Deja vu is a feeling of already having experienced a present situation. In my initial review of Valuing a Business Sixth Edition (VAB6) by Shannon Pratt/American Society of Appraisers, I was reminded that I had reviewed a significant number of the studies summarized in Chapter 19 back in 1997, when my book, Quantifying Marketability Discounts, was published. In this and a few future posts, I’ll share what I believe is the most complete analysis of the historical restricted stock studies that are still relied upon by many business appraisers.
An Aside. VAB6 represents the collective efforts of many business appraisers, who, under the auspices of the American Society of Appraisers, developed this sixth edition to maintain its place in the valuation literature and to honor Shannon Pratt. I was one contributor to VAB6. Jeff Tarbell and I wrote Chapter 36, “Valuation Provisions in Buy-Sell Agreements.” Several colleagues at Mercer Capital also contributed to the book.
There were nine published restricted stock studies in 1997 when Quantifying Marketability Discounts was published. A tenth study by Management Planning, Inc. was published as a chapter in that book. The ten studies are shown in the following table.
These restricted stock studies have been heavily relied on by business appraisers in efforts to develop marketability discounts for illiquid minority interests of businesses for many years. A focus on their averages have been the primary source of the unsupported notion that marketability discounts should be on the order of 35%, plus or minus a bit, without reference to the characteristics of illiquid interests being valued. A few quick observations about the table, from the perspective of 2022, include:
- They were published a long time ago, or between about 25 and 50 years ago.
- With the exception of the first study, the SEC Institutional Investor Study, the sample sizes were all quite small.
- The overall average and median are about 32% to 33%, with the highest being 45% and the lowest being 24%.
- The available standard deviations are high relative to the averages for the studies where this analysis was possible.
- The range of observed discounts was very wide, indeed. The low discount was a negative 30%, which is actually a premium. The high discount was 91%.
As a prelude to reviewing these studies in a series of posts, it is appropriate to review the status of SEC Rule 144 at the time these studies were performed. This is important because the restricted stock transactions were regulated by SEC Rule 144. This review is as of 1997 and pre-April that year when the initial period of restriction for restricted stock transactions was lowered from two years to one year.
SEC Rule 144 Pre-April 1997
Rule 144 consists of a Preliminary Note followed by paragraphs (a) through (k). When all conditions of Rule 144 have been met, an investor can dispose of securities without compliance with the registration requirements of the Securities Act of 1933.
The following discussion of Rule 144 should be considered a layman’s attempt to explain this important statute and its implications for restricted stocks.
According to the Preliminary Note of Rule 144:
Rule 144 is designed to implement the fundamental purposes of the Act, as expressed in its preamble: To provide full and fair disclosure of the character of the securities sold in interstate commerce and through the mails, and to prevent fraud in the sale thereof * * * The rule is designed to prohibit the creation of public markets in securities of issuers concerning which adequate current information is not available to the public. At the same time, where adequate current information concerning the issuer is available to the public, the rule permits the public sale in ordinary trading transactions of limited amounts of securities owned by persons controlling, controlled by or under common control with the issuer and by persons who have acquired restricted securities of the issuer. [Italics in the original; bold emphasis added.]
The exemptions of Rule 144 are generally not applicable to anyone deemed an underwriter under the rule or to anyone who is deemed to be involved with a distribution of the securities in question. In determining when a person is deemed not to be engaged in a distribution, Rule 144 suggests that several factors be considered:
First, the purpose and underlying policy of the Act to protect investors requires that there be adequate current information concerning the issuer, whether the resales of securities by persons result in a distribution or are effected in trading transactions. Accordingly, the availability of the rule is conditioned on the existence of adequate current public information.
Secondly, a holding period prior to resale is essential, among other reasons, to assure that those persons who buy under a claim of a section 4(2) exemption have assumed the economic risks of investment, and therefore, are not acting as conduits for sale to the public of unregistered securities, directly or indirectly, on behalf of an issuer….
A third factor, which must be considered in determining what is deemed not to constitute a distribution, is the impact of the particular transaction or transactions on the trading markets….The larger the amount of securities involved, the more likely it is that such resales may involve methods of offering and amounts of compensation usually associated with a distribution rather than routine trading transactions….
With regard to the holding period for restricted securities, several provisions apply. While the provisions go into much greater detail than we will discuss here, at paragraph (d)(1), we find the following general rule:
(d)(1) General rule. A minimum of two years must elapse between the later of the date of the acquisition of the securities from the issuer or from an affiliate of the issuer, and any resale of such securities in reliance on this section for the account of either the acquiror of any subsequent holder of those securities, and if the acquiror takes the securities by purchase, the two-year period shall not begin until the full purchase price or other consideration is paid or given by the person acquiring the securities from the issuer or from an affiliate of the issuer. [emphasis added].
In general, a purchaser of restricted shares of a public company has a minimum two year holding period before the restrictions placed by Rule 144 will lapse. Investors in restricted securities must therefore consider themselves subject to the risks of equity ownership for at least two years without a practical means of selling those shares.
Even when the two year minimum holding period for restricted shares has elapsed, the shares are generally subject to additional restrictions on the volume of securities that can be sold. Paragraph (e) discusses limitations on the sale of securities by affiliates of a company. If restricted securities are sold by an affiliate of an issuing public company, the amount of shares that can be sold is subject to the following rules:
If restricted securities are sold by an affiliate of a publicly traded issuer, the volume of sales within the preceding three months of a sale or series of sales cannot exceed the greater of:
(e)(1)(i) One percent of the shares or other units of the class outstanding as shown by the most recent report or statement published by the issuer; or,
(e)(1)(ii) The average weekly reported volume of trading in such securities on all national securities exchanges and/or reported through the automated quotation system of a registered securities association during the four calendar weeks preceding the filing of notice required by paragraph (h)…; or,
(e)(1)(iii) The average weekly volume of trading in such securities reported through the consolidated transaction reporting system contemplated by Rule 11A3-1 under the Securities Exchange Act of 1934 (§240.11A3-1) during the four-week period specified in paragraph (e)(1)(ii) of this section.
Generally, sales by non-affiliated persons must follow the same rules, unless otherwise excepted by paragraph (k) which states:
(k) Termination of certain restrictions on sales of restricted securities by persons other than affiliates. The requirements of paragraphs (c), (e), (f), and (h) of this rule shall not apply to restricted securities sold for the account of a person who is not an affiliate of the issuer at the time of the sale and has not been an affiliate during the preceding three months, provided a period of at least three years has elapsed since the later of the date the securities were acquired from the issuer or from an affiliate of the issuer….
In other words, the restrictions of Rule 144 lapse for non-affiliates three years after the purchase date.
Affiliates are also subject to Rule 144A, which deals with private resales of securities to qualified institutional buyers (who are deemed to be knowledgeable and not in need of the protections of Rule 144). Affiliates are also subject to Rule 145, which is designed to provide protection by registration under the Securities Act of 1933 to persons offered securities in certain business combinations. An affiliate can also sell if its shares are the subject of an effective registration filed by the issuing company with the SEC.
The bottom line of this analysis of Rule 144 is that restricted stock is subject to restrictions under Rule 144, but that the restrictions are modified at the end of two years, and the restricted shares can be sold, subject to the volume limitations noted above. The restrictions lapse completely after the end of the third year following purchase for non-affiliates.
The restricted stock studies discussed below involved the purchase of restricted shares by non-affiliated, closed-end mutual funds. Therefore, the restrictions were expected to lapse within two-to-three years. In other words, the restricted shares were expected to become at least partially marketable within two years of their purchase, and freely tradable within three years.
We have provided this somewhat lengthy discussion of Rule 144 as an important point of differentiation with nonmarketable minority interests of closely held companies. This point of comparison will be considered in more depth in future posts.
With this background on pre-1997 SEC Rule 144, we will begin to review the restricted stock studies listed in the table above. I hope readers of this blog will find this look-back at the commonly referenced studies interesting and helpful.
With only minor editing, this and the future posts will reflect my views of the studies at the time that Quantifying Marketability Discounts was published in 1997. To the extent that I comment from a current perspective, I’ll note that at the time. We will begin with a review of the SEC Institutional Investor Study in the next post.
In the meantime, be well!
 Hicks, J. William, Securities Law Series: Resales of Restricted Securities, 1994 Edition (Deerfield, Ill., Clark Boardman Callaghan, 1994), p.93.
 17 CFR Ch. II (6-1-93 Edition) §230.144.
 There are certain exceptions or exemptions under Rule 144, but those are beyond the scope of this discussion.
Ibid. Rule 144 has been updated since the late 1960s; however, the basic rules were sufficiently similar during the period the restricted stock studies (discussed below) were performed, at least for purposes of this analysis.
 17 CFR Ch. II (6-1-93 Edition) §230.144A.
 17 CFR Ch. II (6-1-93 Edition) §230.145.