Marketability discounts are often applied by business valuation experts to reflect the difficulty in selling shares in a private business compared to selling shares in a publically listed company.
You can sell shares in a listed stock at the click of a button, with a minimal brokerage cost; there is a visible level of investor demand. Selling shares in a private business is somewhat more laborious and more costly. There is no ready market, no button to click.
Take two identical businesses A and B. Company A is publically listed; company B is privately owned. Given the marketability advantage, a rational investor will prefer shares in company A over shares in company B. Consequently, assuming the market is efficient, an investor will be prepared to pay a higher price for shares in company A versus company B.
Why is this relevant? A business valuation expert may value the shares in a private business by looking at comparable listed companies. To arrive at the value of the private business, the valuation expert may need to apply a marketability discount to the value of the comparable public companies.
In research, marketability discounts are often referred to as DLOM, being the abbreviation for Discounts for Lack of Marketability. The two types of studies often referred to for the evidence of, and the amount of the DLOM, are the restricted stock studies and the initial public offering (IPO) studies.
Restricted stock studies
A restricted stock is what you’d expect; a stock issued by a public company that has restrictions attached. Typically this means that the stock cannot be publically traded, but it can be privately traded. Restricted stock may be issued by a company to avoid stock price dilution and listing registration costs.
Given the restriction on trading, the restricted stock is issued by the company at a discount to its market price and this is the basis for implying a marketability discount. The restricted stock studies look at the prices at which companies issue restricted stock and compare those prices to the listed stock price.
Numerous restricted stock studies have been carried out over the last fifty years. The research generally appears to indicate a range of marketability discounts of between 25% and 35%. Some of the studies are listed below:
- SEC institutional investor study – New York Stock Exchange companies from 1969 to 1970; the study calculated an average marketability discount of 25.8% for stocks that could only be traded over the counter when the restrictions expired
- Gelman study – prices paid for restricted securities by closed-end investment companies from 1968 to 1970; the study calculated an average marketability discount of 33%
- Moroney study – prices paid for restricted stocks by registered investment companies, from 1969 to 1973; the study calculated an average marketability discount of 35.6%
- Trout study – prices paid for restricted stocks by mutual funds, from 1968 to 1972; the study calculated an average discount of 33.45%
- Willamette Management Associates study – private placement of restricted stocks from 1981 to 1984; the study calculated an average marketability discount of 31.2%
- Silber study – restricted stocks issued between 1981 to 1988; the study calculated an average marketability discount of 33.75%
John Emory made ten studies between 1980 and 2000, comparing prices in closely held stock transactions, when no public market existed, to the prices subsequently achieved when the companies listed. The study found an average marketability discount of between 42% and 60%.
The higher marketability discounts in the survey, compared to the restricted stock studies, could be due to not at arm’s length pre-IPO transactions.
Factors that can impact the attractiveness of a private business and so potentially make those share more marketable, and so reduce the marketability discount, include:
- high dividend yield
- strong growth and good prospects
- a minority interest that would provide control
- honest and friendly controlling shareholder
Factors that can make an interest less marketable include share transfer restrictions, per the shareholder’s agreement.
Simon is a CA Business Valuation specialist, Chartered Accountant and a Certified Fraud Examiner. Simon specialises in providing valuation services. Prior to founding Lotus Amity, he was a Corporate Finance and Forensic Accounting partner with BDO Australia. Simon provides valuation services in disputes, for raising finance, for restructuring, transactions and for tax purposes.
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