Valuations of privately-held common stock often include a discount for lack of marketability (DLOM). Selecting the appropriate discount is a matter of judgment & expertise, which should include the following steps:
Identify a baseline value to which the discount is applied. Typically, a valuation methodology, such as the guideline public company method, provides an indicated value. This value assumes the security is marketable (registered) and liquid (there is sufficient trading volume to absorb buy and sell orders). The DLOM adjusts for the consideration that the security to be valued is neither marketable nor liquid.
An alternative method may value the common stock relative to a recent price paid for preferred shares. In this instance, the baseline security (preferred stock) is unregistered and the market is illiquid. It may be appropriate to apply an incremental DLOM to the common, but this DLOM is likely to be smaller than the DLOM referenced in the first example.
Estimate the expected time to liquidity and other factors which influence the DLOM. The DLOM for a security with near-term prospects for liquidity is smaller than the DLOM for a security without these prospects. The restricted stock studies have documented that, when the SEC reduced the holding period for unregistered securities, the discount associated with these securities declined.
In addition to time, factors which increase the DLOM include high volatility, an absence of dividend rights, an absence of put or redemption rights, and concentrated ownership.
Take into account the range of discounts indicated by objective research. This research includes the restricted stock studies and efforts to quantify the discount using regression analysis and put option analogies.
Take into account guidance from the standards setting and regulatory agencies. If the appraisal is performed for tax purposes, it may be appropriate to consider tax court decisions involving the DLOM. If the appraisal is performed for financial reporting purposes, SEC speeches and policy should be taken into account.
The Restricted Stock Studies
PPC’s Guide to Business Valuations1 cites a variety of studies that address the issue of discounts for lack of marketability. All of these studies are based on analyses of minority interests. Independent studies of restricted stock transactions provide data on hundreds of transactions. These transactions involve “letter” stocks – stocks that are identical to the corresponding freely traded stocks except they are restricted from trading in the open market for a certain period. The studies cite a range of discounts on restricted stocks, generally around 25-35%.
|SEC Overall Average
|SEC Non-reporting OTC Companies
|Standard Research Consultants
|Willamette Management Associates
|FMV Restricted Stock Study
|Columbia Financial Advisors
The restricted stock studies have several weaknesses. Generally, the restricted stock studies are based on small sample sizes. The companies that issue restricted shares tend to be relatively small, and some do so because of a need for capital. Investors in restricted stocks have shares that may be traded once the restriction lapses. Thus, when the SEC reduced the holding period on restricted shares, the discounts associated with restricted shares declined. For a private company, there is no guarantee that the shares can ever be traded.
John D. Emory’s pre-IPO studies have examined the relationship between stock transactions and subsequent initial public offerings of the same stock in an effort to quantify the discount for lack of marketability. In numerous studies, Emory has reviewed over 2,000 prospectuses and found over 300 qualifying transactions. These transactions reflect discounts in the range of 45 percent.
Mukesh Bajaj and others have criticized the pre-IPO studies and called for a distinction between a marketability discount and a discount for other factors2 . In a review of private placement discounts, Bajaj has noted that, “The discount offered to buyers is compensation for the cost of assessing the quality of the firm and for the anticipated costs of monitoring the future decisions of its managers.” Mark L. Mitchell has responded that the discounts are too high to be considered a monitoring cost.
The SEC Perspective
In a speech at the 2004 Thirty-Second AICPA National Conference on Current SEC and PCAOB Developments, the Associate Chief Accountant for the SEC said, "The second issue we address with frequency is the magnitude of discounts, particularly the magnitude of the discount for the lack of marketability. While there are no bright lines, management has the burden of supporting the amount of the discount they select. It's not enough to simply cite the average marketability discount used by your investment banker or to highlight that the amount of the discount used falls within a broad range you noted in an academic study. As a starting point in evaluating these discounts, we try to understand the duration of the restrictions and the volatility of the underlying stock. Generally, the longer the duration and the higher the volatility, the higher the discount.
"The AICPA Practice Aid lists other examples you might consider, but it too is not an all-inclusive list. It's important to note that if you are deriving a marketability discount from what you believe to be comparable companies, you need to ensure that the discount only gives effect to the lack of liquidity of the comparable companies' stock and not to other factors specific to the comparable companies such as the successful execution of a business plan or the reduction in risk associated with achieving projected results. In responding to staff comment in this area, management should be cognizant of the fact that while qualitative factors may have entered into their determination, they ultimately quantified a discount. At the end of the day, management must provide sufficient objective support for the amount of any discount taken."
In light of these remarks, a put option model may be appropriate for determining the DLOM since it takes into account the expected life of the restriction and expected volatility.
Registration statements filed by companies planning to go public seem to indicate that a DLOM of no more than 10-15% is appropriate within 12 months of an IPO.
Put Option Models
Put option models provide one approach to estimating the DLOM. One proponent of this method, David B.H. Chaffee, III, has explained the theory as follows, “If one holds restricted or non-marketable stock and purchases an option to sell those shares at the free market price, the holder has, in effect, purchased marketability for those shares. The price of that put is the discount for lack of marketability3 .” In this example, the put option provides protection from downside risk. Francis A. Longstaff has developed an alternative model to capture the benefit of being able to liquidate an investment when the stock reaches a peak.
It is noteworthy that the put option models may generate higher discounts than what the SEC will accept for financial reporting purposes. If a company plans to file for a public offering within one to two years, many auditors and appraisers believe that a DLOM of no more than 10% to 15% is appropriate. This belief is based in part on review comments received from the SEC in conjunction with IPO filings.
Depending on the volatility assumption, the put option models may indicate higher discounts than the allowable range of 10% to 15%. “According to the Chaffee study, the appropriate DLOM for a privately held stock with a two-year required holding period and a volatility between 60 percent and 90 percent is between 28 percent and 41 percent4 .” Longstaff and Finnerty have found the following correlations between volatility and the DLOM, all with a holding period of 2 years:
The difference in indicated DLOMs is evidence that the put option models are hardly perfect in quantifying the discount for lack of marketability.
1 Jay E. Fishman, et Al. PPC’s Guide to Business Valuations. Thomson Reuters. February 2009.
2 Mukesh Bajaj, et al. Firm Value and Marketability Discounts.
3 David B.H. Chaffee, III “Option Pricing as a Proxy for Discount for Lack of Marketability in Private Company Valuations,” Business Valuation Review. December 1993.
4 Travis R. Lance. “The Use of Theoretical Models to Estimate the Discount for Lack of Marketability.” Insights. Autumn 2007.