This post is the fifth in a series about restricted stock discounts. The series is based in part on Chapter 8 of Business Valuation: An Integrated Theory Third Edition by myself and Travis Harms. Before addressing any specific restricted stock studies and what they might mean, it is important to understand the similarities and differences between restricted shares and freely traded shares.
A publicly-traded company’s restricted stock is identical in every respect to its publicly-traded shares, except for applicable restrictions under SEC Rule 144. We explore this statement now. This is true for any single company. But, as we will see, there are significant differences between public companies issuing restricted stock, so all restricted stock discounts are not the same.
Similarities between restricted shares and freely traded shares for a single issuer of restricted stock are spelled out in Exhibit 8.2.
The individual characteristics of freely traded shares are apparent when we lay them out as above. Except for the restrictions on trading imposed by Rule 144. Restricted shares of publicly-traded companies are identical to their freely-traded counterparts. The words are easy to say but the implications are perhaps less than obvious. Exhibit 8.2 focuses on the similarities between the shares from the viewpoint of market participants and valuation analysts. What is clear about the restricted shares is that, on transaction dates, investors have access to all information available to the public investors in each company’s publicly-traded shares.
The restricted shares that are issued represent ownership in the very same public companies that public investors invested in on the various transaction dates. The shares were identical in all respects except for the mandatory period of restriction under SEC Rule 144. We explore this statement now.
To understand why restricted shares usually trade at discounts, and often steep discounts, to their freely traded counterparts, we must understand how restricted shares differ. One difference lies in the information available to the managers of issuing public companies and to investors purchasing restricted shares, as seen in Exhibit 8.3.
Like all transactions, restricted share issuances are the product of negotiation between two or more parties with adverse interests. The issuer of restricted shares is motivated to receive the highest issuance price (i.e., the smallest discount), while buyers of the shares are motivated to pay the lowest price (i.e., the largest discount). The observed discounts reflect the relative negotiating leverage of the parties.
Restricted stock transactions were an important source of funding for small public companies for years. If other sources of financing had been available, managers would have sought less expensive (i.e., undiscounted) funding. Both buyers and sellers were aware of this circumstance.
And both buyers and sellers were aware that the investors’ shares would be restricted for a period of two years or more. The investors certainly knew that their funds would be tied up and not be freely tradable, and they took this restriction into account. Why? An expected holding period of two or more years, with no ability to sell their investments in the public marketplace, exposed them to risks that were not faced by investors in public shares, who could sell at any time if their investment preferences changed. The sellers and buyers were aware of the restrictions. The restrictions, in addition to the risks inherent in the public company shares, were important elements in the pricing of restricted stock transactions.
There was another important element in the pricing of restricted stock transactions. Simply put, performance mattered with these transactions as it does for any investment. What is not well-known about the restricted stock studies is that the operating performance of many restricted share issuers was less than stellar. In a previous post, we discussed the Silber Study, which was published in 1991 in the respected Financial Analysts Journal (The CFA Institute).
Most writers who have written anything about restricted stock studies have focused only on the overall conclusion of the Silber Study, which had an average restricted stock discount of 34%. See the summary statistics from the Silber Study below.
The average of the Silber Study may have been 34%, but the range of discounts were very wide (from a negative discount, or premium, to an 84% discount). The standard deviation of 24% showed a wide variation in observed discounts. The average performance statistics provide little perspective.
The overall average is all that most appraisers looked at in the Silber Study and in all the other studies. Now, look at the additional information Professor Silber provided as he examined the differences between transactions with higher versus lower restricted stock discounts.
What a difference a more informed look makes! The average for transactions with discounts exceeding 35% was 54%, while the average for transactions with discounts less than 35% was 14%. The standard deviations for the two groups were smaller than for the overall group. What could have caused this difference? Professor Silber provided summary statistics for the two subgroups as shown above. Simply put, the companies with lower discounts were just more attractive in terms of cash flow, perceived risk, and likely expected growth than the companies with higher discounts. They were larger in terms of revenue and market capitalization and more profitable than the companies in the larger discount sample.
Better-performing companies were able to negotiate capital raises with lower restricted stock discounts. The better relative profitability of the lower discount companies enabled them to negotiate better prices. The more poorly performing companies were not so fortunate, and had to accept large restricted stock discounts in their capital raises.
In the next post, we will examine the why of restricted stock discounts in more detail.
Until then, be safe and be well!