My most recent post, titled Fair Market Value and the Nonexistent Marketability Discount, generated quite a discussion when posted on LinkedIn. In the last week or so it has received 5,600 impressions (whatever those are), 41 Likes, and 29 comments. Most of the discussion has been productive and welcomed!
The post provided a solid rationale that there is no such thing as a marketability discount for controlling interests of companies. One of the questions asked relates to the distinction between lack of marketability and lack of liquidity. Some would like to say that companies are marketable – they can be sold, but they are not liquid. And so a discount for lack of liquidity might be appropriate.
This post examines these two concepts, marketability and liquidity, or the lack of one or both in the context of fair market value determinations of controlling ownership interests of private companies.
The Sixth Edition of Shannon Pratt’s Valuing a Business (with the ASA Educational Foundation) was published in late 2022. Let’s refer to the book as Pratt’s Sixth Edition. Chapter 19 is titled “Discounts for Lack of Liquidity and Lack of Marketability.” (p. 419)
The Introduction of Chapter 19 contains the following paragraph:
“These two concepts of lack of liquidity and lack of marketability are related but distinctly different. As with all valuation adjustments, it is important to identify the base of comparison to which the adjustment relates. The prior edition of this book defined how liquidity and marketability could be differentiated. Since that edition, the discussion about these two concepts has evolved. This chapter presents current thinking on the subject. No doubt these concepts will continue to be refined.” (P. 420) (emphasis added)
A section of the chapter called “Liquidity and Marketability – Closely Related But Not the Same” introduces the discussion of marketability versus liquidity. (p. 423) There are two subsections titled “Liquidity” and “Marketability,” respectively. Regarding liquidity, the text states:
“The cost of the relative illiquidity of marketable securities is embedded in its price. In most cases, there is no need for an analyst to adjust the price of a marketable security for the cost of illiquidity. Indeed, it is embedded in the pricing information from this market, which often forms the basis of comparison in valuing a subject interest.” (P. 421)
 Transaction costs also rise with illiquidity. However, in most circumstances, transaction costs are not factored into the appraisal of the subject interest since the pricing information of frequently traded comparable securities is not adjusted for these factors.”
The International Valuation Glossary – Business Valuation (“the Glossary”) provides definitions of liquidity and marketability and their related discounts. These are quoted in Pratt’s Sixth Edition.
Liquidity — the ability to quickly or readily convert an asset, business or investment to cash at minimal cost. (P. 422)
Marketability — the ability to quickly or readily convert an asset, business, or investment to cash at minimal cost that reflects the capability and ease of transfer or salability of that property. Marketability is also affected by, among other things, the particular market in which the asset is expected to transact and the characteristics of the asset. (P. 423)
Discussion of Definitions and Base Values
Both definitions begin with “the ability to quickly or readily convert an asset, business, or investment to cash at minimal cost”. That is the entire definition of liquidity.
The definition of marketability expands on that concept by adding that marketability “reflects the ease of transfer or salability of that property.” The definition is further refined to discuss the particular market in which an asset is expected to transact and the characteristics of the asset being valued.
The expansion of the definition of marketability is important in that it provides more than just the quick conversion to cash. Looking at the entire definition of marketability, I believe that the likely meaning of the ease of transfer is the relative ease of transfer or salability in the particular market and given the characteristics of the asset, e.g., a controlling ownership interest, being valued in relation to the market for entire companies. After speaking with one member of the committee that created the Glossary, I believe that my interpretation is on-point.
Many appraisers, including the drafters of Chapter 19, want to equate the “liquidity” represented by cash in three days with the “illiquidity” of the time it takes to sell controlling interests. They suggest that a discount for lack of liquidity is needed because of the time it takes to sell. There are problems with this reasoning, as pointed out in my last post.
- The definition of fair market value, the standard of value employed in most appraisals, calls for a hypothetical transaction to occur on the valuation date. All marketing, due diligence and documentation has occurred before or on the valuation date and a hypothetical transaction occurs on the valuation date. Importantly, the transaction occurs for cash and/or cash equivalent consideration. There is no “marketing” after the valuation date. It has already occurred. It is simply incorrect to suggest that a controlling interest should be discounted because of marketing time after the valuation date.
- The concept of marketing before the valuation date is analogous to the concept of exposure time in real estate appraisal. Exposure time is defined in the Uniform Standards of Professional Appraisal Practice (USPAP) as the: “estimated length of time that the property interest being appraised would have been offered on the market prior to the hypothetical consummation of a sale at market value on the effective date of the appraisal.”There are no concepts of “marketability discounts” or “illiquidity discounts” in real estate appraisal because it is clear that a property has been assumed to have been on the market for a sufficient time and that appropriate effort has been expended before the valuation date so that the assumed hypothetical transaction reflected by the appraisal (for cash or its equivalent) can occur on the valuation date.The same holds true for fair market value determinations of controlling interests of businesses. There has been (assumed) sufficient “exposure time” (marketing, due diligence, and documentation) and effort that the hypothetical sale contemplated by the definition of fair market value can occur on the valuation date for cash or its equivalent. There can be no “marketability discount” or “illiquidity discount” based on time or expense to market companies after the valuation date.
- As noted above, the cost of any illiquidity of publicly traded securities is reflected in their transaction prices. When trades occur, we only see one price, the transaction price.
- The very same logic pertains to the sale of controlling interests in companies. Appraisers use transaction multiples from transactions in similar companies with the guideline transactions method. Only one price is observed when private company transactions close: the price agreed to by buyers and sellers. If a transaction had noncash consideration, it is up to the appraiser to put that on a cash-equivalent basis before calculating multiples. Any cost of illiquidity in the sale of companies is reflected in their prices, just as with publicly-traded securities.
- There is no relevant base value from which either a discount for lack of liquidity or for lack of marketability might be taken. And no discount has any meaning unless the base value from which it is taken is defined.
Pratt’s Sixth Edition recognizes this fact and considers four possible base values. I quote and then comment below each possible base value.
“If the appropriate standard of value is fair market value, the price ultimately expected to be reached between a willing buyer and a willing seller – before the costs and risks listed above are considered – is a benchmark from which the discount for lack of liquidity could be taken.” (emphasis in original) (pp. 457-458)
This first suggested base value does not hold water in fair market value determinations. The price that (hypothetical) willing buyers and sellers agree on for a business is its fair market value. It is certainly not the benchmark from which an illiquidity discount for a controlling interest should be taken. Any effect of illiquidity is reflected in the agreed upon pricing. The price agreed to by a willing buyer and a willing seller is, well, the price.
“The price one might receive in an initial or secondary public stock offering (i.e., the publicly traded equivalent value).” (p. 458)
The price in a potential IPO is simply irrelevant for the great majority of private businesses. Most companies will never have the size or characteristics to make them attractive public candidates. They may nevertheless be quite attractive companies. Further, in IPOs, normally only a small portion of companies are offered to the public. That is different than placing the entire company on the market. This is not a relevant base value.
The “publicly traded equivalent value” is a hypothetical concept. Appraisers value companies at the marketable minority level (financial control), which is also called the “as-if freely traded” value. It is a hypothetical price at which appraisers assume would be the price at which a private company’s shares would trade if there was a free and active market for its shares.
The as-if freely traded value is not a benchmark from which a discount for illiquidity for controlling interests might be taken. The as-if freely traded value is coincident with financial control value, so there is no reason to apply any discount for lack of liquidity. See the levels of value chart in a prior post. And see both of the levels of value charts in Pratt’s Sixth Edition (at p. 55 and p. 389). No such discount is reflected on either chart.
“The price achievable in a private sale of the entire closely held business enterprise.” (p. 458)
If a company achieves a price in a private sale of the entire business, That is the price and value of the business. This value does not represent a benchmark level from which an illiquidity discount for controlling interests might be taken.
“A control transaction of a publicly funded company.” (p. 458)
Frankly, I am not sure what this means. But it is not a base or benchmark value from which an illiquidity discount for controlling interests might be taken.
None of the base values proposed in Pratt’s Sixth Edition (and in prior editions) will serve as a base value from which a discount for illiquidity for controlling interests might be taken.
We can discuss the concepts of liquidity and marketability in the context of three specific examples.
The expansion of the definition suggests that marketability may differ for different assets that trade in different markets. Consider three assets:
- 1,000 Shares of META Platforms (Facebook). META is trading in the vicinity of $210 per share as I write. An investment of 1,000 shares would have a market value of $210,000. An investor owning 1,000 shares could issue a sale order today and have cash in her brokerage account in a very short time. An investor who wants to buy 1,000 of META could place an order and acquire ownership of the asset effective almost immediately. With either of these transactions (buy or sell), I would pay no brokerage fees if I executed in my Schwab account. I would not even have to worry about stock certificates since Schwab acts as a custodian for my interests.
What does an investor acquire when purchasing 1,000 shares of META? He acquires a literal “stock certificate” representing a very, very small but pro-rata claim on all the cash flows of the company, and is the pro-rata beneficiary of any future dividends or stock repurchases. The shareholders have collectively delegated to or allowed control by METAs management and the board of directors.
The current market price of $210 per share represents the current consensus pricing (per share) for all of META in the market today. The market is highly liquid. And META shares are marketable. And current pricing certainly represents freely-traded pricing (marketable minority) and financial control pricing. It is the base price to which any strategic or synergistic premium might be applied — if a potential purchaser expected such benefits.
- META Holdings, Inc. (the entire company). The market capitalization of META is about $550 billion as I write. I might be able to handle an investment of 1,000 shares of META, but I am not the market for the entire company. That market is quite limited, but it exists, and is international in nature. As big as META is, someone or ones would step up if META were “on the market.”If Mr. Zuckerberg were to decide to sell META, it would likely take some time to find a buyer or consortium of buyers. But what would happen in the meantime? The company would continue to operate and, hopefully, continue to create value for all its shareholders. META shares would continue to trade, undiscounted because of any potential sale. There is no discount for lack of liquidity or lack of marketability. If Mr. Zuckerberg and the META board of directors were to talk with potential suitors, rest assured that no suitor would suggest that a discount for lack of marketability or a discount for lack of liquidity is appropriate. Mr. Zuckerberg would laugh at such a suggestion.Is META, the company, liquid according to the definition of liquidity above? No, it would not be likely to be sold or converted to cash quickly in one day or two or three. Does anyone care? Not really. To reiterate, there is no discount for lack of liquidity or lack of marketability.
- XYZ Company (100% of equity). XYZ is a successful professional services firm with revenues of about $25 million, an EBITDA margin of 16%, and no debt. Earnings are about $4 million and have been growing each year. There is little seasonality to its earnings and distributions are made on a quarterly basis to its owners.Assume that it will likely take about a year to identify an appropriate buyer and to negotiate and close a sale. The board commences a sale process. At the end of three months of “marketing,” the company makes a distribution of $1 million from its earnings to its owners. At the end of six months and nine months, the same thing occurs. All of this occurs during the marketing period.Assume the XYZ board closed its sale one year after its “marketing” began. Its owners would take their last $1 million distribution at or just before closing. And they would receive $30 million cash at closing (7.5x EBITDA).What is the buyer purchasing? Well, clearly, the buyer desires to step into the shoes of XYZ’s owners and enjoy the benefits of its expected cash flows into the future. That’s what they just paid for. There is no discount for lack of illiquidity or marketability. And there is no basis, in an appraisal of the same company, to apply any discount for future marketing efforts. In an appraisal, the hypothetical transaction occurs on the valuation date just as the assumed closing of the XYZ sale occurred on the valuation date.
In my last post, I concluded that no marketability discount is applicable to controlling the ownership interests of businesses. In this post, I reached the same conclusion. Further, there is no discount for illiquidity applicable to controlling interests of businesses.
If someone is able to define different levels from the base value of financial control/marketable minority in terms of differences in expected cash flow, growth, and/or risk, then we can talk about such a discount.
To date, no one has done so.
As always, I welcome your comments on this post. If you’re reading this on LinkedIn, please do comment there.
As always, be well!