Article: The Market Approach in Estimating Marketability Discounts
The discount for lack of marketability (“marketability discount” for short) is among the more hotly debated business appraisal topics. Because investors prefer investments that can be converted to cash quickly, investors will pay less for an illiquid security than they would pay for an otherwise comparable but actively traded alternative.
Different assets trade in markets characterized by differing degrees of liquidity. The ultimate market in this respect is in government bonds, where the seller of a treasury bill gets cash the next business day. While the price is locked immediately, the public equity markets are not as fast, generally requiring three business days to convert to cash.
At the other extreme are securities that cannot be resold without the consent of a third party. Worse yet, that party is opposed to the sale and makes no distributions. A rational investor would likely refuse to waste time with such a transaction. Therefore, in appraisal terminology, the offering would carry a 100% “discount for lack of marketability.” (Please note that other discounts are involved when a security carries unlimited liability for an entity’s debt or generates taxable income without yielding cash to pay the tax.)
The theoretical extremes mentioned in the previous paragraphs suggest discounts as high as 100% and as low as 0%. As appraisers, we are often asked to opine regarding the value of securities not traded on a public exchange. This stock typically has value, but not as much as if it were freely traded. The challenge for the appraiser is to determine the magnitude of that difference–the marketability discount. A significant discount can have a dramatic impact on the transaction price, on the resultant taxes, and, of course, on the ultimate economic outcome.
One technique appraisers might use to determine the appropriate marketability discount is a market based determination, which is generally based on one of two types of studies: restricted stock studies or pre-IPO studies. The elder of the two, restricted-stock studies, is based on a stock sold under Securities and Exchange Commission Rule 144, where a company with publicly traded stock may sell shares directly to an investor outside of the normal secondary offering procedure. However, the buyer is required to hold the stock for a certain period of time before it can be resold and the transaction must be reported to the SEC. For these transactions, a discount can be calculated by comparing the selling price to the same day’s market quotes.
This method requires caution when used for closely held companies, since there are certain differences between the marketability discount associated with a privately held stock and the discount implied by the difference in price between the restricted and freely traded shares of a public company. The most significant difference is that the buyers and sellers in the restricted stock studies expected the securities to become marketable after a period of time, where a closely held company securities purchaser generally cannot hold such an expectation.
The amount of time for which trading is restricted has changed over the years. Under the original version of the rule, no resale was permitted for two years, a volume limitation applied for a year, and the stock became unrestricted (unless the holder was an insider) at the end of three years. In 1990, a rule change allowed sales in the first two years among “accredited” (presumed to be sophisticated) investors. A 1997 alteration reduced the initial two-year holding period to a year, and an early-2008 change reduced it further (to six months), while outright removing the dribble-out period for non-insiders. Since closely-held stock is less marketable than any of the restricted stock varieties, some argue that the older rules are more useful in drawing comparisons to privately held securities.
The other type of study on which appraisers draw in determining marketability discounts is the pre-IPO study. In general, these studies compare the price at which shares transacted in the two years prior to a company’s initial public offering to the price at which the company ultimately went public.
While the restricted-stock studies compare transactions that occurred on the same date, the pre-IPO studies compare transactions that took place on different dates. Appraisers use a variety of techniques to overcome this unfortunate shortcoming–some ignore it, some use an industry index to adjust the relative prices for the passage of time, and others use a broader index such as the S&P 500 to account for the time passage.
Of course, both study types have their pitfalls. One of the greatest criticisms is that both suffer from selection bias. Obviously, transactions in companies whose IPO does not actually happen cannot be included in a pre-IPO study. Therefore, all of the data points in a pre-IPO study relate to companies who had a successful IPO. It is argued, then, that the companies represented in the pre-IPO studies are particularly attractive and, as a result, are not necessarily directly comparable to businesses in general.
On the other hand, the issuance of restricted shares is often a higher cost alternative to issuing additional publicly traded stock because the issuer would anticipate receiving more money per share from an open, secondary offering. Some analysts argue that, since restricted stock was issued at a discount instead, it implies a need for quick cash. Naturally, this suggests a business could be in trouble. Correspondingly, it is asserted that troubled companies are overrepresented in restricted stock studies. To a degree, these issues can be mitigated by searching for completed transactions by companies financially similar to the appraisal subject.
Both types of studies suggest measures of central tendency for discounts ranging from 20 to 40 percent, but there is a wide data spread, which has caused ever increasing scrutiny from appraisal report users when average or median discounts from the studies are directly applied to appraisal subjects.
Appraisal report consumers are demanding increasing analysis in arriving at the discount amount and more explanation of both the theoretical basis for the discount and the economic rationale for the application of a particular discount. Tax Court cases are replete with judges admonishing appraisers for both the IRS and the taxpayer to expend more analytical capital focusing on the facts and circumstances of a particular company and to more judiciously compare the company to those used in the studies.
While there is no doubt that the marketability discount exists, the determination of the particular discount applicable to a subject company can be a matter of considerable dispute. The professionals at Decosimo Advisory Services not only have the most recognized credentials in the business valuation profession for this discount determination process, but also have perspective that comes from a great deal of real world transactions assistance. We are experienced in applying the market (and other) methods to determine and credibly support marketability discounts. If you or one of your clients needs a nonmarketable security appraisal, please call us at 800.782.8382.