Greg Caruso and Mike Gregory provided good comments to my last post, #4 – The Myth of the 25% – 45% “Typical” Range of Restricted Stock Discounts Must Die.  The discussion that these comments began is important for appraisers, so their comments and my responses constitute this fifth post in the series on restricted stock studies and discounts.

Greg Caruso’s question:

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.

My response:

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.

Mike Gregory’s question:

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 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.

My response:

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.

I enjoyed discussing the topics in this series of posts with Mike and Greg. Please continue to 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

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

• 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.