This is the third post in a series on restricted stock discounts. The first two posts provided initial background on restricted stock discounts to provide the basis for discussion. The second post addresses the question: Why are illiquid minority values always (almost) lower than marketable minority values. The answer to that question is not because restricted stock discounts exist. This post will examine the restricted stock discount in light of the guideline transactions method, a valuation method within the market approach to business valuation. The first two posts can be referenced:
- RSD-2: Why Are Illiquid Minority Values Always (Almost) Lower Than Marketable Minority Values?
The Guideline Transactions Method
The use of restricted stock studies to develop marketability discounts is a form of what is known in valuation as the guideline transactions method. Interestingly, I am not aware of any other writers (other than my co-author, Travis Harms) who have observed that using restricted stock studies and discounts to develop marketability discounts is an application of the guideline transactions method. The guideline transactions method has been discussed in a number of articles and valuation texts, including the third edition of Business Valuation: An Integrated Theory (Mercer and Harms). This method is known more for its weaknesses than its strengths, although with timely and comparable transactional data, the method can be useful.
The guideline transactions method is defined in the ASA Business Valuation Standards as:
A method within the market approach whereby pricing multiples are derived from transactions of significant interests in companies engaged in the same or similar lines of business.
Glossary, ASA Business Valuation Standards (American Society of Appraisers, 2009). We will not footnote further references to the ASA Business Valuation Standards specifically in the remainder of this series, but will reference the particular standards by number and name.
There are important aspects of guideline transactions that should be considered as we discuss studies of transactions designed to develop adjustments to valuation ratios in order to reasonably value particular subject interests. The “Conceptual Framework” of the guideline transactions method is discussed in SBVS-2 Guideline Transactions Method (at Sections II.A, II.B and II.C):
II.A. Transactions involving the sale, merger or acquisition of businesses, business ownership interests, securities and intangible assets can provide objective, empirical data for developing valuation ratios for use in business valuation.
II.B. The development of valuation ratios from guideline transactions of significant interests in companies (or intangible assets, if applicable) should be considered in the valuation of businesses, business ownership interests, securities and intangible assets to the extent that sufficient and relevant information is available.
II.C. Guideline transactions are transactions involving companies (or interests) that provide a reasonable basis for comparison to the investment characteristics of the company (or interest) being valued. Ideal guideline transactions are in the same industry as the subject company. However, if there is insufficient transactional information available in that industry, it may be necessary to select transactions involving other companies having an underlying similarity to the subject company in terms of relevant investment characteristics such as markets, products, growth, cyclical variability and other relevant factors. Prior transactions in the company being valued may also be considered to be guideline transactions. (emphasis added)
Companies involved in restricted stock transactions are most often not comparable to typical private company valuation subjects. We will show this quite clearly in a future post in this series on restricted stock discounts. The primary idea underlying the guideline transactions method is that the transactions considered should provide a reasonable basis for comparing with the investment characteristics of a subject business interest.
As we will see, the universe of restricted stock transactions is quite limited and, for the most part, very much dated. Issuers of restricted stocks in the period from the latter 1960s until the mid -1990s were primarily small, public companies in need of capital that was unavailable from cheaper sources. Most were unprofitable. These are the companies whose restricted stock discounts were studied in the often referenced restricted stock studies. We will examine these studies in more detail later in this series.
Considerations When Using the Guideline Transactions Method
Additional guidance is provided in SBVS-2 Guideline Transactions Method at Sections V.A.3, V.A.4, and V.A.5, which states that valuation analysts should exercise care regarding issues like:
V.A.3. The computation of the valuation ratios, which may be derived by relating prices in guideline transactions to the appropriate underlying financial, operating, or physical data of the respective companies (or interests) involved in the transactions
V.A.4. The timing of the price data used in the valuation ratios (in relationship to the effective date of the appraisal)
V.A.5. How the valuation ratios were selected and applied to the subject’s underlying data (emphasis added)
Section V.A.3 addresses the computation of valuation ratios based on guideline transactions and suggests relating prices to appropriate underlying financial, operating, or physical data of the guideline companies. This is true whether using the guideline public company method or the guideline transactions method.
Section V.A.4 suggests that care be exercised regarding the timing of guideline transactions in relationship to relevant valuation dates. This issue particularly relevant for transactions involving restricted stock issuances or pre-IPO transactions. It also raises questions about the timing of restricted stock and pre-IPO transactions relative to current valuation dates, as indicated above and discussed in more depth later in this series.
Section V.A.5 says that guideline transaction valuation ratios should be selected and applied to a valuation subject’s underlying data. As we saw above, restricted stock discounts merely relate one price (a transaction price) to another (a public market price) at the time of the respective transactions.
Another concern about the guideline transactions method not mentioned in SBVS-2 relates to the number of transactions necessary to comprise a valid sample for use of the method. Generally, more relevant transactions available at or close to a valuation date suggest a more reliable use of the method. If few or no relevant transactions are available, the use of the guideline transactions method (or the guideline public company method) should be called into question.
Conclusions in Advance
We are taking this series in bite-sized steps. For now, let me provide the following conclusions to provide a roadmap of where the series is headed. Each of these conclusions will be shown to be true as we proceed with this RSD series:
- Restricted stock discounts from whatever source are not timely, but, for the most part, date back several decades
- The issuing companies are not similar in nature to most closely held businesses currently being valued by business appraisers
- Restricted stock discounts (averages or otherwise) are not valuation ratios and cannot be applied to underlying financial, operating, or physical data of subject companies
- In addition to being dated, the number of restricted stock transactions is too small to provide meaningful comparisons to companies in almost any particular industry today
In the next post of this series, we will examine the concept of valuation ratio and look at it in light of restricted stock discounts. Advance Notice: Restricted stock discounts are not valuation ratios and cannot be applied to anything to develop marketability discounts for illiquid minority interests of closely held businesses.
This series of posts is being adapted from Chapter 8 of Business Valuation: An Integrated Theory, Third Edition, recently released in the Wiley Finance Series by John Wiley & Sons, Inc. The book is available on Amazon.com. Buy the book and be the first reviewer on Amazon.com. It will likely change the way you think about many business valuation concepts.