Marketability discounts: Appraisers relying less on empirical study averages  

With the widespread availability of public market databases, spreadsheet software and other analytical tools, valuators are no longer relying solely on empirical study averages to determine marketability discounts. They’re now placing greater emphasis on how to identify what truly affects marketability and how to better match empirical data to the specific attributes of each subject company.

According to the International Glossary of Business Valuation Terms, marketability is “the capability and ease of transfer or salability of an asset, business, business ownership interest or security.” The quest for valuators, therefore, is to find acceptable methods for quantifying the discount for lack of marketability.

Going to market

Among other things, marketability encompasses access to and costs associated with public offerings. Large public stocks — say, shares of IBM or Wal-Mart — are fully marketable. Investors in these securities can typically convert their investments to cash in less than 72 hours. Minority interests in small private companies represent the other end of the spectrum. That is, they lack access to a ready market and, therefore, require more time and effort to sell — assuming they can be sold at all.

When a valuator uses the income or market approach to value a private business interest, his or her preliminary conclusions are cash-equivalent values derived from analysis of public market data. In other words, valuation approaches generally appraise the company on a “marketable” basis. These preliminary values require an adjustment — commonly referred to as the discount for lack of marketability — to reflect a private business interest’s lack of marketability.

The question becomes: How should the discount for lack of marketability be quantified?

Then and now

Decades ago, business valuation was a relatively new and untested profession. Valuators generally took an average from a pre-initial public offering (IPO) or restricted stock study, and then subjectively modified the average based on the subject company’s specific characteristics.

When a company undergoes an IPO, it must report all stock transactions that have taken place within three years of the offering. Analysts compare these pre-IPO transactions with the companies’ subsequent offering prices to support the discount for lack of marketability.

With restricted stock studies, prices that accredited private investors pay for restricted shares are compared to the prices public investors pay for SEC-registered shares. Because the SEC limits transfers of restricted shares, they’re less marketable than registered stock, making them a viable proxy for the discount for lack of marketability.

Now, most valuators have abandoned the blanket use of empirical study averages and instead are solidifying their understanding of pre-IPO and restricted studies and analyzing any relevant market data before determining marketability discounts.

Data still relevant

Although pre-IPO and restricted stock studies may be somewhat under siege, their data is still worthwhile. Research has generated these insightful hypotheses:
Discounts based on pre-IPO studies or restricted stock underestimate the difficulty of transferring a private company interest. Some private companies may require an additional adjustment — beyond those supported by empirical studies — to reflect their relative lack of marketability. For instance, pre-IPO studies include more materially different types of companies (in terms of size, management quality and access to financial data) than they do closely held businesses. Similarly, though restricted stocks are subject to a one-year holding period, they’re registered with the SEC and, therefore, are more marketable than private business interests.

Specific factors affect a company’s marketability. Among those factors are firm size, block size, stock volatility and external market conditions. Valuators can use these factors as selection criteria to link pre-IPO or restricted stock transactions to the subject company on the valuation date.

Public stock returns give insight into private company volatility. Volatility (or financial risk) is one of the key determinants of marketability. A public company’s volatility is simply the standard deviation in stock returns over time. But for thinly traded public stocks or a private company, volatility is in the eye of the beholder.

Experts have analyzed public stocks and identified several proxies of volatility. Some valuators use these proxies to estimate a closely held company’s volatility. Among the financial characteristics found to affect volatility are size, balance sheet strength, profitability and dividend payments.

In the final analysis

Determining valuation discounts is one of the more challenging aspects of valuing a business. And as new ways to measure marketability discounts are revealed, some hypotheses will survive, while others will be proven faulty. That’s why it’s important to work with an expert in the valuation field.