Discounts for Lack of Marketability

By Stuart A. Ober, CFE, AIFA ®

VR's Guide to Discounts for Lack of Marketability ("DLOM" or "marketability discounts") (updated through the first quarter 2008), provides an assemblage of multiple views of DLOM, and how they apply to the business valuation profession. The contents are updated annually, providing new court cases and analytical tools for the valuation of both public and private companies.

The Guide includes new analysis, original articles on DLOM, articles republished from the Business Valuation Update newsletter, conference presentations, and excerpts from BVR's teleconferences. There are also hundreds of the most important, and most recent, full-text court cases with an on-point discussion of the court's ruling, in such areas as tax, matrimonial, shareholder oppression, and other practice areas.

The discount for lack of marketability ("DLOM") remains the largest dollar issue in the majority of disputed business valuations. How DLOM is determined remains one of the most challenging aspects of business appraisals.

What is the concept behind DLOM? Very simply, DLOM deals with how quickly a registered stock shareholder can convert registered stock, or a business owner can convert a business interest, into cash. Clearly, the less marketable the registered stock or the business interest, the lower the value of the asset, and the higher the DLOM. And, conversely, the more marketable the registered stock or the business interest, the higher the value of the asset, and the lower the DLOM.

As Shannon Pratt notes in the Guide, the liquidity in public markets has increased dramatically within the last 15 years. This is due to a number of reasons, including (1) the reduction to three business days for the settlement period of securities (the length of time between the sale and the payment to the investor), (2) the reduction of sales commissions due to the introduction of discount brokers, (3) the reduction of the spread between the "bid" and "asked" prices with the change from a fraction-of-a-dollar price to a decimal price, (4) the development of derivative securities (such as "puts," "calls," and much more sophisticated derivatives), which has allowed "hedging" on public securities and further enhancing the liquidity of the public markets, and (5) the increase in recent years in trading volume for the average public stock.

The size of the discount for lack of marketability is affected by many factors, including receipt of cash distributions during the holding period (the greater the distributions, the lower the marketability discount). The discount is affected by quantifiable measures such as company size, assets, earnings, and revenues.

Restricted Stocks

Restricted stocks are those stocks of public companies that are restricted from public trading under SEC Rule 144. Except for the public trading restriction of not being able to be sold on the open market, these securities are the same in all respects as their publicly traded counterparts (i.e., their owners receive dividends, voting rights, liquidation rights [security holder's rights in the event that the firm liquidates], etc.).

What makes restricted securities interesting is that they can be bought by qualified institutional investors, creating greater marketability, and, also, providing a database of trades to quantify the marketability discount. Thus, restricted stock studies have been conducted comparing the price of a trade in restricted shares of a public company with the public market price on the same date, providing a benchmark for the marketability discount.

History of Restricted Stock Restrictions

Until 1990, sales of restricted stocks had to be registered with the SEC. The minimum holding period was two years, and discounts for lack of marketability over all marketplaces averaged approximately 35%.

However, in 1990, the SEC removed the requirement to register sales of restricted stocks, which resulted in more trading of restricted stocks, providing greater liquidity and, thus, lower discounts. The marketability discount averages dropped to the mid-20's.

In February 1997, the SEC introduced Rule 144(A) which lowered the minimum holding period for restricted stocks from two years to one year, and resulted in a further reduction in discounts for restricted stock (with one study averaging under a 20% marketability discount).

In essence, the observations of the restricted stock studies show that as the liquidity of the securities increases, the marketability discounts are reduced.

History of Restricted Stock Studies

The SEC Institutional Investor Study was the first restricted stock study, and covered the period from 1966 through mid-1969. The average restricted stock discount in that study was approximately 26%, and the "OTC Nonreporting Companies" average discount was about 33%.

Until 1990, several restricted stock studies consistently showed average discounts of approximately 33% to 35%. However, after 1990, the year the SEC relaxed its constraints, the average discount dropped to the mid-20's.

Then, after 1997, when the SEC lessened the minimum-required holding period from two years to one year, the average marketability discounts dropped to the teens or low 20's, according to Shannon Pratt.

As Barry S. Sziklay points out in his article on "Discounts and Premiums: Discount for Lack of Marketability," one of the best sources for guidance on the Tax Court's thinking on the marketability discount is found in the Mandelbaum decision. In Mandelbaum, the Court set forth its analysis of the application of restricted stock, and is a "must read" for business appraisers. In discussing the Mandelbaum opinion:

...the Court presented the following nine factors…that should be considered in determining discounts for lack of marketability:
1. Financial Statement Analysis.
2. Company's Dividend Policy.
3. The Nature of the Company, Its History, Its Position in the Industry, and its Economic Outlook.
4. Company's Management.
5. Amount of Control in Transferred Shares.
6. Restrictions on the Transferability of Stock.
7. Holding Period for Stock.
8. Company's Redemption Policy.
9. Costs Associated with Making a Public Offering.

Kathryn Aschwald's article on "Restricted Stock Discounts Decline as a Result of a 1-Year Holding Period," is included in the Guide. The following excerpts are from her article:

Rule 144 Stock Original Restrictions

The registration exemption on restricted stocks is granted under Section 4(2) of the 1933 Securities Act. The intent of Section 4(2) is to allow "small" corporations the ability to raise capital without incurring the costs of a public offering. Regulation D, a safe harbor regulation, which became effective in 1982, falls under Section 4(2) of the code and provides uniformity in federal and state securities laws regarding private placements of securities. Securities bought under Regulation D are subject to restrictions, the most important being that the securities cannot be resold without either registration under the Act or an exemption. The exemptions for these securities were originally granted under Rule 144.

Prior to April 29, 1997, the exemption was that Rule 144 allowed the limited resale of unregistered securities after a minimum holding period of two years. Resale was limited to the higher of 1% of outstanding stock or average weekly volume over a four-week period prior to the sale, during any three-month period. There was no quantity limitation after a three-year holding period.

A holder of restricted stock must either register their securities with the SEC or qualify for a 144 exemption, in order to sell their stock in the public market. A holder of restricted stock can, however, trade the stock in a private transaction.

Rule 144A Relaxes Restrictions in 1990

Historically, when traded privately, the restricted stock transaction was usually required to be registered with the SEC. However, in 1990, the SEC adopted rule 144A which relaxed the SEC filing restrictions on private transactions. The rule allows qualified institutional investors to trade unregistered securities amongst themselves without filing registration statements. A limited market was, thus, created for restricted securities.

Holding Period Reduced to One Year in 1997

On February 20, 1997, the SEC announced that effective April 29, 1997, the holding period requirements contained in Rule 144 would be amended to permit the resale of limited amounts of restricted securities by any person after a one-year, rather than a two-year holding period.

Also, the amendment permits, under Rule 144(k), unlimited resales of restricted securities held by non-affiliates of the issuer after a holding period of two years, rather than three years.

The amendment also applies to SEC Rule 145 which governs the resale of securities received in connection with reclassifications, mergers, consolidations, and asset transfers, such that the holding period requirements of Rule 145 correspond to the amended holding periods for resales under Rule 144.

These two changes have increased the liquidity of restricted securities.

Restricted Stock Studies Prior to SEC Rule 144 Amendment

There exists a body of knowledge regarding discounts for lack of marketability for restricted securities based on data on transactions in restricted stocks. The duration of the restriction varies from one situation to another, but typically lapses within two years. There are eight published independent studies of restricted stock transactions spanning a period from the late 1960's through 1983. These studies consistently indicate a discount of 35% from the freely-traded counterpart stock. The average discounts indicated in these eight studies ranged from 26% to 45%.

Discounts Decrease after Rule 144A

In more recent years (subsequent to the years included in the studies discussed above), the market for restricted securities has increased due to the exemptions to Rule 144 allowed with Rule 144A private placements of restricted securities to qualified investors.

There have only been three studies published which include data on transactions in restricted securities after Rule 144A (1990), and before the reduction in Rule 144 stock holding periods (April 29, 1997). These three studies are a study conducted by Management Planning, Inc., titled "Analysis of Private Sales of Restricted Stocks of Public Companies: 1980-1995" (the "Management Planning Study"); a study by Lance Hall with FMV Opinions, Inc. and Timothy Polacek, a tax lawyer (the "FMV Restricted Stock Study TM"); and a study published by Bruce Johnson, ASA, of Munroe, Park & Johnson, Inc. (the "Johnson Study").

The Management Planning study included transactions that occurred from 1980 through 1995. The average discount indicated by the 49 transactions in the study was 27.7% and the median was 28.9%. The range of discounts in the Management Planning Study was 0% to 58%. The average discount in this study is lower than the discounts in the earlier studies, including transactions prior to 1990, which, typically, indicated average discounts of 35%.

The reason for this difference lies, perhaps, in the fact that fully one-third of the time frame in which the transactions occurred was after 1990 and the enactment of Rule 144A, which created a limited market for restricted securities. The study, as published, made no attempt to separate the data by date, or to calculate the discounts before and after 1990. However, based on the data published, it was observed that 20 of the 49 transactions (41%) in the study occurred from 1990-1995. These 20 transactions took place at an average discount of 26.7% and a median of 29.1%. The range of discounts for the 1990-1995 period was 2.8% to 49.5%.

The FMV Restricted Stock Study TM revealed limited information. The overall mean discount of the FMV study was 23%, and covered 100 transactions during the years 1979 through 1992. However, the article reported that for the period May 1991 through April 1992, restricted stock transactions occurred at prices that reflected a discount of 21% from similar blocks of unrestricted stock. Again, this study indicates lower discounts after the creation of a limited market (and, thus, increased liquidity) for restricted securities.

The Johnson study covers transactions that occurred during the years 1991-1995. The average discount for lack of marketability for the 72 transactions observed in the Johnson study was 20%. The range of discounts varied from a premium of 10% to a discount of 60%.

Again, this study points to lower discounts after Rule 144A which increased the liquidity of restricted securities. Mr. Johnson noted that the discount for lack of marketability was less than the earlier studies. This is primarily due to an increased number of investors who have entered into the market for restricted stocks in the past five years.

CFAI 1996-97 Restricted Stock Study

Columbia Financial Advisors, Inc. ("CFAI") conducted a study of the sale of restricted securities in the U.S. This study examined only private common equity placements over the period January 1, 1996 through April 30, 1997.

A search of Securities Data Company's United States New Issues Private Placement database revealed that there were 123 private placements of common stock in the U.S. from January 1, 1996 through April 30, 1997. There were no private placements of restricted common stock in the U.S. from February 15, 1997 through April 30, 1997 for which there was sufficient data available to determine a restricted stock discount. This study eliminated from these original 123 transactions those transactions with no offer price or public market price available, leaving 101 transactions. The CFAI study further eliminated those transactions with non-U.S. issuers and/or securities that were not traded in the U.S., leaving 29 transactions.

For each of these 29 companies, CFAI searched the issuing company's SEC filings using the EDGAR on-line database in an attempt to independently verify that the securities that were privately placed were indeed restricted and/or unregistered. This process resulted in the elimination of an additional six transactions that did not involve restricted securities.

Of the remaining 23 companies, CFAI was able to independently verify, through a review of various SEC filings and telephone interviews with the issuing companies, that eight of the transactions did, indeed, involve restricted securities. The remaining 15 transactions were listed by Securities Data Company as private placements of common stock with no registration rights, including one Rule 144A private placement (which by definition involves restricted securities). Thus, this study relied on Securities Data Company's characterization of these transactions, and included these characterizations in their analysis.

CFAI obtained various information for these private placements, including the private placement offer price, the offer date, and the issuing company's public market price one day prior to the private placement date.

CFAI's analysis of these transactions led to the following observations. First, the exchange on which the issuing company's non-restricted stock is traded seemed to have an impact on the size of the discount, with the highest discounts generally seen for those issuing companies whose stock was traded on the OTC and Small Market Capitalization markets.

The average discount for all 23 transactions was approximately 21%. The average discount for those eight transactions that CFAI was specifically able to verify to involve restricted and/or unregistered securities was 26%. The average discount for those issuing companies whose stock was traded on the NASDAQ, OTC, and/or Small Market Capitalization markets was 23%. For all 23 transactions, the discounts ranged from 0.8% to 67.5%, and the median was 14%.

Discounts Lower than Earlier Studies

These discounts are generally lower than the discounts recorded in the earlier studies noted above which, generally, indicated discounts of approximately 35%. The increase in volume of privately placed stock (Rule 144A) in the past several years offers an explanation. As activity in a market increases, more and better information becomes available.

In addition, there are now more participants in the market for restricted stocks due to Rule 144A and, therefore, increased liquidity. This would tend to decrease discounts because better information results in less risk and, thus, a lower required rate of return. The lower discounts in this particular study may also reflect, to some degree, the market's anticipation of the SEC's change in the holding period from two years to one year, although CFAI states it has no way to verify this. Since June 1995, the SEC proposed amendment to Rule 144 was published for public comment. Therefore, knowledgeable private placement and Rule 144A market participants were most likely aware of the proposed changes.

Discounts Lower after Change in Holding Period Requirements

Using the same methodology and sources discussed above, CFAI conducted another restricted stock study in an attempt to identify the impact of the increased liquidity of restricted securities as a result in the reduction in holding period requirements which became effective April 29, 1997. CFAI examined only private common equity placements over the period January 1, 1997 through December 31, 1998.

There were 270 private placements of common stock in the U.S. from January 1, 1997 through December 31, 1998. CFAI eliminated those transactions that did not involve publicly traded companies, leaving 44 transactions. For each of these 44 transactions, CFAI searched the issuing company's SEC filings using the EDGAR on-line database in an attempt to obtain the offer price and details about the placement. Through this process, CFAI eliminated an additional 29 companies for which there were no offer prices reported and/or the placements were not restricted or unregistered. All remaining 15 transactions involved companies whose common stock was traded on the OTC, NASDAQ, or Small Cap markets.

As in the earlier study, CFAI obtained the private placement offer price, the offer date, and the issuing company's public market price one day prior to the private placement date. The average discount indicated by this study was 13%. The range of discounts was 0% to 30%, and the median was 9%. These discounts are generally lower than the discounts recorded in CFAI's earlier study, which indicated an overall average discount of 21%. The lower discounts in this study in all probability reflect the market's reaction to the SEC's change in the holding period from two years to one year. The reduction in the holding period exposes the owner of the restricted security to less investment risk, as it is less likely that the price would fall in a one-year period versus a two-year period.

COLUMBIA FINANCIAL ADVISORS, INC. RESTRICTED STOCK STUDY
Discounts Prior to 1990	Average Discount (%)
SEC Prior to 1990	25.8
Milton Gelman	33.0
Robert Trout	33.5
Robert E. Mahoney	35.6
J. Michael Maher	35.4
Standard Research Consultants	45.0
Willamette Management Associates	31.2
William L. Silber	33.8
OVERALL RANGE	25.8 - 45.0

Discounts after 1990 (Rule 144 Amendment)
But prior to reduction in required holding periods	Average Discount (%)
Management Planning Study, 1990-95 Transactions	26.7
FMV Study, 1991-92 Transactions	21.0
Johnson Study, 1991-95	20.0
CFAI Study, 1996 - Feb. 14, 1997	21.0
Tetra Tech, Inc. SEC Form 10-K	16.0 - 28.0
OVERALL RANGE	16.0 - 28.0

Discounts after April 29, 1997	Average Discount (%)
CFAI Study, 1997-1998	13.0
Tetra Tech, Inc. SEC Form 10-K	15.0
OVERALL RANGE	13.0 -15.0

As Mr. Pratt summarizes:

Public Stock Market More Liquid

There have been several developments that have made the public stock markets in the United States more liquid in recent years.

Reducing Settlement Time

The settlement time has been reduced from five working days to three working days.

Reduced Commissions

The rise of the discount broker (e.g., Charles Schwab, Ameritrade, etc.) has significantly reduced trading costs.

Reduced Spreads

The change from the fractional quotation system to the decimal quotation system has significantly reduced the spreads between bid and ask prices.

Rise of Derivatives

The increased use of derivative securities (e.g., puts, calls, and more sophisticated derivatives) has increased the liquidity in the public stock markets. SEC loosened Rule 144 restrictions, and, thus, has made the trading of restricted stock more liquid, resulting in reduced discounts.

Pre-1990:

The SEC required a minimum two-year holding period for restricted stocks, in addition to registration with the SEC when restricted stock was sold as a block. Discounts on trades in restricted stocks averaged approximately 35% from the late 1960's until 1990.

1990:

The SEC dropped the registration requirement for trades in restricted stocks. Average discounts dropped to the mid-20's.

1997:

The SEC lowered the minimum holding period for restricted stocks from two years to one year.

These factors have contributed to lowering the marketability discount for publicly traded securities.

____________________________________________________________________________________
Stuart A. Ober, CFE, AIFA ® serves as a consultant and expert in fiduciary and securities litigation. He may be contacted at 845-679-2300 or ober@stuartober.com.

BVR's Guide to Discounts for Lack of Marketability is available from BVR at 503-291-7963 or at www.bvresources.com.