Restricted stock transactions cannot be used to estimate marketability discounts for illiquid interests in private companies. That was my conclusion in Quantifying Marketability Discounts (out of print) in 1997, and that is our opinion in Business Valuation: An Integrated Theory, Third Edition currently.

In the earlier book, I performed a detailed quantitative analysis to prove why there were too many moving with pre-IPO transactions for them to provide credible evidence for current marketability discount determinations. There is a more qualitative analysis in the current book leading to the same conclusion. This post examines pre-IPO transactions qualitatively in a more visual fashion.

What Is a Pre-IPO Discount?

A pre-IPO discount is a discount reflected by the difference between two prices.  The first price is the price at which a transaction occurred with a minority interest of a private company in the months prior to when it ultimately engaged in an initial public offering.  The second price is the price recorded for the newly public company in its IPO. The following figure provides the definition of the pre-IPO discount and then provides an example calculation of a discount from a hypothetical transaction.

In this post, we examine one hypothetical Company that had a pre-IPO transaction and then, six months later, engaged in an initial public offering.  We then look at the dispersion of pre-IPO discounts in the early pre-IPO studies prepared by John Emory.  Finally, we make some observations and conclusions regarding pre-IPO studies and discounts and also relate back to the earlier posts discussing restricted stock discounts.

A Hypothetical Pre-IPO Transaction/Discount

The following diagram illustrates the hypothetical pre-IPO transaction described above.  We walk through the transaction “by the numbers” to be sure that we fully describe a transaction and the moving parts involved.

1. The pre-IPO transaction occurs on a specific date, say January 31, 2020.  The transaction occurs based on the hypothetical Company’s historical performance and outlook, with the likely knowledge that there is at least the possibility of an initial public offering in the foreseeable future.  The transaction is occurring in all likelihood because certain insiders are hoping to gain or increase positions in the Company’s shares at low prices in anticipation of the IPO.
2. There is a pre-IPO transaction.  Perhaps it was based on an appraisal as of that date.  In that event, there would be a marketable minority value indication in the report of, say, $10 per share (V = CF / (R – G)).  Say that the expected cash flow is $1.00 per share and that the discount rate is 14% and the expected growth is 4%.  V = $1.00 per share / (14% – 4%), or $10.00 per share.
3. Assume that the report developed a marketability discount of 35%.
4. When applied to the $10.00 per share marketable minority value, the marketability discount yields a pre-IPO transaction price of $6.50 per share.  In the event that there was no appraisal, there was an unobserved but implied marketable minority value, an unobserved but implied marketability discount, and, of course, the pre-IPO transaction price of $6.50 per share for the illiquid minority shares being purchased in the pre-IPO transaction.
5. The pre-IPO price was determined based on the financial statements and historical performance and expectations of the Company leading to the transaction date.  The Company was capitalized as shown on its balance sheet.  There was no new capital from an IPO transaction that might increase expectations for cash flow and growth and provide expectations of lower risk.  In other words, the Company was a private business, perhaps with the hope or expectation of a future public offering, but certainly, on January 31, 2020, any future IPO transaction was uncertain.
6. Time passes.  Let’s say that an investment banker was retained and a public offering was set into motion.  The IPO is set to go off on July 31, 2020, or six months after the pre-IPO transaction date.
7. The IPO occurs on July 31, 2020
8. The initial price is $13.00 per share, which represents a 30% premium to the pre-IPO marketable minority value of $10.00 per share.  This “IPO pickup” is unobserved, but in all likelihood, it is there in some amount.
9. Comparing the IPO price of $13.00 per share with the pre-IPO transaction price of $6.50 per share, we can observe that the pre-IPO transaction occurred at a 50% discount to the IPO price.
10. The pre-IPO price is, of course, unchanged from the transaction pricing six months prior to the IPO.
11. What has changed in the six months between January 31, 2020, and July 31, 2020?  With the passage of time, the Company’s performance presumably continued to improve.  Market conditions could have improved and industry conditions for the Company could have improved, as well. The IPO raises millions of dollars in new capital, the majority of which likely is invested into the Company to fuel future growth.  This investment changes expectations for cash flow and growth in cash flow. IPOs are generally preceded by stock splits to get shares into a reasonable pricing range.  New shares are issued, diluting the ownership of pre-IPO shareholders.  This new capital serves to reduce risk and to increase expectations for growth relative to the marketable minority value of $10.00 per share at the pre-IPO transaction date.  Relative to the pre-IPO marketable minority value (#2 above), the IPO price might be calculated as follows.  V = $1.00 per share / (13.0% – 5.3%) = $13.00 per share.  The expectations for reduced risk and enhanced growth decrease the capitalization rate for the IPO (R – G) relative to the capitalization rate at the pre-IPO transaction date.  And this simple example has not considered the impact of changes in expectations for cash flow based on new investment.  Changes in expectations like this are, in all likelihood, the sources of the “IPO pickup” of 30% that occurred.  In addition, there could be some degree of speculation built into the IPO pricing.

The diagram above should make it clear that the Company, six months after the pre-IPO transaction, has changed.

• On January 31, 2020, the hypothetical Company was a privately owned business with its own historical performance and outlook.
• Six months pass in our example.  We do not know what changes were made at the Company in anticipation of the initial public offering.  Perhaps a restructuring was necessary.  Perhaps new management was brought in to strengthen the management team.  Perhaps a lot of things.  In any event, the Company had to deal with the passage of time and the anticipation of the IPO.
• With the IPO, the Company raised millions of dollars, the great majority of which was invested to strengthen the Company, reduce risk and increase growth expectations.

What does the 50% pre-IPO discount tell us about these important changes that are the direct cause of the enhancement in value from pre-IPO days to the public offering time?  Absolutely nothing.  What does the pre-IPO discount tell us about the appropriate marketability discount for a current subject interest?  Absolutely nothing.

What Does an Average of Pre-IPO Discounts Tell Us?

As with restricted stock transactions, there is no economic evidence in any pre-IPO discount.  And there is no economic evidence of an average of hundreds or thousands of pre-IPO discounts.  A pre-IPO discount is not a valuation driver and cannot be used to apply to a marketable minority/financial control value to estimate a marketability discount.  In the example above, the pre-IPO price was $6.50 per share and the IPO price was $13.00 per share.  The calculated pre-IPO discount is 50%.

John Emory performed pre-IPO studies beginning in the late 1970s and continuing for more than twenty years.  The Emory studies were examined in Quantifying Marketability Discounts.  The average discounts for the various studies were generally in the 40% to 45% range, with standard deviations in the range of 18% to 20%, indicating considerable variability (just as with the restricted stock discounts discussed earlier in our Deja Vu series).  To illustrate this variability and to show that any use of averages from the studies (Emory’s or any of the other studies) was not meaningful, the following diagram showing the scatter of Emory study results for a number of studies was shown in Quantifying Marketability Discounts.

Note that some pre-IPO discounts were negative, which says that some pre-IPO transactions occurred at prices higher than the ultimate IPO prices.  Some pre-IPO transactions occurred at very large discounts of 60% to 80% or more relative to the ultimate IPO prices. The picture should make it clear that the calculation of an average of pre-IPO discounts merely hides the great dispersion of the actual discounts and provides no meaningful economic information.

Pre-IPO studies continue to the present date.  The Valuation Advisers Lack of Marketability Discount Study is available at www.bvresources.com.  This study contains some 17,000 transactions, including some 2,300 transactions in foreign countries.  The study allows sorting in a number of fields, including industry or business description, sales, assets, operating income, operating profit margin, NAICS or SIC code, and, of course, the dates of pre-IPO transactions and the IPOs themselves.

Concluding Observations from the Deja Vu Series

Restricted stock and pre-IPO studies are the most commonly cited sources of market evidence for marketability discounts applicable to illiquid minority interests in private companies.  Yet, as we have demonstrated in this Deva Vu series thus far, the observed discounts from these studies do not provide direct economic evidence for such application.

• In the case of the restricted stock studies, the observed discounts are ultimately a function of the expected holding period and the holding period premium to the base return. These two factors give rise to observed restricted stock discounts.  While the implied holding period premiums may provide a useful benchmark when estimating returns on illiquid minority interests in private companies, additional parameters (the period until liquidity is expected, future capital appreciation, and interim cash flows during the period of illiquidity) are required to develop the appropriate marketability discount.  The observed restricted stock discounts are not directly applicable to illiquid minority interests in private companies.
• Pre-IPO discounts relate the price at which illiquid minority shares are transacted to a subsequent initial public offering price for the same company. However, the IPO itself changes the nature of the pre-IPO company.  As a result, the observed discounts include both the impact of illiquidity and the changing characteristics of the company.  Since valuation analysts are generally not able to separate the two components, the observed pre-IPO discounts do not provide relevant evidence for the marketability discounts applicable to illiquid minority interests in private companies.

The value of a business is the (present) value of all expected future benefits to be derived from it into perpetuity and discounted to the present at a discount rate reflective of the risks associated with achieving those cash flows.  Virtually one disagrees with this statement.

The value of an interest in a business is the (present) value of all expected future benefits to be derived from the interest (which are derivative of business cash flows).  Those cash flows are:

• Expected interim benefits such as dividends or distributions
• Over the expected holding period of the investment
• Including the expected terminal value at the end of the expected holding period
• Discounted to the present at a discount rate reflective of achieving the expected benefits of the interest

The restricted stock studies and pre-IPO studies tell nothing directly about these benefits and simply cannot be used as a basis for developing marketability discounts for illiquid minority interests of businesses.  We can learn and infer some useful information from restricted stock transactions that is helpful in the kind of analysis suggested by the definition of the value of an interest in a business.

It is time for the business appraisal profession to wake up and apply the same valuation principles used when valuing businesses to the valuation of interests in them.

In the meantime, be well,

Chris