Lack of Marketability Discounts Do Not Come Out of Thin Air

By: Joseph B. La Pray

Investors like to know what they are getting into before they make a deal. One of the things investors look for before buying a stock is some assurance that they will be able to exit the investment if they change their mind. In other words, investors value liquidity in their investments.

One of the best ways to determine the value of a business (or any other asset) is by comparison with the known values at which other, similar assets have been sold in arms length transactions between willing buyers and willing sellers. Business appraisers often value ownership interests in private businesses by comparing them to similar businesses whose stock is publicly traded. However, publicly traded stock can be sold and converted to cash within about seven days simply by calling a stockbroker, whereas it may take many months and, in extreme instances, even years to find a buyer for stock in a privately-held company. All else being equal, investors are less willing to tie-up their resources in a privately-held stock for which they may never be able to find a buyer than in a stock which is readily marketable in the public market. In order to attract investors to non-publicly traded stock these shares sell at a discount compared to stock in similar, publicly traded companies.

Determining the appropriate size of the discount for lack of marketability is one of the appraisal profession's ongoing challenges which has only recently began to be thoroughly explored. Beginning in the late 1960's several landmark studies were conducted which have been used routinely in the quantification of marketability discounts for privately held stock. Each of these studies analyzed transactions involving companies which had some outstanding shares which were publicly traded, and some identical outstanding shares which were restricted from being sold in a public market. Restricted shares typically are issued when a company transfers stock to managers or affiliates prior to going public. Rule 144 of the Securities and Exchange Act of 1934 requires that when such stock is issued it cannot be sold in a public market for a defined period of time. This rule is intended to keep markets clear of stock about which there is little information available. The existence of two types of identical stock in the same company, where some shares are publicly tradable and some shares are restricted from being traded provides an opportunity for analysis of lack of marketability discounts.

While restricted stock cannot be sold in public markets, it can be sold in private placements. The first study comparing private placement transactions of restricted shares with prices for identical publicly traded shares was conducted by the Securities and Exchange Commission and published in 1971. This study made 398 observations of transactions involving sales of restricted stock in companies which also had unrestricted stock traded in public markets. While the SEC study found that restricted shares sold at a discount from publicly traded shares, the discounts were dispersed over a wide range. For example, 26 of the 398 transactions involving restricted shares occurred either at no discount or with a premium of up to 15% relative to the unrestricted (publicly tradable) shares. Another 48 of the transactions had discounts in the range of 50% to 80% from the value of the identical shares which were publicly tradable. Most of the 398 transactions fell between these extremes and the mean discount in the SEC study was 26%.

Eight subsequent studies were published by different financial analysts during the 1970's and 1980's. These studies generally supported the conclusions of the SEC study, finding individual transactions occurring at a wide variety of discounts and overall mean discounts for the eight studies fell in the range from 23% to 35%.

Unfortunately, all marketability discount studies found individual transactions covering an enormous range of differences in value between marketable and restricted shares. An additional problem with these studies is that by the middle 1990's they were all dated. Fortunately, a new study shedding some light on this issue has recently been published by Management Planning, Inc., a New Jersey appraisal and consulting firm.

Similar to the earlier studies, the Management Planning study also examined discrepancies between transaction prices in restricted and unrestricted shares of the same firm and found a wide range of discounts and an overall mean discount of 27.7%, within the range of overall mean discounts found by earlier studies. However, in addition to including more current data, the Management Planning study also attempted to discern why some transactions occurred at higher discounts than others. Statistical analysis of the 49 private transactions which met Management Planning's criteria for inclusion in the study found the following general tendencies:

• There is a tendency for the private transactions of larger companies (as measured by revenues or earnings) to have lower discounts than those of smaller companies.
  
• There is only some tendency for the private transactions of companies with higher rates of growth (as measured by revenues or earnings) to have lower discounts than companies with lower rates of growth.
  
• Interestingly, there appears to be a tendency for higher-priced shares to have lower discounts than lower-priced shares.
  
• There is some tendency for higher market capitalization companies to have lower discounts than lower market capitalization companies, although this relationship is not as strong as we might have expected. The impact of size and safety are likely captured in the revenue and earnings variables.
  
• There appears to be some tendency for several variables involving the block size and trading volume to influence restricted stock discounts. This tendency was observed with block size (in shares), although the differentials between quartile averages were fairly small. Two factors dealing with the length of time it would take to sell a block appear to exhibit some tendency in influencing the size of restricted stock discounts.

In summary, the Management Planning study found that lower discounts generally applied for restricted shares in larger companies (as measured by revenues and earnings), and for higher-priced and higher capitalization companies than for restricted stock in smaller companies with lower-priced stock and lower capitalizations. It must be emphasized, however, that each individual transaction is unique and different variables are at work in each situation.

Appraisers are constantly searching for objective empirical information which will help them determine a correct value. The more objective evidence an appraiser has to work with, the better an opinion he or she can render. There will probably never come a day when data can be fed into a computer which will then determine the most correct value for a business interest because there are too many variables determined by the element of investors' unique personal judgements. While the recently released Management Planning study is a valuable new tool for the job of estimating discounts for lack of marketability relative to comparable interests which are marketable, the effects of dividend yield, buy/sell agreements and other factors are not captured in any of the studies to date. The Management Planning study does not resolve the problem of quantifying the appropriate lack of marketability discount which is applicable to a given business interest, but it does provide business appraisers with a new tool to improve the accuracy of their work.

For whatever purpose it is intended, a good appraisal should be understandable, supportable and creditable. Objective empirical evidence such as the Management Planning study on lack of marketability discounts provides business appraisers with guidance on quantifying lack of marketability discounts and enables them to better serve the needs of their clients.

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