Introduction

Five recent posts on this blog have addressed the topic of restricted stock discounts (one, two, three, four, five). At the risk of some overlap with earlier posts, we will restart the series in a more disciplined manner, and rather than numbering them #1, #2, and so on, we will number them as RSD-1, RSD-2, and so on.

The purpose of this series of posts is to highlight the fact that attempting to use averages of restricted stock studies as a basis for determining marketability discounts (or DLOMs, if you prefer) applicable to illiquid minority interests of private companies is not a valid valuation method. We will examine restricted stock discounts in light of valuation theory, business valuation standards, and common valuation practice. The ultimate conclusion is that the common usage of restricted stock discounts as a market approach for developing marketability discounts is flawed.  Valuation analysts should rather employ methods under the income approach that evaluate the expected cash flows, growth and risks associated with receiving these benefits for illiquid minority interests of private businesses in relationship to the marketable minority base values to which they are compared.

Defining the Restricted Stock Discount

The restricted stock discount (RSD) is defined in the following equation, which is Exhibit 8.1 from Business Valuation: An Integrated Theory Third Edition (Z. Christopher Mercer and Travis W. Harms). The book is in the Wiley Finance Series and is also available on Amazon.com.  

Why do restricted stock discounts have this name? At the briefest, prior to April 29, 1997, investors purchasing significant shares of publicly traded companies were required to hold those investments for a two year period of restriction under Rule 144 of the Securities and Exchange Act.[1]  At the end of the two year period of restriction, investors could sell their shares into the public market subject to what are called the “dribble-out” rules, which limit the volume of shares that can be sold in any given period in order to protect public markets and investors.  This restriction was lifted after three years, but most investors remained effectively subject to the need to sell their shares slowly in order not to disrupt their markets. 

Restricted stock discounts get their name because the shares purchased were restricted as just described.

Referring to Exhibit 8.1, we learn only the following:

• The public share price is $20.00 per share.
• The restricted share price is $15.00 per share.
• The public share price is $5.00 per share, or 33.3% greater than the restricted share price.
• The restricted share price is $5.00 per share lower than the public share price.
• The restricted stock discount is 25%.

That is all the information available in Exhibit 8.1.  We do know that the restricted shares of the public company are identical in every respect to the public company with the exception of restrictions on their marketability.  We address this important issue in more depth in a subsequent post.

The bottom line is that there is no direct economic information in a restricted stock discount.  A RSD simply measures the difference between two prices.  The data points required to calculate a restricted stock discount reveal nothing regarding the underlying economics of the restricted stock transaction. 

• There is no information in the observed discount that will tell any valuation analyst that the announced price of $15.00 per share for restricted shares of the hypothetical public company above was reasonable or why the price was $15.00 per share rather than $12.00 per share or $17.00 per share. 
• There is no information in the information above that will help any valuation analyst infer the reasonableness of a marketability discount (or pricing) for illiquid minority interests of any private company that might be examined.
• There is, in fact, no information in this single discount we are examining for the public company, or, for that matter, in any average of similar restricted stock discounts for other companies, that can assist in assessing the reasonableness of a marketability discount (or resulting value) for the illiquid minority shares of any private company being examined.

What information might be economic in nature?  Information that would help us to understand the meaning of the observed 25% restricted stock discount might include:

• The historical performance of the public company and its outlook for the future as assessed by market participants.
• The size of the block of restricted shares sold in relationship to all other shares outstanding (often, relatively large blocks were sold).
• The expected use of the restricted stock proceeds and the impact of the new investment on the outlook for future performance.
• The historical stock performance of the public company and its pricing relative to similar public companies.
• The required returns of investors in the restricted shares of the public company.
• The effective length of the period of restriction before the public company’s shares would become freely tradable
• And so on…

There is a great deal of information we do not know about any particular restricted stock discount, but one thing we know for sure: the observed discounts fail to reveal any direct economic information.

Restricted Stock “Method” Is Set Early On

Between the late 1960s and the mid-1990s, a number of restricted stock “studies” were performed.  What they had in common is that they examined a limited number of restricted stock transactions, calculated means and/or medians, and some provided ranges and even individual transaction discounts and some operating data about the companies. We will provide summary information on these studies in a subsequent post.

Valuation analysts quickly began to draw an analogy between restricted stock discounts and marketability discounts for illiquid minority interests in private companies.

By 1981, with the publication of the first edition of Shannon Pratt’s Valuing a Business (no longer in print, but I have my copy!), the “restricted stock methodology” was set.  The chapter titled “Data on discounts for lack of marketability” concluded with the following (on page 155):

The four studies discussed [the SEC Institutional Investor Study, the Moroney Study, the Maher Study, and the Solberg Study of court decisions – more on the studies later]  are quite consistent in indicating an average discount for lack of marketability of approximately 35 percent for restricted stocks of publicly-traded companies.  Most such securities eventually will be registered, and become freely tradeable.

Shares of closely-held companies, most of which will never be freely tradeable, suffer more from lack of marketability than do restricted shares of publicly-traded companies.  Once the analyst has made his best estimate of the price at which the shares involved in the valuation would sell if they were freely marketable, the discounts at which restricted securities of publicly-traded companies sell can provide useful guidance to determine an appropriate marketability discount.

For many valuation analysts, the method has neither changed nor advanced over the last forty years.  The rule of thumb goes something like this–Restricted stock discounts tend to average around 35%, so most marketability discounts are in the range of 35%, plus or minus a bit.  They are seldom less than 25% or more than 45% based on the central tendency measures in the studies that we show below.  As we will see, there is no tendency for restricted stock discounts to hover around 35%.  In fact, they are all over the proverbial map depending on the relative bargaining power of issuers and investors.  Nevertheless, the “method” was set early on.

Conclusion

There is no economic information in any single restricted stock discount or in any average of multiple discounts to assist valuation analysts in determining marketability discounts for illiquid minority interests of private businesses in relationship to the base values, or marketable minority (or financial control), to which they are compared. In the next post, we will look briefly at the shareholder level of value in light of the Integrated Theory, before then examining the restricted stock discount in the context of business valuation standards.

Until next time, be safe and be well!

Chris

[1] For a more detailed discussion of restricted stock discounts, see Chapter 8 of Business Valuation: An Integrated Theory Third Edition noted previously.  The period of restriction was reduced to one year as of April 29, 1997.