When a small business is having their company appraised, there are many different pieces that factor into the final figure. The discount for lack of marketability is a valuation adjustment that requires a particularly detailed process, and is often contested. An appraiser needs a complete understanding of this discount, and obviously can’t just pick a number out of a hat.
For this reason, appraisers use empirical evidence, such as restricted stock studies and pre-initial public offering studies, and more to quantify a discount for lack of marketability.
The Discount Application
The International Glossary of Business Valuation Terms defines marketability as “the ability to quickly convert property to cash at minimal cost.” Public stock is generally easy to sell because stock exchanges provide a ready market. Private business interests, however, can require significant time, money and effort to sell.
Even with this difference, appraisers will often use public stock data when estimating the value of private firms. This can lead to an apples-to-oranges comparison, so appraisers may apply discounts for lack of marketability to their preliminary value estimates. Such discounts make up for the increased time and effort in selling private business interests.
Restricted Stock Studies
The discount for lack of marketability is shown as a percentage reduction in the subject company’s value. Appraisers typically use empirical evidence to come up with this percentage.
An example of empirical evidence would be restricted stock studies. Some companies issue restricted (or letter) stock in mergers or acquisitions or to raise private capital without registering new shares. They only difference between restricted stock and freely traded stock is that it has a minimum holding period of one year. Public companies must report restricted stock transactions to the SEC.
A restricted stock study compares restricted stock prices to freely traded stock prices on the same day to estimate the discount for lack of marketability. Valuators see the key difference between restricted stock and freely traded stock as the degree of marketability. IRS Revenue Ruling 77-287 specifically endorses the use of restricted stock transaction data to support the lack of marketability discount for private business interests.
Matters of Size
Typically, the range of median discounts for lack of marketability is between 35 and 50 percent. But the actual discount assigned by an appraiser can vary significantly from this range, depending on the investment’s characteristics.
It’s critical for appraisers to evaluate specific attributes, such as profitability, financial position, liquidity, transfer restrictions and expected holding period, and their effect on marketability. Appraisers who merely rely on average discounts from restricted stock studies are unlikely to survive a deposition or cross-examination.
In general, a company’s strong performance correlates with a lower discount for lack of marketability. The risk of a company’s underlying assets can also have an effect on its discount.
Moreover, investors place a premium on reliable financial data and professional management. Dividends are also important, as companies provide an immediate return on investment when they distribute cash to their investors. Along the same lines, the more potential buyers interested in a business, the lower its discount will be.
Remember, figuring out the discount for lack of marketability is a complex process that calls for specialized expertise. A discount based only on study averages will not withstand the scrutiny of a court case. Appraisers need to use quantitative methods to find more meaningful, defendable comparisons. For more information, and to find out more about valuation methods, contact Filler & Associates.