Lack of Marketability Discount Requires Empirical Support
The discount for lack of marketability is an often-contested valuation adjustment that requires a particularly detailed process. When calculating any valuation adjustment, an appraiser obviously can’t just pick a number out of a hat. He or she must consider the situation and the unique characteristics of the interest that’s being valued. No Random Numbers Business valuation professionals use empirical evidence, such as restricted stock studies and pre-initial public offering studies, to quantify a discount for lack of marketability. This discount is generally taken on noncontrolling private business interests. Controlling interests may be subject to a liquidity discount that reflects the time and costs of selling a private business. But there aren’t any empirical studies for liquidity discounts. The Discount Application The International Valuation Glossary — Business Valuation defines marketability as “the ability and ease of marketing and transferring, or the salability of an asset, business or investment.” Public stock is generally easy to sell because stock exchanges provide a ready market. In contrast, private business interests can require significant time, money and effort to sell. Despite these marketability differences, valuators often turn to public stock data when estimating the value of private firms. Because such methodology sometimes results in apples-to-oranges comparisons, experts may apply discounts for lack of marketability to their preliminary value estimates. Such discounts account for the illiquidity of private business interests relative to public stocks. Restricted Stock StudiesA discount for lack of marketability is stated as a percentage reduction in the subject company’s value. Valuators typically quantify this percentage for noncontrolling private business interests using empirical evidence. One example is restricted stock studies. Some companies issue restricted (or letter) stock in mergers or acquisitions or to raise private capital without registering new shares. Restricted stock is identical to freely traded stock, except that it’s subject to a minimum one-year holding period. Public companies must report restricted stock transactions to the Securities and Exchange Commission. Restricted stock studies compare restricted stock prices to freely traded stock prices on the same day to estimate the discount for lack of marketability. Analysts hypothesize that the key difference between restricted stock and freely traded stock is the degree of marketability. IRS Revenue Ruling 77-287 specifically endorses the use of restricted stock transaction data to support the lack of marketability discount for private business interests. Pre-IPO Studies An appraiser may also look at pre-initial public offering (pre-IPO) studies. The SEC requires companies to disclose all stock transactions (including stock options) within three years of going public. A pre-IPO study compares these private transactions to the company’s IPO price. Some studies exclude non-arm’s-length transactions, such as those involving company insiders and stock options. Others attempt to adjust stock prices for changes in market conditions between the private transaction date and the IPO date. Whereas restricted stock studies compare different types of publicly traded interests, pre-IPO studies provide direct comparisons of a company’s private stock price to its public price. Consequently, the average discounts published in pre-IPO studies are generally higher than those observed in restricted stock studies. Matters of Size In general, empirical studies suggest a range of median discounts for lack of marketability from 35% to 50%. But the actual discount for lack of marketability that an appraiser assigns to a specific business interest can vary significantly from the norm, depending on the investment’s characteristics. It’s paramount for appraisers to evaluate specific attributes — such as profitability, financial position, liquidity, transfer restrictions and expected holding period — regarding their effect on marketability. Valuators who merely rely on average (or median) discounts from restricted stock or pre-IPO studies are unlikely to survive a deposition or cross-examination. Key Considerations When quantifying a discount for lack of marketability, strong performance (such as high profits or low leverage) generally correlates with a lower discount. The risk of a company’s underlying assets also affects its discount for lack of marketability. Moreover, investors place a premium on reliable financial data and professional management. Dividends matter, too. Companies that distribute cash to investors provide an immediate return on investment, thereby lowering discounts for lack of marketability. It’s also important to note that the more potential buyers interested in a company, the lower its discount for lack of marketability. Digging Deeper At the end of the day, a discount for lack of marketability based only on empirical study averages may not withstand scrutiny. That’s why experts are digging deeper than ever for more meaningful, defendable comparisons. For example, there are quantitative methods (such as those based on discounted cash flow) to derive an estimate for a discount for lack of marketability. Ultimately, it’s a complex process that calls for specialized expertise. |