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.
No Random Numbers
Appraisers use empirical evidence, such as restricted stock studies and pre-initial public offering studies, and more to quantify a discount for lack of marketability percentage for non-controlling private business interests.
The Discount Application
The International Glossary of Business Valuation Terms defines marketability as “the ability to quickly convert property to cash at minimal cost.” 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, appraisers often turn to public stock data when estimating the value of private firms. Because such methodology sometimes results in apples-to-oranges comparisons, appraisers 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 Studies
A discount for lack of marketability is stated as a percentage reduction in the subject company’s value. Appraisers typically quantify this percentage for non-controlling 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 SEC.
A restricted stock study compares 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.
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 percent. 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. Appraisers who merely rely on average (or median) discounts from restricted stock or pre-IPO studies are unlikely to survive a deposition or cross-examination.
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.
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 appraisers are digging deeper than ever for more meaningful, defendable comparisons. For example, there are quantitative methods (such as those based on discounted cash flows) to derive an estimate for a discount for lack of marketability. Ultimately, it’s a complex process that calls for specialized expertise.