We have conducted these studies for taxpayers, private and publicly traded companies and have testified for the Internal Revenue Service on Discounts.
Factors Affecting Marketability Discount
The major factors affecting the need and magnitude of the discount are:
- put option rights
- dividend payments
- potential buyers
- size of the block
- information access and reliability
- restrictive transfer provisions
General Sources of Information
There are four general sources of information on the discounts for a lack of marketability:
- restricted stock studies
- studies of private transactions prior to public offerings
- studies of the costs of flotation
- primary research for brokering the security interest
Other commonly cited discounts are those for:
- Potential loss of key person
- Portfolio holdings
- Lack of liquidity
- Legal/contractual restrictions
Blockage is a term which is more commonly used with publicly traded securities, rather than in the privately held securities arena. This term refers to large quantities, or “blocks,” of securities which may have less of a value per unit than that of smaller quantities of an asset or item. This term is similar to the concept of economies of scale, where larger portfolios or groups of assets will sell for a smaller dollar/unit, than smaller portfolios or groups of assets.
The most typical example would be a large block of stock in a publicly held corporation. If the size of the block is large, relative to the daily trading volume, then a discount from the current market price is made in order to induce a trader to buy the entire block. This concept is typically confronted when valuing estate interests or for filing an estate gift tax form with the Internal Revenue Service.
Key Person Discount
Sometimes one person in an organization will provide the “lynch pin” to the entire operation. If this person dies or leaves, then the risk of the business operating as a going concern increases, and the value of the business decreases.
Sometimes businesses (e.g., conglomerates) have two or more lines of businesses which are non-related. In this case, a discount may be paid for a position in the stock of the conglomerate holding company. The rationale is that one or more lines of business would not fit into an expansion or acquisition plan of a company, and that the non related businesses would be a drag on the overall business of the acquiring company. Some studies have indicated a 10 percent discount from the breakup value. However, the discount would depend upon the situation and the company.
On the other hand, there may be a premium due to the reduction of risk or acquisition and due diligence costs from an investor’s point of view. More business entities means less risk due to diversification. The real issue is who the most typical buyer would be. If the most typical buyer would be an investor, then there may be no discount, and possibly a slight premium. If the most typical buyer would be a company in the same industry as one of the subsidiary companies of the holding company, then there may be a discount.
Liquidity (Waiting for a Dividend)
In some cases holding companies have leaseholds or other assets where the yield is quite low and the reversion of these assets constitutes the entire value. In this case, a higher than normal discount rate is applied in order to bring a reversionary or terminal value to a present value in today’s dollars. Another example would be that of an ESOP cashout. While the put option may be called by the employee, the employee often has to wait for 9-12 months in order to receive the proceeds. Therefore, while the proceeds are fixed, the amount would still have to be discounted for the cost having lost simple interest on the proceeds.
Sometimes contractual restrictions are so limiting that a buyer would place a discount on the purchase price in order to account for a lack of liquidity and the amount of litigation that it would take in order to obtain the liquidity of the investment to cash.
- Built in Capital Gains
- Buy Sell Agreements
- Layered Multi-Entity Discounts
- Key Man Discounts
- Businesses versus RELPs
The most important issues to remember when valuing an interest in a company are:
- the risk associated with the class of asset;
- the historical business entity distribution or dividend and debt; and
- the payback period after the discount is made.
The last item is the most important. If the payback or investment becomes less than one to two years (after the discount has been made), then investors will “come out of the woodwork” to invest in this investment or business interest. Therefore, there is less of a marketability problem, and therefore less of a discount.