Mercer’s Musings #5: Pre-IPO Studies/Discounts and Marketability Discounts

Introduction and Conclusion

My musings on the use of restricted stock discounts to estimate marketability discounts (or DLOMs) have led me to the conclusion: Restricted stock studies/discounts cannot be used to estimate DLOMs in any credible, standards-compliant manner. Three of the first four Mercer’s Musings posts address this issue.

This fifth post in the musings series takes a look at the usefulness of pre-IPO discounts in estimating marketability discounts. Astute readers will know the conclusion of this musing at the outset. To give the answer away: Pre-IPO discounts/studies cannot be used to estimate DLOMs in any credible, standards-compliant manner.

What is a Pre-IPO Discount? – 1

Begin at the very beginning. A pre-IPO discount measures the difference between the price at which a transaction occurred in an illiquid minority interest of a company relative to the price at which it subsequently went public by engaging in an initial public offering (IPO).

Exhibit 8.21 (Mercer-Harms Business Valuation: An Integrated Theory Third Edition) (“IT3”) illustrates how pre-IPO discounts are calculated. The hypothetical, pre-IPO transaction in this example occurred at a (split-adjusted) price of $6.50 per share, and the subsequent IPO price was $13.00 per share.

The calculated pre-IPO discount is 50% in the example, and is consistent with the medians and averages of discounts found in several older pre-IPO studies (which are cited in Chapter 8 of IT3. The question is: What does that 50% pre-IPO discount mean or imply for the valuation of illiquid minority interests in private companies today?

Economic Information in Pre-IPO Discounts?

As with control premiums and restricted stock discounts, it is clear that the pre-IPO discount measures only the difference between two prices. The information we can glean from this definition and example is limited to the following:

A transaction occurred at some point prior to an IPO (perhaps three months, six months, nine months, or a year or more)
The pre-IPO price was $6.50 per share
The price at the subsequent IPO was $13.00 per share
The pre-IPO price was $6.50 per share, or 50% lower than the IPO price
The IPO price was $6.50 per share higher than the pre-IPO price, or 100% higher than the pre-IPO price

There is no direct economic information in this example of a pre-IPO discount that can shed light on the appropriate marketability discount for any private company. Further, there is no direct economic information in any averages of groupings of pre-IPO discounts that can shed light on appropriate marketability discounts for any private companies.

As with the restricted stock studies examined in earlier posts in this series (linked above), there is no economic evidence in the older pre-IPO studies cited in IT3 (Emory, Willamette, Hitchner, etc.). The older studies cannot provide help in developing marketability discounts today.

What is a Pre-IPO Discount? – 2

The disconnect between a pre-IPO discount and any bearing on valuing illiquid minority interests of private companies (and marketability discounts) becomes clearer in a picture. The following figure is adapted from Figure 8.26 of IT3.

Examining the same hypothetical transaction, we find:

A pre-IPO transaction occurred six months prior to the date that a hypothetical company engaged in its initial public offering. That transaction took place at $6.50 per share. See the left side of the figure above.
Whether there was a formal appraisal or not at the pre-IPO transaction date, there was an implied marketable minority/financial control (base) value for that entity at that date. In the figure above, that is $10.00 per share on the left side. This $10.00 per share value was likely unobserved unless the transaction was based on an appraisal. But it was there.
The $6.50 per share pre-IPO price represented a 35% discount to the base price of $10.00 per share. Whether the base price was $9.00 per share or $11.00 per share or some other price is irrelevant to this analysis. The transaction almost certainly represented a discount to the marketable minority/financial control value at the time. If it were not so, the pre-IPO transaction would likely not have occurred. The purpose of many pre-IPO transactions is to enable insiders to acquire as much stock as possible at the lowest possible prices.
Six months later, there was an IPO at $13.00 per share, as reflected on the right side of the figure. We observed the pre-IPO price of $6.50 per share and now see the IPO price of $13.00 per share.
The implied pre-IPO discount is 50% (1 – $6.50/$13.00). However, the pre-IPO studies can make no comment about the implied 30% “IPO pick-up” in pricing that often occurs with IPOs, and which did occur in the example.
The observed pre-IPO discount of 50% is actually a combination of the relief of the unobserved 35% marketability discount in the pre-IPO transaction and the unobserved 30% IPO pick-up.

A direct result of this analysis is that pre-IPO discounts are not “marketability discounts” at all. They reflect a combination of factors as we have just concluded. Pre-IPO discounts, therefore, do not provide “evidence” of marketability discounts at all.

There are more moving parts that the figure above does not take into consideration, some or all of which influence the difference between the pre-IPO price of $6.50 per share and the IPO price of $13.00 per share in unknown directions (see below).

The Valuation Advisors Lack of Marketability Discount Study and Valuation Ratios

The Valuation Advisors Lack of Marketability Discount Study is available at the link on the Business Valuation Resources website. This study is introduced with the following:

Defend your discounts for lack of marketability with the most current data in the Valuation Advisors Lack of Marketability Discount Study. This robust, online database includes 18,700+ pre-IPO transactions, including 2,300+ non-U.S. deals covering 45 countries. This must-have tool enables you to reference actual DLOMs for companies with similar characteristics to your subject company and ensures you have the most convincing data available. (emphasis added)

The suggestion is that the Valuation Advisors Lack of Marketability Discount Study can be used, in effect, to conduct a form of the Guideline Public Company Method as defined in the ASA Business Valuation Standards in “Statement on Business Valuation Standards (SBVS) – 1.” According to SBVS-1, valuation ratios from comparable public companies can be used, with appropriate adjustments, to apply to earnings or other metrics of a subject company in order to estimate the value of the subject entity. I wrote about this issue at length in a prior blog post: RSD -4: Restricted Stock Discounts are Not Valuation Ratios, a part of a series I wrote examining restricted stock discounts and studies (available at this link).

The same analysis is applicable to pre-IPO discounts, which also are not valuation ratios.

SVBS-1 states the following:

V. Valuation ratios derived from guideline public companies (italics added with my comments in brackets [])

A. Comparisons are made through the use of valuation ratios. The computation and use of such ratios should provide meaningful insight about the value of the subject company, considering all relevant factors. Accordingly, care should be exercised with respect to issues such as:

1. The selection of the underlying data used to compute the valuation ratios [all that is available are the pre-IPO discounts, which are not valuation ratios at all]
2. The selection of the time periods and/or the averaging methods used for the underlying data [the data in the Valuation Advisors Study dates back to 1985-1986 timeframe (almost 40 years ago). As with restricted stock data bases, much of the data is quite old and simply not relevant to valuations today]
3. The computation of the valuation ratios, which may be derived by relating prices of the guideline public companies to the appropriate underlying financial, operating, or physical data of the respective guideline companies [It should be clear that no valuation ratio can be calculated using a pre-IPO discount]
4. The timing of the price data used in the valuation ratios (in relationship to the effective date of the appraisal) [dated, as indicated just above]
5. How the valuation ratios were selected and applied to the subject’s underlying data

The International Valuation Glossary – Business Valuation defines a valuation ratio by defining Multiples:

Multiple — a ratio calculated as the value of a business or security divided by Economic Income or a non-financial metric. Also known as market multiple, pricing multiple, or valuation ratio. (bold in original, italics added)

The following figure replicates Exhibit 6-3 of IT3 (p. 182) and provides common examples of valuation ratios.

Pre-IPO discounts (and restricted stock discounts) measure the difference between two prices only. These discounts do not relate the value of a public company divided by economic income or financial metrics as indicated in the definition of Multiple above and as illustrated in the figure above. Take one pre-IPO discount. Take the average of several or many pre-IPO discounts, regardless of how “comparable” the individual entities may be to a private subject company. My conclusion is the same.

Pre-IPO discounts are not valuation ratios, and cannot be derived from public companies and applied to subject companies.

Value is a Function of Expected Cash Flow, Growth and Risk

We know that the value of a business is a function of its expected cash flows, their expected growth, and the risks associated with achieving the cash flows. In other words, the value of a business is a function of three important factors, expected cash flow, risk and growth.

The value of an interest in a business is a function of the expected cash flows to the interest (which are derivative of the expected cash flows of the business itself, the growth of those cash flows, including a terminal value at the end of an expected holding period, and the risks associated with achieving those cash flows. In other words, the value of an interest in a business is a function of three important factors, expected cash flow, risk and growth.

The Valuation Advisors Lack of Marketability Discount Study provides limited information on the companies that went public. That information includes (per the link from the Business Valuation Resources website):

Industry or business description
Revenues
Operating income
Operating profit margin
Assets
Date of transaction or IPO
NAICS or SIC code

The data also includes the calculated pre-IPO discount for each transaction. We query the data base for IPO companies in the same SIC Code as a subject private company that an appraiser is valuing as of a current date.

Valuing an Illiquid Minority Interest of a Private Company

The following figure illustrates available information regarding the averages of the assumed guideline company group from the Valuation Advisors Study. The data shown are not from an actual run of the data base but are shown for analysis and perspective. Also included are additional data points for reference and information about the subject private company.

The question that must be addressed is: How will information about companies that went public and had prior pre-IPO transactions (information on the left side above) assist the valuation analyst in developing a marketability discount for a private company (information on the right above) being valued in March, 2024 (or any current date)? Assume that all of the IPO companies are in the same SIC Code as the subject company, and, like the subject company, they were all profitable, so they are “comparable” to an extent.

The average pre-IPO discount for the sample of 50 transactions in the figure above is 38%. The range is from a low (premium) of (5%) to a high of 53%.

The appraiser has developed information about the subject company and the subject 15% interest. The private company is profitable and has a 15% operating margin. The WACC for the subject company is 12.5%, with an equity discount rate of 15% (not shown). The private company is expected to pay a dividend that will yield 6.5% based on the marketable minority value of $18 million. Based on her analysis, the appraiser concludes that the dividend can be expected to grow at about 5% per year over an expected 8 to 10 year holding period.

There is no information at all on the left side of the figure above that informs the appraiser about the value of the 15% subject interest. For that to be true, the left side would have to provide insight into expected cash flows and their growth, and none is available. It could also inform the appraiser about the risk associated with the subject 15% interest over the holding period, and none is available.

Assume that the appraiser concludes that the appropriate marketability discount should be 38%, or the average pre-IPO discount above. That would value the company at the nonmarketable minority level at $11.2 million ($18.0 x (1 – 38%). Given the expected dividend yield of 6.5% (based on the $18 million marketable minority value (or $1.17 million per year for the private company), the implied yield would be 10.4% ($1.17 / $11.2). Is that reasonable? There is no information on the left side of the figure to address the question.

Now assume that, based on a change of expectations, the appraiser believes that the expected holding period for the interest should be 3 to 5 years. What is she to do? Nothing changes on the left side of the figure and the facts have changed on the right side. What should the marketability discount be?

Other Issues with Pre-IPO Studies/Discounts

There are a many moving parts to pre-IPO transactions and the pre-IPO discount in addition to the factors already discussed. These factors include the following:

The passage of time between the pre-IPO transaction and the IPO itself
The further passage of time, perhaps years, between the pre-IPO transaction and the current valuation date for any appraisal
Expected cash flow enhancements (at the very least, from earnings on cash raised in the IPO)
Expected risk reductions as result of the new capital
Higher growth expectations than before the IPO given the new capital raised
Issuance of new shares in pre-IPO stock splits
Sale of new shares to raise new capital for the company and resulting dilution for existing shareholders
Ongoing access to the public markets

As with companies engaging in historical restricted stock transactions, relatively few companies that engage in IPOs were paying dividends or distributions. Many companies that appraisers are called upon to value do provide such shareholder-level cash flows.

I wrote about these differences in Quantifying Marketability Discounts, which was published in 1997 (and no longer in print), concluding at that time that pre-IPO studies could not be used to help assess marketability discounts. We reached the same conclusion in all three editions of Business Valuation: An Integrated Theory (2004, 2007, 2021).

These above characteristics are particular to each IPO candidate, and have nothing to do with the corresponding characteristics of any illiquid minority interest in any private company that appraisers might be valuing today. In other words, they cannot inform appraisers about the impact on value of the critical factors of expected cash flow, risk and growth that define the value of illiquid minority interests of private companies at the present time.

Valuation analysts cannot reasonably expect to hold all these factors equal or account for them in a manner that enables the pre-IPO discount studies to offer valid evidence for the development of marketability discounts for illiquid minority interests in private businesses.

Conclusion

To restate the conclusion from the beginning: Pre-IPO discounts/studies cannot be used to estimate DLOMs in any credible, standards-compliant manner.

As always, comments, criticisms, or insights are welcome.

Chris