#4 – The Myth of the 25% – 45% “Typical” Range of Restricted Stock Discounts Must Die

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The valuation lore with many valuation analysts who cite “the restricted stock studies” (and seldom much more) is that the “typical” range of restricted stock discounts is from about 25% to 45%, with an average of about 35%.  This post addresses, and hopefully kills, this myth.

This is the fourth post in a series on restricted stock discounts and studies based primarily on Chapter 8 of our (Mercer and Harms) forthcoming third edition of Business Valuation: An Integrated TheoryThe book will be available on Amazon.com and from other booksellers in mid-October.  The series thus far:

  1. The Silber Study of Restricted Stock Discounts – 1991.  This post repeated a long-ignored study by Professor Silber that should have told us that averages mean nothing.
  2. Restricted Stock Discounts: the Expected Holding Period Premium is the Cause. We examine the logic and math of the only difference between restricted shares and their freely traded counterparts that created restricted stock discounts.
  3. Quantifying Expected Holding Period Premiums in Restricted Stock Transactions.  Using the logic of one hypothetical restricted stock transaction, we estimate the expected holding period and calculate a range of expected holding period premiums.

In today’s post, we tackle the myth that the “typical” range of restricted stock discounts is 25% to 45%, with an average of about 35%.

Did you ever wonder why so many valuation analysts conclude that the marketability discount in the valuation of illiquid minority interests, almost regardless of the characteristics of individual interests, is about 35%, plus or minus a bit?

First, we let’s talk about the sources of this myth.  By the early 1980s, there were a handful of studies that investigated the purchases of a number of publicly-traded closed-end investment funds that began to finance smallish public companies that did not have alternative sources of financing.

Because both the companies issuing restricted shares and the closed-end fund investors were publicly-traded, the price and certain details of transactions had to be provided in public disclosures of the companies and the funds. The Securities and Exchange Commission published the first study in 1971.  The SEC Institutional Investor Study (“the SEC Study”) covered 398 transactions that occurred between 1966 and 1969.  The median and mean of the transactions were 24% and 26%, respectively. The range of restricted stock discounts in the SEC Study was very wide, from a premium of 15% to a high discount of 80%.

That study was bookended by a 1983 study of 28 transactions performed by Charles Stryker and William Pittock in their company newsletter.  The median discount was 45%, and no average was provided.  Again, the range of discounts was wide, from 7% to 91%.  There were two studies in between these two (Gelman and Maher).

Throw in the 1991 Silber Study, the subject of the first post in this series, which had an average discount of 34% and a range from a premium of 13% to a high discount of 84%.  We already know that the central message of that study has been ignored by valuation analysts for decades.

And look at the 1993 Maloney Study, which had median and mean observations of 34% and 35%, respectively.

The die that 25% to 45% was the “typical” range of discounts was set.  Take a moment to examine a summary of these studies and a bit more from Exhibit 8.15 of the third edition of Business Valuation: An Integrated Theory.

cm.net exhibit 8.15

The studies I just mentioned are summarized in the first six rows of Exhibit 8.15.  The medians and averages are highlighted to facilitate review.  At the upper left of the highlighted area, we see the median and mean of the SEC Study of 24% and 26%, respectively.  That is the basis for the 25% lower end of the mythical range of restricted stock discounts.

On the fourth row, we see the median of the Stryker/Pittock Study of 45%.  That is the basis for the upper end of the mythical range of 45%.

All the other observations are in the range of 33% to 35%, which provides the basis for the so-called “typical” restricted stock discount of 35%.

Assuming there were no duplicate transactions in these six studies, which there almost certainly were, a good portion of the valuation profession has been relying on this information for nearly four decades.  Note the following regarding the first six studies:

  • There were at most 764 transactions.
  • The earliest transactions occurred in 1966 an the latest transactions occurred in 1988.  This means that valuation lore is based on transactions that occurred somewhere between about 32 and 54 years ago.
  • The first of the six studies was published in 1971 and the last was published in 1993.  These studies were published between 27 and 49 years ago.

One last observation from Exhibit 8.15: No study has been published since the Moroney Study in 1993, which has supported the mythical range of 25% to 45% as typical for restricted stock discounts.

If dissemination of this post and the related content in our new book does not kill the myth of 25%/45%/35% in business appraisal, it will likely never die.


The third edition of  Business Valuation: An Integrated Theory will be available in mid-October. Let me suggest not so immodestly if I may:IT3-3D

  • If you are a valuation analyst, you need to obtain and read the book.  There is no other book on the market remotely addressing valuation theory in the understandable way that is done in the third edition.
  • If you supervise valuation analysts, you need to be sure that every one of your analysts has their personal copies of the book for ready reference.
  • If you are teaching valuation courses of any kind, you need to obtain and read the third edition.
  • If you are a market participant in a business where business valuation is important for mergers and acquisitions or other reasons, you need to obtain and read this book.

Please do take the time to comment on this post below.  The valuation profession needs open discussion, and it can begin with many of us, including you.

Until the next post, be safe and be well.

Chris

 

Please note: I reserve the right to delete comments that are offensive or off-topic.

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5 thoughts on “#4 – The Myth of the 25% – 45% “Typical” Range of Restricted Stock Discounts Must Die

  1. Do you think it matters how long it may take to find an actual buyer and for the transaction to close successfully? The various time frames of the studies reflect 2 year, 1 year and six month holding periods at various historical dates. The holding periods drive results in the study for a given time frame.

    Might the size of the entity matter with large and midsize firms having significant data and firms that are less than $10 million having different DLOM characteristics? These are just a couple of ideas that may impact the decision making. Jim Hitchner in his book Discount for Lack of Marketability Guide and Toolkit identifies I believe 38 possible factors to consider.

    Having a copy of the actual study, understanding the nature of the data in a particular study, and considering the application of a particular study to a subject entity may provide additional insight on applicability.

    This is nothing to take away from your commentary, but rather than addressing a number, this seems to be highly factual in nature.

    You raise a good point to not simply start with a range in mind and work to document that range. Thank you for sharing your ideas and initiating this discussion.

    • Mike,

      Prior to April 1997, SEC Rule 144 mandated a two year holding period before investors in restricted stocks of public companies could begin to achieve liquidity. At that time, the holding period was reduced to one year. And since then, it has been reduced to six months. The idea behind the restrictions on gaining liquidity was to help assure that restricted stock investors did not 1) buy for quick gains, and 2) would be neutral to the public market pricing during that period of illiquidity.

      After the period of restriction lapses, investors are able to “dribble” stock into the public market under the so-called “dribble-out” rules. If investors had acquired a large block of stock in a public company, and 5% to 10% and sometimes more were common block sizes, the dribble-out rules could create periods of a few months to a couple of years or more before liquidity could be achieved.

      So the actual holding periods for restricted stock transactions are the combination of the mandated period of restriction (two years for pre-1997 transactions) and the half-life of the dribble-out period, which can be estimated based on the trading volume of each public company and the size of each investment.

      All of the companies that issued restricted stock were publicly traded. So public disclosure was available for them. We saw in #1 – The Silber Study of Restricted Stock Discounts – 1991 that bigger, more profitable and more attractive companies tended to warrant lower discounts (i.e., higher prices relative to their public prices) than less attractive companies.

      Every restricted stock transaction involved a real, publicly traded company and real investor or investors (usually publicly-traded closed end funds in the early years). These real buyers and sellers looked at the characteristics of each investment. Hitchner’s DLOM Guide and Toolkit suggests, you say, 38 possible characteristics to consider. Real investors attempt to focus on the characteristics that are most important for each investment.

      When applying the QMDM, appraisers attempt to focus on the relevant range of discounts given the particular characteristics of each illiquid minority interest being valued. Valuation is ultimately a range concept – except for actual transactions – so it is important to focus on the relevant range of prices for each illiquid minority interest being valued. And that means selecting the relevant range of marketability discounts from which to reach conclusions at the nonmarketable minority level of value.

      Thanks so much for your thoughtful comment. As I said in my response to Greg, it is important that this discussion be broadened.

  2. Many business valuators use 35% because they consider it “safe”. Plus it requires less thinking and proof since it is the “accepted” number. While this theory has not held up well in court most business valuations do not end up there.

    I am quite interested in knowing more about your views on actually calculating a correct discount. Looking forward to that.

  3. Greg,

    There can be no “one-size fits all” when it comes to the valuation of businesses and business interests. Based on my experience, many marketability discounts in appraisal reports are 35%, perhaps plus or minus a little. The myth of 35% has persisted, in part, because many appraisers do not examine the elements of value at the nonmarketable minority level.

    The value of a business is based on expected cash flows (of the business), the risks (of the business in achieving those cash flows), and the expected growth of those cash flows of the business.

    The value of an interest in a business is based on the expected cash flows (to the interest), the risks of achieving those cash flows (to the interest), which begin with the risk of the business itself, and the expected growth of the cash flows to the interest, which are derivative of the business.

    Many readers know that I advanced a quantitative model to value illiquid minority interests in relationship to their related businesses. That model is the Quantitative Marketability Discount Model, or QMDM. I’ll write about that as this series of posts continues.

    I don’t know if the QMDM calculates a “correct” marketability discount, but it does assist business appraisers in quantifying reasonable marketability discounts in light of expected cash flow, risk and growth. The QMDM is available at //www.chrismercer.net/store.

    It will also be discussed in great detail in the third edition of Business Valuation: An Integrated Theory (Mercer and Harms), which will be available on Amazon.com in mid-October.

    Thanks for your comment! This discussion needs to see the light of day.

  4. Chris –
    Excellent and very thought-provoking. You’re right, if this series of articles doesn’t kill the 35% +/- default DLOM, nothing will. I like using a protective put / covered call option analysis to estimate a DLOM, and while that too, has limitations, like all methods, it seems to be more grounded in current data (volatilities of public peers) and accepted theory. There are known methods to adjust for leverage and size, and the back of my brain has been working on if/how an option-based method mathematically ties to QMDM. I calculate the HPP when doing this approach to see if the resulting holding period return makes sense given the life cycle stage of the company.

    The main critique of the option method is that one cannot actually use options to hedge against private company stock. This goes way back, but Mark Cuban sold his company to Yahoo in the heady days of the dot-com bubble. He received mostly Yahoo restricted stock in return, and was prohibited from selling it, pledging it or using it as collateral, or hedging it thru options on Yahoo. If I recall correctly, he bought protective puts on a basket of stocks with high correlation to Yahoo stock, and that successfully protected his proceeds in the dot-com bust. Not every private company has a group of correlated public peers, nor every holder of illiquid shares an investment bank willing to structure such an instrument, but an option analysis can be used in conjunction with other methods like QMDM to paint a more-reasoned picture.