In this lookback series of posts on restricted stock studies, we begin with the first such study, the SEC Institutional Investor Study. This review appeared in my book Quantifying Marketability Discounts, which was published in 1997. That book, introduced the Quantitative Marketability Discount Model (QMDM) as a method to develop marketability discounts using a shareholder-level discounted cash flow model. While introducing a new method for developing marketability discounts under the income approach, I felt it was important to have a solid review of the restricted stock studies, which provide a (not very good, in my opinion) method under the market approach.
The SEC Study
The Securities and Exchange Commission’s study of the actions of institutional investors culminated in a major report issued in 1971. One aspect of the overall study was an analysis of the discounts at which restricted stocks (letter stock) of publicly traded companies were issued during the late 1960s. This portion of the study is called Discounts Involved in Purchases of Common Stock. The study is referred to in this book and in other valuation literature as The SEC Institutional Investor Study (the “SEC Study”).
Exhibits 2-1 through 2-6 provide a summary of data found in the SEC Study. Since it is so frequently referenced, we will review its findings in some detail. The SEC Study covers 398 transactions involving the issuance of restricted common stock from 1966 through the first half of 1969. Comments or observations are made regarding each of the exhibits as follows, beginning with Exhibit 2-1.
Exhibit 2-1: Discounts of Purchase Price of Restricted Common Stock Classified by Trading Market. This exhibit classifies the transactions by trading market (New York Stock Exchange, American Stock Exchange, OTC-Reporting, and OTC-Non-Reporting companies). The various transactions are broken into bands of discounts, e.g., 10% to 20%, and 20% to 30%. The number of transactions and their market values are then provided, and sorted by the exchange of the company involved. We can make several observations from Exhibit 2-1:
- The average transaction size for a restricted stock purchase in the SEC Study is fairly small, about $1.2 million per transaction (in the late 1960s).
- The great majority of transactions involved companies in the reporting and non-reporting over-the-counter markets, which is an indication of the speculative nature of issuers of restricted stocks.
- Generally, higher discounts appear to be associated with smaller transactions, and those transactions are concentrated in the OTC markets (reporting and non-reporting companies).
- There is a fairly clear “exchange effect” in the results. For example, 84% of the NYSE transactions reflected discounts of 30% or less, while only 44% of the OTC-Non-Reporting transactions were under 30% (implying that 56% of the discounts exceeded 30%). The exchange effect is likely a size effect (related to issuing companies), as Exhibit 2-3 suggests.
- 62% of the transactions studied reflected discounts of 30% or less. Consistent with the previous observation, most of the remaining 38% of the transactions involved OTC companies.
- Exhibit 2-1 indicates a wide range of transaction discounts. For example, 26 transactions (7% of the sample) occurred either with no discount at all or with a premium of up to 15%. At the other end of the spectrum, 48 transactions (12% of the sample) had discounts in the range of 50% to 80%.
- Carrying the analysis a bit further, some 30% of the transactions reflected discounts of less than 10% (including those with premiums), and about 21% of the transactions indicated discounts of more than 40%. There is a fairly wide dispersion of discounts reflected in the SEC Study.
- The median discount, interpolating from either Exhibit 2-1 or 2-2, is 23.6%. Using the midpoints of the discount ranges specified in these exhibits, the arithmetic mean discount is 23.6%. Excluding the transactions reflecting premiums, the arithmetic mean rises to 28.1%.
Exhibit 2-2: Classified by Type of Institution (Purchasers). The great majority of the restricted stock purchasers were institutional buyers such as banks, investment advisors, and insurance companies (89% by dollar value and 79% by number of transactions). The inference of this categorization is that the purchasers of the letter stock were sophisticated investors. The study was called the SEC Institutional Investor Study because the SEC wanted to understand the nature of investors in restricted shares.
Exhibit 2-3: Classified by Size of Transaction and Sales of Issuer. With the exception of issuers with sales of less than $100,000, there is a clear inverse relationship between sales and discounts. The higher the sales of the issuer, the lower the discounts seem to be. Only 338 transactions are reflected in this table, so data on some 60 transactions (18% of the sample) were unavailable for analysis.
Exhibit 2-4: Classified by Size of Transaction and Earnings of Issuer. An apparent inverse relationship exists between the magnitude of earnings and discounts. Companies with higher earnings tend to issue stock with lower discounts that those with lower earnings.
Exhibit 2-5: Classified by Sales of Issuer and Average Percentage Discount, Over Time. The relationship between size (as measured by sales) and discounts inferred above is confirmed in Exhibit 2-5. The weighted average discount for the 278 companies reflected in this exhibit is 21.9%, a bit lower than the 25.8% discount estimated in Exhibit 2-1, but with 120 fewer observations.
Exhibit 2-6: Classified by Earnings of Issuer and Average Percentage Discount, Over Time. Once again, there is a fairly clear inference from the SEC data that companies with higher earnings tend to have lower discounts than those with lower earnings.
Unfortunately, the SEC Study reflects market evidence that is more than 25 years old [now more than 50 years old in 2022]. The study included only 398 transactions, with complete data for only 278, as indicated in Exhibits 2-1 through 2-6. We have mined this source of market evidence because there has not been a comparable study in the ensuing years. The volume of new-issue restricted stock transactions declined after the mid-1970s, and such transactions occur much less frequently today.
The more common type of restricted stock issuance today occurs when a public company issues shares in an acquisition. It is often not feasible to measure the restricted stock discount for current transactions because we do not know the cash-equivalent transaction price that reflects the impact of a restricted stock discount. In fact, that is the question that appraisers are frequently called upon to determine.
Comments From 2022
The weighted average discount in the SEC Study was about 23%. This average was lower than the averages of the next few studies and was basically ignored by appraisers for many years. We should have been looking at the relationships between restricted stock discounts and the size of issuers as measured by revenues or earnings all along. Larger companies (revenues or size) tended to have lower restricted stock discounts. The overarching lesson from the SEC Study is that size matters. Larger, more attractive companies tended to issue restricted stock at lower discounts than smaller, less attractive issuers.
This should not come as a surprise. Size premiums for equity discount rates reflect this same inverse relationship.
Since all of the pre-1997 institutional investors faced the same holding period requirements under SEC Rule 144, and since the expected cash flows and growth for each of the public issuers were the same as found in the public disclosures, the differentiating factor for investors was risk. Companies with greater risk profiles required higher discount rates and higher marketability discounts.
In the next post, we will review the Gelman Study, which was published in the Journal of Taxation in 1972. We will also review the Trout Study, which was published in Taxes in June 1977.
In the meantime, be well!
 Institutional Investor Study Report of the Securities and Exchange Commission (Washington, D.C.: U.S. Government Printing Office, March 10, 1971). The portion relating to the discounts observed with the issuance of restricted stocks is titled “Discounts Involved in Purchases of Common Stock,” at Volume 5:2444-2456, Document No. 92-64, Part 5.