibilities ranged from none to 100 percent. A willing buyer or seller would likely look at that range and calculate a weighted average of the valuation inputs. This, in effect, is what the court implicitly did in selecting a 20 percent repurchase fraction.  

The next question was the ap-propriate discount for the shares to be repurchased. Neither of the estate’s experts provided an analysis on this point (one expert did not address the possibility of a repurchase at all and the other concluded no purchase was reasonably foreseeable.). As a result, the court adopted the Service’s expert’s position in its entirety. The IRS expert noted that the company’s investment bankers had suggested a repurchase should take place at a discount of 10 percent to 15 percent. In addition to the 12.5 percent mid-point for this range, he added 1.4 percent for the time-value of money due to the delay between the valuation date and the likely date of repurchase. 

APPRAISAL REPORTS

The remaining issue was the ap-propriate illiquidity discount for the remaining 80 percent of the estate’s Reliance stock. The estate provided two reports for the court’s review: the original appraisal submitted with the estate tax return and the report of an expert retained for the trial. 

The estate’s expert at trial applied a simple three-step analysis, based on the idea that the most likely way for the estate to cash in its shares was to dribble them out into the market. The first step of the analysis was to estimate the likely proceeds from this procedure, which the expert did by adding the current value of the shares as of the valuation date to the expected dividends during the dribble-out period. The second step was to estimate the discount rate appropriate for the proceeds equal to the required rate of return on the stock (13.2 percent). Finally, the expert determined the value of the proceeds by discounting them back to the present. Overall, this resulted in a 17.4 percent discount from the valuation date price.

The report submitted with the estate tax return also assumed that the dribble-out procedure was the likeliest route to cash for the estate, but took a different tack. This expert assumed that the estate would hedge its downside risk by purchasing put options covering the dribble-out period. In this analysis, the valuation date price value of the shares was first discounted to the present using the risk-free rate. Then, the estimated cost of the necessary put options was subtracted. This method yielded an overall discount of 24.5 percent. 

The Service’s expert also assumed a dribble-out procedure, but assumed that a hypothetical owner of the estate’s shares would hedge its risk during the dribble-out period using contracts such as cashless collars or prepaid variable forwards. The total cost of such contracts resulted in a discount of only 5 percent from the valuation date trading price. 

HEDGING PROBLEMS

The report submitted with the tax return and the Service’s expert’s report correctly concluded that the appropriate valuation method for the shares, assuming that their value could have been locked in through hedging contracts, was to discount the current value to the present through the dribble-out period using the risk-free rate. If the value had been locked in by hedging contracts, the future value of the shares would equal their current (valuation date) value. However, as the court pointed out, “the hedging contracts used . . . likely would not have been available for a block of stock such as the estate’s Reliance shares.”¹³

Small-capitalization public companies rarely have very active trading markets for options and the ability of an investor to hedge a position with publicly traded put options (or, even better, with collars) at a low cost depends on put-call parity holding. Often, in fact, small-capitalization companies have no publicly traded options. Moreover, research shows that put-call parity does not hold for illiquid or hard-to-borrow¹⁴ stocks and it would certainly not hold if a single investor was trying to purchase puts (and sell calls) sufficient to hedge a position equal to more than 13 percent of an issuer’s stock and more than three years of trading volume.¹⁵ With respect to private hedging contracts written by, for example, an investment bank, the court points out that “cashless collars and prepaid variable forward contracts generally are used with blocks of stock that are highly liquid and marketable.”

A more serious theoretical problem with the approach of the appraisal report submitted with the return is that hedging with put options alone may inflate the cost of the hedging maneuver. Buying puts does not merely hedge the position—it allows a holder to profit from all of the upside potential of the stock, while insulating him from all of the downside risk. This derivative contract has an inherent value—because of its asymmetrical payoff—far above its value as a hedge against the volatility of the underlying stock.¹⁶ This explains why the discount taken in this report was the highest of the three experts’ discounts.

DECISION

First, the court rejected all of the methods that assumed hedging instruments would have been available to the estate. Because of this and because the court found that the estate’s trial expert’s approach “appears to be a reasonable and generally accepted method,” his dribble-out methodology was accepted. But because the court already had decided to assume a 20 percent repurchase by Reliance, the dribble-out period for the remaining shares was shortened from 39 months to 31 months, to account for fewer Reliance shares to be dribbled out. Reducing the dribble-out period and keeping the estate’s expert’s 13.2 percent discount rate yields a total 14.4 percent illiquidity discount. Considering both the 13.9 percent discount for the 20 percent of shares repurchased and the 14.4 percent discount for the remaining 80 percent yields a weighted average 14.2 percent overall discount.¹⁷

It might be said that the court’s choice in Gimbel was between bad and worse. The hedging methods presumed available to a hypothetical owner of the estate’s shares were in fact not available. On the other hand, the characterization of the dribble-out method as implemented in the estate’s trial expert’s report as “generally accepted” is erroneous. 

Simply put, the estate’s method—assuming that the current market price of a stock will be constant over a certain period, and then discounting the resulting cash flows to the present using the issuer’s cost of capital—flies in the face of established financial theory. This approach is not advocated by a single textbook, appraisal journal article, academic financial paper, revenue ruling, accounting pronouncement, or any other authoritative text that I am aware of. On the contrary, it is near-axiomatic in financial theory that the expected rate of return of a stock equals its required rate of return, which in turn equals its cost of capital.¹⁸ Therefore, to assume that the estate would liquidate its shares at the valuation date stock price more than three years after the valuation date—in essence, assuming a zero expected rate of return—is not just inappropriate, it completely contradicts the calculated 13.2 percent “expected rate of return” the estate, according to the court, applied.¹⁹ A less inappropriate method sometimes used by appraisers is to project the value of a security into the future using its expected rate of return, and then discounting it back to the present at a higher discount rate (a discount rate estimated on the assumption that the required rate of return on illiquid shares is higher than the required rate of return on liquid shares.). However, while this method is theoretically sound, it suffers from a lack of observable empirical data with which to estimate the illiquidity-increment to the discount rate.²⁰

VALUATION METHODS

Anyone who has read more than a few decisions on marketability discounts knows that one method is discussed (some would say favored) more than any other: restricted stock studies. In case after case, the court has reviewed the evidence of discounts from restricted stock transactions to determine the illiquidity discount for private equity.²¹ It might seem strange, then, that this data was not reviewed in Gimbel, which directly involved restricted stock. Clearly, the restricted stock study data is even more applicable to restricted securities of a public company than it is to shares of a privately held firm. To understand why this data was not reviewed in Gimbel, the court’s discussion of a possible private placement is instructive. The court noted that the estate had attempted to find a private institutional or strategic buyer and that Reliance’s investment bank “made some inquiries in this regard but was not able to find an interested investor” for the stock.²² The court concluded that “the evidence indicates that, other than a repurchase by Reliance, as of the valuation date a private market for the estate’s Reliance shares did not exist.”²³

There was likely no lack of institutional investors interested in illiquid investments as of the valuation date—and there certainly is none today. Nevertheless, it is possible that there truly was no buyer for the estate’s securities at any price. Furthermore, the estate’s affiliate status—assuming it could not be mitigated in some way—would tend to reduce demand for its shares.²⁴ Any private sale from an affiliate of the issuer, while perfectly legal, would restart the one-year Rule 144 holding period.²⁵

However, the lack of a private buyer for the estate’s shares does not reduce the usefulness of the restricted stock discount data. The analogy with marketability discounts for private equity should make this clear: The Tax Court routinely applies this data to privately held stock regardless of the fact that there is hardly ever an actual ready “market” of buyers willing to purchase minority interests at those discounts. Minority interests in privately held firms almost never sell, but that does not mean we cannot estimate their values. Restricted stock studies are important because they provide insights into investor preferences: What discounts are buyers willing to offer and sellers willing to accept in comparable situations for comparable equity interests?²⁶ This is a question worth investigating, regardless of whether actual buyers are lining up to buy a particular block of stock.²⁷

Theoretical models also are available that do not contradict established financial theory. One study develops a model for illiquidity discounts assuming investors have perfect market timing ability, based on the pricing formula for a look-back option.²⁸ The discount, in this model, is a function of the time remaining until the end of the illiquidity period and the volatility of the stock. Another paper has developed a model for the discount based on the pricing formula for average-price put options.²⁹ This model does not assume any special market timing abilities on the part of the investor. Another illiquidity discount model derives the discount under the assumption that the stock cannot be hedged (which appears to have been the case in Gimbel).³⁰

LIQUIDITY SOLUTIONS

Institutional investors, which have large, diversified portfolios and, sometimes, predictable and stable cash flow needs (as in the case of endowments and life insurance companies), generally fit the profile as the most suitable investors for illiquid stock. In addition, as of Gimbel’s valuation date, a small but growing group of hedge funds was beginning to invest in restricted securities of public companies.³¹ Also, since the valuation date, innovative new firms have gone one step further and established relatively active secondary markets in restricted securities.

According to bankers active in this segment around the valuation date, exchange funds were one of the liquidity solutions most actively promoted at the time, partly because there were also tax reasons favoring their use. In an exchange fund, several investors pool their illiquid securities and the fund itself slowly liquidates them. Rather than receiving a share of the proceeds from their own contributed securities, the investors receive a share of all of the securities contributed. As such, the investors hold diversified investments from the point of contribution on. After contribution, if the fund is diversified enough to mirror a major index, the investor might hedge his exposure at minimal cost: for example, with options on the Standard & Poor’s 500 (which are very actively traded so that put-call parity would almost always hold). 

EMPIRICAL EVIDENCE

To gain a better understanding of the appropriate discount for a 13 percent stake in Reliance as of 2000, we need to review restricted stock data. Two kinds of private sales are possible for restricted stock: issuer-to-investor sales and investor-to-investor sales, both of which have been studied in published articles. Issuer-to-investor sales, usually referred to as private placements, are carried out under the “4 (2)” exemption from the registration requirement of the Securities Act of 1933, while investor-to-investor sales are completed using the so-called “4 (1- 1/2)” exemption.³²

The restricted stock private placement studies are well known from the tax and accounting literature. (See “The Preferred Method,” p. 37.) For more than 30 years, studies of such transactions have indicated average discounts ranging from 15 percent to 35 percent, with somewhat larger discounts more common in private placements in the 1960s through the 1980s and average discounts in the 15 percent to 25 percent range more typical in later years, especially after 1997, when the SEC reduced the Rule 144 holding period.³³ Most of the studies, in other words, pertain to restricted shares subject to a very different regulatory framework than the one that exists today. In fact, the most comprehensive of the earlier studies, the SEC’s Institutional Investor study from 1967, was performed before Rule 144 was promulgated. As a result, conclusions from these studies should be applied to restricted shares today only with extreme care and after adjusting for the changes in the liquidity of restricted stock. The studies also generally show higher discounts for riskier issuers and for larger fractions of total shares placed. The Gimbel estate’s interest in Reliance, while a large block, was not significantly larger than the average for the private placement studies. Because Reliance was a relatively large firm in a stable industry, we may assume that its shares are somewhat less risky than the average. As such, the appropriate discount for the estate’s shares might be lower than the average for the studies. 

While investor-to-investor transactions under the “4 (1-1/2)” exemption are more difficult to find than private placements (such transactions do not generally need to be publicly disclosed), a study of such transactions has recently been published.³⁴ The LiquiStat database of private sales transactions facilitated by Restricted Stock Partners, a firm that has established one of the first relatively active trading markets in restricted securities,³⁵ contains 194 transactions from April 2005 to December 2006, including 61 trades in blocks of common equity. Data from these trades show much higher discounts than those in private placement studies. (See “LiquiStat Equity Trades,” p. 44.)

The LiquiStat database also provides insights relevant to another important estate-planning vehicle: nonqualified stock options (NQSOs). While guidance on restricted stock valuation is lacking, good guidelines for how to value nontraded options or warrants for tax purposes are almost nonexistent. There are no recent Tax Court cases³⁶ and the only guidance from the Service is Revenue Procedure 98-34, which grossly overvalues NQSOs.³⁷ But by how much? One academic study points out that because employee stock options are not transferable “the only way to cash them in is to exercise them . . . Such early exercise reduces the market value of the options.”³⁸ Another paper shows that executives demand large premiums for accepting stock options in lieu of cash compensation, because the Black-Scholes model always overvalues nontraded stock options and also because far in-the-money executive options are routinely exercised at vesting or fairly shortly thereafter, as the expected utility from locking in gains exceeds the utility from holding the options.³⁹ Yet another study of early exercise found an average actual time to exercise of 5.8 years (as opposed to total allowed time to exercise of 10 years).⁴⁰ Another recent paper estimates that employee stock options, at grant, are worth approximately half their Black-Scholes values.⁴¹

Based on 76 warrant transactions, the Liquistat database shows that the average discount from the Black-Scholes values for the LiquiStat database of warrant trades is 41.5 percent, which is significantly higher than the average restricted stock discount. (See “LiquiStat Warrant Trades,” p. 46.) It is also apparent that the discount is higher for high-volatility stocks and out-of-the-money options.⁴² This is a logical and expected outcome, as out-of-the-money options have value solely due to their time premiums—a part of the value the option holder cannot access by exercising. Presumably, as these empirical results are supported by earlier research on nontraded options, they will provide enough evidence to “retire” from further use the obsolete and inappropriate safe harbor procedures of Revenue Procedure 98-34. 

PRACTICE TIPS

Both higher and more defensible discounts are possible. McClatchy provides practitioners with rules for when a block of stock will be considered affiliate shares. While the Gimbel court was unable to review some of the most salient evidence on illiquidity discounts for restricted securities, the case still offers an interesting perspective on such discounts, in particular how to analyze post-valuation date repurchases of an estate’s shares. It is hard not to think, though, that the result might have been different had the court heard the latest evidence on restricted stock discounts from real-world, arm’s-length transactions. Finally, the LiquiStat data is another arrow in the quiver of the appraiser who needs to find the elusive bulls-eye of the appropriate illiquidity discount for nonmarketable shares and options. Surprisingly for some, these discounts are significantly greater than past studies have indicated and greater than the current consensus in the tax valuation community.                                      

Endnotes

1. Estate of Charles K. McClatchy, 147 F.3d 1089 (9th Cir. 1998).
2. Estate of Georgina T. Gimbel v. Commissioner, T.C. Memo. 2006-270 (Dec. 19, 2006).
3. Securities and Exchange Commission Rule 144 (a), 17 C.F.R. Section 230.144 (1999).
4. Note that the opposite also holds: A person with no management responsibilities or other elements of control over the company may be considered an affiliate with ownership percentages below 10 percent. This is sometimes the case when a holder sells himself down below the 10 percent mark. Corporate counsel may in these situations occasionally require a more significant sell-down, say, below 7 or 8 percent, in order to issue the opinion letter to remove the restrictive legend from the shares.
5. Estate of Gimbel, supra note 2, at pp. 7-8. Note that the court does not refer to the 10 percent “threshold” in its opinion.
6. Ahmanson Foundation v. United States, 674 F.2d 761, 767-68 (9th Cir. 1981).  In Ahmanson, the Ninth Circuit held that the valuation should take into account value transformations that “go into effect logically prior to the distribution of property in the gross estate to the beneficiaries.”
7. United States v. Land, 303 F.2d 170, 172 (5th Cir. 1962). In Land, the Fifth Circuit held that the death of a key partner may change the value of an interest in a company when certain contractual restrictions lapse at death. A buyer “would not be influenced in his calculations by past risks that had failed to materialize or by restrictions that had ended. Death tolls the bell for risks, contingencies, or restrictions which exist only during the life of the decedent.”
8. Estate of McClatchy, supra note 1, at pp. 5-6.
9. Ibid.
10. The McClatchy decision has been much criticized by legal commentators. See, for example, Arthur Sederbaum, “Son of Mandelbaum—Recent Developments in Valuation of Closely-Held Business Interest” Tax Management Memorandum, Sept. 23, 1999 (arguing that the Ninth Circuit ignores that both sides of the willing buyer-willing seller spectrum are supposed to be “hypothetical”).
11.  See, for example, as cited in Gimbel, Saltzman v. Comm’r, 131 F.3d 87, 93 (2d Cir. 1997); Trust Services of America, Inc. v. United States, 885 F.2d 561, 569 (9th Cir. 1989); and Morris v. Comm’r, 761 F.2d 1195, 1201 (6th Cir. 1985). For more recent examples, see Estate of Helen M. Noble v. Comm’r, T.C. Memo. 2005-2 (Jan. 6, 2005).
12. Estate of Gimbel, supra note 2, at p. 21.
13. Ibid., at p. 25.
14. Christopher Geczy, Richard B. Evans, David K. Musto and Adam V. Reed, “Failure is an Option: Impediments to Short Selling and Options Prices,” working paper, Dec. 7, 2005, Social Science Research Network, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=423881.
15. Conversely, if the estate intended to hedge a smaller block of stock and the company’s shares were relatively easy to borrow, it would have been perfectly simple to hedge the estate’s position without going to the trouble of purchasing put options or finding an investment bank willing to write a private hedging contract. The shares could have been hedged by locating sufficient borrow, then selling shares short, equal to the number of restricted shares held.
16. On the other hand, a cashless collar (if put-call parity holds or a private contract can be obtained) would remove both the downside risk and the upside potential. (They involve buying a put and selling a call on the same stock or index.) Thus, in situations in which such instruments are available, their cost can be much lower than purchasing put options. 
17. It’s interesting to compare this with what actually happened to the estate’s shares: About two thirds of the shares were repurchased. The court’s opinion does not address what happened with the remainder. However, after the repurchase, there is little evidence indicating that the estate would have been considered an affiliate. Thus, the estate could conceivably have liquidated its entire interest just a few months after the valuation date. 
18. Markets are assumed to “clear” at the price at which the expected rate of return equals the required rate of return. The equilibrium expected return, in other words, equals the required return. 
19. Estate of Gimbel, supra note 2, at p. 24.
20. See Shannon P. Pratt, Robert F. Reilly and Robert P. Schweihs, Valuing a Business, 4th ed., McGraw Hill, New York (2000), at p. 411.
21. See, for example, Mandelbaum v. Comm’r, T.C. Memo. 1995-255 (May 31, 2005) (discussion of restricted stock data and factors that influence the magnitude of the discount beyond the study discount average) or more recently, Dallas v. Comm’r, T.C. Memo. 2006-212 (Sept. 28, 2006) (held that transaction data closer in time to the valuation date should have been given more weight).
22. The court’s opinion does not directly describe the extent of those inquiries. However, from the discussion. it does not appear to have been a very active or aggressive sales effort. 
23. Estate of Gimbel, supra note 2, at p. 18.
24. One possibility, not discussed in the decision, is that the estate would sell itself down far enough during the dribble-out period to allow resale of all securities without regard to the volume limit (“dribble out”) provisions of Rule 144. This would happen if the estate was no longer considered an affiliate. (See Rule 144(k).) If we assume that the 10 percent threshold controls the estate’s affiliate status, this could potentially cut as much as two years off the total dribble-out period. 
25.  SEC Rule 144(d)(1), 17 C.F.R. Section 230.144 (1999). “A minimum of one year must elapse between the later of the date of the acquisition of the securities from the issuer or from an affiliate of the issuer.”
26. Revenue Ruling 77-287 has a discussion of factors to consider in valuing restricted stock, including a review of relevant empirical data on restricted stock private placement transactions. It’s interesting to note that this revenue ruling is not mentioned in the court’s opinion. 
27. It’s important to distinguish between valuation inputs and indications of market multiples or discounts—which should be considered regardless of practicalities, because they provide general insights into the preferences of investors—and maneuvers, such as hedging transactions, which are designed to provide liquidity to a specific block of shares. 
28. Francis Longstaff, “How Much Can Marketability Affect Security Values?” Journal of Finance, 50, 1767-1774 (1995).
29. John Finnerty, “The Impact of Transfer Restrictions on Stock Prices,” working paper, Fordham University, June 2003, available at www.fordham.edu.
30. David Tabak, “A CAPM-based approach to calculating illiquidity discounts,” Nera Economic Consulting, working paper, Nov. 11, 2002, available at www.nera.com.
31. These hedge funds are commonly referred to as PIPE funds as they make private investments in public equity (PIPEs). 
32. See www.restrictedstockpartners.com/3_b.asp. Restricted securities may be resold in privately negotiated transactions if such transactions comply with an exemption under the Securities Act. Sellers and buyers in privately negotiated transactions generally use the so-called “4 (1-1/2)” exemption. The “4 (1-1/2)” exemption is a hybrid exemption that was derived from Section 4(1) of the Securities Act, which provides an exemption for resale transactions “by any person other than an issuer, underwriter or dealer,” and Section 4(2), which provides a private placement exemption for issuers. The “4 (1-1/2)” exemption contemplates a private resale that is similar to an issuer’s Section 4(2) sale. As the SEC has noted, “This is a hybrid exemption not specifically provided for in the 1933 Act but clearly within its intended purpose.” SEC Act Release No. 6188 (Feb. 1, 1980). 
33. See Pratt, Reilly and Schweihs, supra note 20, at pp. 391-403.
34. Espen Robak, “Lemons or Lemonade? A Fresh Look at Restricted Stock Discounts,” Valuation Strategies, January/February 2007, at pp. 4-15.
35. The LiquiStat database is a compilation and analysis of restricted securities trading data, licensed to Pluris Valuation Advisors LLC from Green Drake Capital Corp., its affiliate. Restricted Stock Partners, a division of Green Drake Capital Corp., member NASD/SIPC, has created the Restricted Securities Trading Network (RSTN). The RSTN is believed to be the largest trading network for restricted securities, with more than 200 institutions and accredited investors as members. For more information, see www.plurisvaluation.com/liquistat.
36. One exception is Menard v. Comm’r, T.C. Memo. 2004-207, Sept. 16, 2004. (In a “reasonable compensation” income tax case, the Tax Court rejected the application of a liquidity discount for executive stock option. However, apparently no evidence was presented to support such a discount.)
37. The revenue procedure mandates the use of theoretical models like the Black-Scholes model or a binomial model, with a specified range of inputs. For example, the time to expiration used must be the full allowed time to expiration, rather than the expected time to exercise. Also, no discounts for illiquidity can be taken even for nontraded options. These requirements conspire, as it were, to render the revenue procedure totally unsuited for determining the fair market value of nontraded, illiquid options. 
38. Nalin Kulatilaka and Alan J. Marcus, “Valuing Employee Stock Options,” Financial Analysts Journal, November/December 1994, at pp. 46-56.
39. Brian J. Hall and Kevin J. Murphy, “Stock Options for Undiversified Executives,” Journal of Accounting and Economics 33, February 2002, at pp. 3-42.
40. Jennifer Carpenter, “The Exercise and Valuation of Executive Stock Options,” Journal of Finance 52 (March 1998), at pp. 127-158.
41. John D. Finnerty, “Extending the Black-Scholes-Merton Model to Value Employee Stock Options,” working paper, Fordham University, January 2005.
42. For a comprehensive review of the factors driving the size of the discount for options and warrants, see “Discounts for Illiquid Shares or Warrants,” white paper on the LiquiStat database, available at www.plurisvaluation.com/pressroom.