This is the sixth in a series of posts regarding restricted stock discounts (RSDs). The series is based on Chapter 8 of Business Valuation: An Integrated Theory Third Edition (Mercer and Harms). Exhibit references in the series relate to exhibits from Chapter 8 for the most part.
Today, we will address the expected holding period premium (HPP), or the premium in return demanded by investors in restricted shares of publicly traded companies. How did we get to this point?
- RSD-1 Background on Restricted Stock Discounts. In this first post, we defined the restricted stock discount and provided a bit of background into how appraisers began to think that all marketability discounts are 35%, give or take a bit.
RSD-2: Why Are Illiquid Minority Values Always (Almost) Lower Than Marketable Minority Values? That is a good question. The answer lies in differences in expected cash flows, risk and growth between the two levels of value.
RSD-3: Restricted Stock Discounts and the Guideline Transactions Method. The third post observes that the use of averages of restricted stock discounts from historical studies is a flawed use of the guideline transaction method.
RSD-4: Restricted Stock Discounts Are Not Valuation Ratios. Restricted stock discounts measure only the difference between two prices and contain no economic or valuation information.
RSD-5: Restricted Shares of Public Companies are Identical to Freely Traded Shares, But… Restricted shares have the same expectations for future cash flows, risk and growth as do freely traded shares, so why is there a difference in price?
The answer lies in the topic for this sixth installment in the series – the expected holding period premium.
The Expected Holding Period Premium
We now put a finer point on the key difference between restricted shares and freely traded shares of any public company. We do so in the following exhibits. The restricted share price (Vrs) is lower than the freely-trading price (Vft) because of the existence of the restricted stock discount (Exhibit 8.8).
Exhibit 8.9 makes clear that expected cash flows for the company are the same for both the public and the restricted shares. Also, the expected growth is the same. The only reason for the existence of a restricted stock discount is in the greater risks, relative to public owners, assumed by restricted stock investors over the period of restriction on selling shares in the open market.
Finally, Exhibit 8.10 defines the incremental risk associated with restricted shares as HPP, or the expected holding period premium in return required by restricted stock investors over the period of restriction to induce their investments in the public companies.
Having identified the expected holding period premium, we now must understand how it comes about and how it can be measured. We do so in the following example for a publicly traded issuer of restricted shares (PubliCo) where we assume:
- The public price is $10.00 per share.
- The restricted transaction occurred at $7.50 per share.
- The effective holding period until liquidity is between three and four years considering the two-year period of mandated illiquidity under SEC Rule 144, and the need to dribble out shares once the initial period of restriction ends.
- The discount rate for the public company is 10.0%. Given that no dividends are expected, this is the expected growth in value for PubliCo. The analysis is relatively insensitive to changes in this assumption.
- The restricted stock discount is 25% (1 – $7.50/$10.00).
The questions we must ask are the following:
- What caused the investors in restricted shares to invest at a 25% discount to the market price?
- Alternatively, why would the management and board of the public company sell shares at such a steep discount?
The answer to the first question has been addressed to an extent. Investors in restricted shares bear risks of illiquidity over a lengthy expected holding period and charge for that risk. The selling public company recognizes this risk and realizes that there is not a cheaper source of equity funds available. The market cleared at a 25% discount.
We examine the why of the discount in the following Exhibit 8.13.
The public price is $10.00 per share as indicated on the vertical axis of the exhibit. The restricted stock price of $7.50 per share is also reflected there. The expected appreciation for the public company (10% per year) is shown in the chart. For readers who think this might be too low for risky issuers of restricted shares, the analysis results are pretty insensitive to the discount rate used.
Assuming compounding, the share price of PubliCo would be expected to rise to $11.00 per share at the end of year one, and to $12.10 per share, $13.31 per share, and $14.64 per share at the ends of years two, three and four, respectively (FV = (1 + 10%) raised to the respective years. Arrows show the expected appreciation, which is the expected value growth path for PubliCo’s publicly traded shares.
The question for analysis is this: what incremental return, or HPP, or holding period premium to the 10% discount rate of PubliCo, can be inferred by the restricted transaction? The price of $7.50 per share occurred at a 25% restricted stock discount. The answer requires our assumption regarding the expected holding period, which is three to four years. Exhibit 8.14 shows the calculations underlying the expected holding period premium.
The stock price is expected to grow to the future prices shown, but the price paid was not the starting point of appreciation or $10.00 per share. The starting point is the discounted price of $7.50 per share. Restricted stock investors expected to pay $7.50 per share and to achieve the future prices of $13.31 per share or $14.64 per share at the end of years three and four as shown above. The rates of return that match these present and future values are the implied required investor returns for the expected holding periods of three and four years.
Our analysis of required returns and holding period premiums provides meaningful information, including:
- In order to induce the purchasers of PubliCo’s restricted shares to invest, the issuer had to provide a 25% restricted stock discount.
- The purchaser’s required returns for three and four year holding periods were about 21% and 18%, respectively.
- The purchaser’s holding period premium (excess return above the public R or 10%) over this expected range of periods was about 8% to 11%.
In contrast to the observed discount, this analysis helps to reveal the underlying economic considerations in the transaction and helps provide a basis for valuing illiquid minority shares of private companies. We will examine the issue of the expected holding period premium in more detail in future posts.
Concluding Observations Thus Far
We summarize a few observations from this series of six posts focused solely on the restricted stock discount:
- The business appraisal profession had latched onto restricted stock studies and restricted stock discounts and a 35%, plus or minus, target for marketability discounts by the early 1980s. (RSD-1)
- The real reason that illiquid minority shares are worth less than their freely-traded or marketable minority private company counterparts lies in differences in expectations for future cash flows, risk and growth. (RSD-2)
- The use of restricted stock studies to estimate marketability discounts for illiquid minority interests of closely held companies is a flawed use of the guideline transactions method. (RSD-3)
- Restricted stock discounts are not valuation ratios (like Enterprise Value/EBITDA or price per case of beer sold) and contain no valuation or economic information. As such, it is not reasonable to apply averages of restricted stock discounts as if they were valuation ratios to derive marketability discounts. (RSD-4)
- Restricted shares as being just like their freely trading counterparts except for the mandated period of restriction from SEC Rule 144. But, there are key differences that were known by both issuers and investors in the historical restricted stock transactions from the various studies. (RSD-5)
- And lastly, for today, the key difference between restricted shares and publicly traded shares of issuers is the differences in expectations for risk over the mandated period of restriction under SEC Rule 133. Those differing risk perceptions required a higher rate of return than available to public shareholders. That higher rate of return is the expected holding period premium. (This post, RSD-6).
The next post will examine the handful of historical restricted stock studies that many business appraisers rely on as a or their sole basis for developing marketability discounts. You may be surprised at what we see.
In the meantime, rush over to Amazon.com and order your personal copy of Business Valuation: An Integrated Theory Third Edition (Mercer and Harms). And enjoy this 332nd day since many business appraisers, attorneys, and other readers of this blog started working from home.
Be safe and be well,
Save the Date for An Upcoming BVR Webinar
Conceptual Overview of the Integrated Theory
Date: Wednesday, February 17, 2021
Time: 10:00am-11:40am PT / 1:00pm-2:40pm ET
The integrated theory of business valuation provides a conceptual framework for disciplined analysis of valuation questions. Too often, valuation analysts are tempted to view individual components of a valuation assignment on a piecemeal basis. Adhering to the integrated theory helps valuation analysts develop base valuation conclusions, discounts, and premiums that are rooted in a shared perspective of the subject company and the subject ownership interest.
This first webinar in the three-part series sets the stage by focusing on the conceptual overview of the integrated theory. In this session, Travis Harms and I will explore the fundamental principles that undergird the integrated theory. We will then describe the integrated theory on an equity basis, giving particular attention to the conceptual scaffolding that the integrated theory provides to discussions of the levels of value and the associated valuation discounts and premiums. We’ll finish by extending the conceptual basis for the integrated theory to the enterprise value perspective.