Update on Study of Discount for Lack of Marketability

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Jun 2005

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The valuation of closely held (i.e.,
not publicly traded) companies and securities is a common assignment in
a bankruptcy and reorganization context. These valuations are performed
to conclude loan collateral value, to identify spin-off opportunities,
to negotiate debt/equity restructurings and to estimate reorganization
value for purposes of fresh-start accounting. In these assignments,
analysts often value the companies/securities using the market
approach/guideline publicly-traded-company method. In these valuations,
analysts typically recognize a fundamental investment difference between
publicly traded guideline companies and the closely held company:
Guideline company securities are efficiently traded on an organized
stock exchange, while closely held securities are fundamentally
illiquid.

The concept of investment marketability relates to the liquidity of
an asset, property or business interest—that is, how quickly and
certainly it can be converted into cash at the owner's discretion.
Investors value liquidity. Rational investors will pay a price premium
for liquidity. Conversely, rational investors will demand a price
discount for the lack of liquidity. For example, the common stock of a
closely held company is not as liquid as the otherwise comparable common
stock of a publicly traded company. The closely held company stock does
not have the same degree of marketability as the otherwise comparable
publicly traded company stock. All other factors held constant, the
closely held stock is less valuable than the comparable publicly traded
stock, reflecting a price discount for lack of marketability.

Empirical research quantifies that this discount for lack of
marketability (DLOM) for closely held stock generally falls into two
fields of analysis: (1) studies of sale transactions in the restricted
stock of publicly traded companies (also known as restricted stock
studies) and (2) studies of private sale transactions in the stock of
closely held companies that subsequently implement successful initial
public offerings (also known as pre-IPO studies).

Willamette Management Associates (WMA) analysts previously published
empirical research pre-IPO studies analyzing the DLOM for the years
1975-97. WMA analysts recently completed an additional pre-initial
public offering (pre-IPO) DLOM study covering the five years of
1998-2002. This discussion summarizes the results of the WMA pre-IPO
DLOM study for the years 1998-2002.

<h4>Restricted-stock DLOM Studies</h4>

Studies of the sale of restricted shares of the stock of publicly
traded companies quantify one indication of the DLOM related to closely
held securities. Typically, restricted stock is identical in all
respects to the freely traded stock of the same public corporation,
except that the restricted stock cannot be traded on a stock exchange
for a specific time period.

Numerous restricted-stock DLOM studies have been performed (and the
study results published) since the late 1960s. These restricted-stock
studies have concluded an average DLOM for restricted shares (compared
to otherwise identical freely traded shares) in the range of 13-45
percent. The DLOM concluded by the more recent restricted stock studies
are smaller than the DLOM concluded by the older restricted stock
studies. One explanation for this phenomenon is the increase in volume
of privately placed stock under Securities and Exchange Commission (SEC)
Rule 144(a) in the past several years. Also, a change in the minimum
investment holding period required by the SEC under Rule 144—from
two years to only one year—took place as of April 29, 1997.

The DLOM conclusions indicated by the published restricted stock
studies are typically lower than the DLOM conclusions indicated by the
published pre-IPO studies. Restricted shares of public corporation stock
are not able to be traded directly on a stock exchange temporarily.
However, the investor has certainty that, in a relatively short time
period, the trading restrictions will lapse. However, the shares of
stock of a closely held corporation may never be traded directly on a
stock exchange. The prospect of any level of efficient marketability is
much lower for closely held corporation shares compared to restricted
public corporation shares. Therefore, the appropriate DLOM related to
closely held corporation shares (or to similar closely held investment
securities) is generally considered to be greater than the DLOM
indicated by published restricted stock studies.

<h4>Pre-initial Public Offering (Pre-IPO) DLOM Studies</h4>

A second type of empirical analysis that quantifies the appropriate
DLOM is the pre-IPO study. A pre-IPO study examines arm's-length sale
transactions in the stock of a closely held company that has
subsequently achieved a successful initial public offering of its stock.
In a pre-IPO study, the DLOM is quantified by analyzing (with various
adjustments) the difference between (1) the public market price at which
a stock was issued at the time of the IPO and (2) the private market
price at which a stock was sold (in an arm's-length transaction) prior
to the IPO.

<h4>WMA Pre-IPO Studies</h4>

WMA analysts previously published the results of 18 pre-IPO DLOM
studies covering the period of 1975-97. We have recently completed an
additional pre-IPO DLOM study encompassing the five years from
1998-2002. As in the previous pre-IPO studies, we include only
private-market stock sale transactions that were conducted on an
arm's-length basis in the 1998-2002 study. The transactional data
analyzed in the 1998-2002 pre-IPO study included (1) sales of closely
held corporation stock in private placements and (2) repurchases of
treasury stock by the closely held corporation. All transactions
involving the granting of employee, executive or other
compensation-related stock options were eliminated from consideration in
the 1998-2002 study. All transactions involving stock sales to corporate
insiders or other related parties were eliminated from consideration in
the 1998-2002 study unless WMA could verify (by a telephone interview
with at least one principal party) that the stock sale transaction was,
in fact, a bona fide, arm's-length transaction.<a href="#1" name="1a">1</a>

In the current pre-IPO study, WMA obtained the list of initial public
offerings from the Corporate New Issues database, provided by Thomson
Financial Securities Data. Eliminated from the analyses were all IPOs
involving financial institutions, real estate investment trusts (REITs)
and natural-resource companies. Also eliminated were all offerings
priced at $1 or less per share and all offerings on units or warrants.
Consistent with the procedures performed in previous WMA pre-IPO
studies, these data were eliminated because such offerings may have
unique investment characteristics. The source documents used to identify
the potential pre-IPO private-market sale transactions were complete SEC
registration statements, primarily Forms S-1. The private-market sale
transactions analyzed occurred during the 36-month period prior to the
IPO. If a corporation had more than one private market transaction that
met the study's criteria, all such private market transactions in that
company were included in the analysis. Also, multiple private-market
transactions occurring within 12 months at the same share price were
treated as a single transaction in the analysis.

For each private-market transaction for which meaningful earnings
data were available in the registration statement as of both the private
transaction and the IPO dates, we compared the price/earnings multiple
of each private transaction with the subsequent IPO price/earnings
multiple. Corporations that had no meaningful earnings data as of either
the private transaction date or the IPO date were eliminated from the
analysis.

Because the private-market transactions occurred over a time period
up to three years prior to the IPO, we made adjustments to reflect
differences in the stock market conditions of the respective industries
between the time of each private transaction and the time of each
subsequent IPO. We adjusted the price/earnings multiples for differences
in the industry average price/earnings multiple between the time of each
private transaction and the time of each subsequent IPO. Both the
calculation of company and industry price/earnings multiples and the
adjustment for temporal changes in stock market conditions within each
industry are consistent with the procedures performed in previous WMA
pre-IPO studies.

The results of the recent WMA pre-IPO study, and the results of the
previous WMA pre-IPO studies, are present in Table 1.

In addition to the above-mentioned WMA pre-IPO DLOM studies, other
recent pre-IPO DLOM studies include analyses performed by John D. Emory
and Valuation Advisors LLC. The results of these recent studies are
summarized below.

<h4>John D. Emory Pre-IPO Studies</h4>

John D. Emory, president of Emory Business Valuation LLC, conducted a
series of pre-IPO DLOM studies from 1980 to 2000. His most recent
pre-IPO study in the series covers the time period of May 1997 to
December 2000.<a href="#2" name="2a">2</a> For
this time period, Emory concluded a mean DLOM of 48 percent and a median
DLOM of 44 percent. These recent DLOM conclusions are consistent with
previously published Emory pre-IPO studies. The previously published
Emory pre-IPO studies concluded a median DLOM ranging from 40 percent in
the 1989-90 and 1990-92 studies, to 66 percent in the 1980-81 study.

Emory also performed (1) a dot.com pre-IPO study and (2) an expanded
pre-IPO study during the same time period. The Emory dot.com pre-IPO
study<a href="#3" name="3a">3</a> included
initial public offering companies that had ".com" in their names. These
types of companies typically involve Internet-related businesses. With
the 92 dot.com IPOs in the May 1997 to December 2000 time period, Emory
found 53 private market stock sale transactions to analyze in this
pre-IPO study. In this particular study, Emory concluded that the mean
DLOM and the median DLOM conclusion were both 54 percent.

In the expanded pre-IPO study,<a href="#4" name="4a">4</a> Emory included companies that were not
included in the general pre-IPO study due to their uncertain financial
condition. In the Emory expanded pre-IPO study, companies that were not
determined to be "reasonably sound" were included in the analysis. The
DLOM conclusions in the Emory expanded pre-IPO study were greater than
the DLOM conclusions in the general pre-IPO study. In the expanded
pre-IPO, Emory concluded a mean DLOM of 50 percent and a median DLOM of
52 percent.

<h4>Valuation Advisors Pre-IPO Study</h4>

Valuation Advisors LLC (VA) performed a pre-IPO DLOM study for each
of the years 1999, 2000 and 2001. The conclusion of the VA 1999 pre-IPO
study indicated a mean one-year DLOM of 51.91 percent.<a href="#5" name="5a">5</a> In the 2000 pre-IPO study, the
mean one-year DLOM was concluded to be 47.07 percent.<a href="#6" name="6a">6</a> The mean one-year DLOM concluded
in the VA 2001 pre-IPO study was 22.41 percent.<a href="#7" name="7a">7</a> However, the mean DLOM became 40.84
percent when a narrowed DLOM range of 10-90 percent was used. This
narrowed DLOM range was considered in order to reduce the influence of
(1) cheap stock or stock options and (2) price premiums due to changing
stock market conditions.

<h4>WMA 1998 DLOM Conclusions</h4>

The mean and median WMA pre-IPO study DLOM conclusions for 1998 are
generally consistent with the DLOM conclusions of our previously
published studies. In 1998, the indicated mean DLOM was 35.0 percent and
the indicated median was 49.4 percent. These DLOM conclusions are
entirely consistent with the long-term (e.g., the decade prior to
1998) trends in prior WMA studies and the DLOM conclusions of other
analysts.

<h4>WMA 1999-2000 DLOM Conclusions</h4>

The DLOM conclusions for 1999 and 2000 are significantly lower than
the DLOM conclusions of our previously published pre-IPO studies. In
addition, the DLOM conclusions for 1999 and 2000 are significantly lower
than the DLOM conclusions reported by the VA study for the same years
and the DLOM conclusions reported by John Emory for the period from May
1997 through December 2000.

Because the WMA DLOM conclusions indicated for 1999 and 2000 are
lower than indicated in our previous studies, one could ask: "Is there a
downward trend for the DLOM?" Although this conclusion is possible, we
believe that there are several reasons why the DLOM results for 1999 and
2000 are atypical of both (1) long-term trends and (2) the conclusions
of other analysts.

First, there were relatively few IPO companies and relatively few
private sale transactions that qualified for inclusion in the WMA
pre-IPO study in 1999 and 2000. The result of a DLOM study based on a
larger data set of private sale transactions is likely to be more
statistically valid. Second, 1999 and 2000 were not typical years with
regard to stock market price trends. This conclusion is illustrated by
Chart 1, the monthly NASDAQ Composite Index for the period of January
1993 through December 2002. The years 1999 and 2000 clearly represent a
"spike" in stock market prices when compared to both prior years and
subsequent years.

Second, the height of the dot.com "bubble" occurred during this time
frame. The 1999-2000 period encompassed both a record number of dot.com
IPOs and a record with regard to dot.com company pricing multiples.
These pricing multiples are often unexplainable based on the dot.com
company financial fundamentals. Of course, a large number of dot.com
companies consummated IPOs around this time, and many of these dot.com
companies subsequently failed.

Third, the average first-day returns for IPO stocks, measured from
the offer price to the first-listed close price, were extraordinarily
high in 1999 and 2000. These average first-day return data are presented
on Table 2. One possible explanation for this return phenomenon is that
many of the 1999-2000 IPOs may have been underpriced. There have also
been allegations of IPO "spinning" on the part of certain investment
banking (I/B) firms. In IPO "spinning," IPO "hot" offerings are
allocated by the underwriter to corporate executives—so that the
IPO shares could be sold or "spun" for a quick profit. The allegation is
that such allocations were made by the underwriter in exchange for
future I/B business. Furthermore, underwriters are alleged to have
charged excessive brokerage commissions to investors to whom lucrative
IPO share allocations were made and required customers to buy shares of
the new stock after the IPO date at much higher prices. Due to all of
these influences, the IPO share prices during 1999 and 2000 may not be
the best indication of the intrinsic value of the subject stocks. To the
extent that IPO prices were artificially low—allowing some
underwriters and corporate executives to make excessive profits—the
DLOM conclusions calculated in our 1999-2000 pre-IPO study may be
understated.

<h4>WMA 2001-02 DLOM Conclusions</h4>

The WMA DLOM conclusions for 2001 and 2002 are also inconsistent with
the conclusions of our previous pre-IPO studies. The mean DLOM
conclusions for 2001 is -195.8 percent (indicating a DLOM price
premium). This conclusion is completely counterintuitive both in terms
of magnitude and direction (i.e., a price premium instead of a
price discount). The mean DLOM conclusion for 2002 is 55.8 percent. This
conclusion is abnormally high compared to the mean DLOM conclusions of,
say, the decade period prior to 1999.

Accordingly, we recommend that analysts do not rely on the indicated
DLOM conclusions for these two years 2001 and 2002 because (1) there are
too few private market stock sale transactions in the study for the
results to be statistically meaningful, and (2) the DLOM indications of
the individual private market transactions are too extreme (both
positive and negative) for the results to be practically meaningful.

For 2001, there were only two private market-sale transactions that
met the selection criteria to be included in the WMA pre-IPO study. In
the year 2002, there were only seven private market-sale transactions
that met the selection criteria to be included in the WMA pre-IPO study.
Due to the low number of private-market sale transactions included in
the study in these two years, any extreme/aberrational prices from
individual private sale transactions have the affect of
disproportionately influencing the overall DLOM conclusions.

With regard to the selection of an appropriate DLOM, we recommend
that analysts either:

<ol>
<li>ignore the 2001 and 2002 results of the WMA pre-IPO study as not
being representative of long-term trends with regard to the DLOM, or

</li><li>consider the 2001 and 2002 results of the WMA pre-IPO study only
within the context of an analysis of longer-term five-year or 10-year
period DLOM data (e.g., the consideration of the total private
market sale transaction data with regard to the five-year period 1998
through 2002, as presented in Table 1).

</li></ol>

Both industry-specific and general capital market events in the years
2001 and 2002 could explain the unusual results of our DLOM study for
those years. The year 2001 included much of the impact of the "burst" of
the "dot.com" bubble. This "burst" ended the several years of apparent
"irrational exuberance" both in terms of (1) the volume of IPO
transactions and (2) the inflated prices of dot.com and many other
stocks. The year 2001 also experienced a significant decline in both (1)
the volume of merger and acquisition (M&A) transaction activity and
(2) M&A transaction pricing multiples. These unusual capital market
events likely affected the DLOM conclusions with regard to 2001 and
2002.

Because of both (1) the unusual events in the stock markets and in
the M&A capital markets in this period and (2) the aberrational
quantitative conclusions of the 2001/2002 analyses compared to
previously published studies, we believe that the quantitative
conclusions for 2001 and 2002 are not reliable indicators of the current
DLOM.

<h4>WMA 1999-2002 Conclusions Compared to Other Studies</h4>

For the period 1999-2002, the WMA pre-IPO DLOM conclusions differ
from the DLOM conclusions of the Valuation Advisors and the Emory
studies for two primary reasons. First, the selection criteria for
inclusion of private-market transactions in the respective pre-IPO
studies vary. Second, and more importantly, changes in subject company
earnings and in the prices/earning multiples within the subject company
industry (between the time of the private transaction and the IPO) are
included in the WMA pre-IPO DLOM calculation. The DLOM conclusions in
the VA and in the Emory pre-IPO studies are calculated by simply
comparing the private transaction (pre-IPO) price to the IPO price with
adjustment for changes in industry-specific stock market conditions.

<h4>Summary and Conclusion</h4>

This discussion focused on the concept of marketability (or the lack
thereof) in business/security valuations performed for bankruptcy
purposes. This discussion summarized the general types of empirical
research that have been conducted with regard to estimating a
market-derived DLOM to be used in the valuation of closely held
investments. This discussion also presented the results of the most
recent WMA pre-IPO DLOM study within the context of other pre-IPO
studies.

With regard to our 1998-2002 DLOM study, the DLOM conclusions for
1998 are a mean discount of 35.0 percent and a median discount of 49.4
percent. These conclusions are consistent with our previous studies and
with the results of other published DLOM studies. The DLOM conclusions
for 1999 and 2000 are lower than we would expect based on our previous
studies and on the results of other published DLOM studies. As explained
above, there are several capital market reasons why the 1999 and 2000
results of our DLOM study are suspect. The DLOM conclusions for 2001 and
2002 are simply not reasonable. As explained above, there are several
capital market reasons the 2001 and 2002 results of our DLOM study are
unreliable. In addition to these reasons, the extremely small number of
observations analyzed in 2001 and 2002 would suggest concern in the
reliability of the DLOM conclusions for these two years.

Therefore, we recommend that analysts do not rely on the discrete
results of our DLOM study for the years 2001 and 2002. Rather, we
recommend that analysts rely on the collective results of the five-year
period 1998-2002 as a reasonable indication of the DLOM for the
contemporary period. As presented in Table 1, the mean DLOM for the
five-year period 1998-2002 is 23.9 percent, and the median DLOM for the
five-year period 1998-2002 is 36.1 percent.

In estimating the appropriate DLOM, an analyst should consider all of
the facts and circumstances relevant to the subject business/security
valuation. Based on the unique facts of a specific analysis, there are
times when the restricted stock DLOM studies may be more relevant, and
there are times when the pre-IPO DLOM studies may be more relevant. This
is because marketability and lack of marketability are relative (and not
absolute) terms.

The concept of marketability of a closely held security is often
intertwined with the concept of ownership control of a closely held
security. However, these two investment valuation concepts (while
generally related) are distinct in both theory and practice.
Consideration of how marketability and ownership control (or the lack of
either of these two investment attributes) can affect value is an
integral procedure in the estimation of business/security valuation
discounts or premiums. The investment attributes of marketability and
ownership control are fundamental considerations in valuations performed
for bankruptcy purposes. However, these investment attributes should
also be considered in valuations performed for other purposes.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The specific analytical
procedures performed in the various WMA pre-IPO DLOM studies are
detailed on pages 408-411 of Valuing a Business, fourth edition,
by Shannon P. Pratt, Robert F. Reilly and Robert P. Schweihs, published
in 2000 by McGraw-Hill. <a href="#1a">Return to article</a>

<a name="2">2</a> Emory, John D. Sr., ASA,
Dengel, F.R. III, and Emory, John D. Jr., "The Value of Marketability as
Illustrated in Initial Public Offerings of Common Stock May 1997 through
December 2000," Business Valuation Review, September 2001, p.
15-19. <a href="#2a">Return to article</a>

<a name="3">3</a> Emory, John D. Sr., ASA,
Dengel, F.R. III, and Emory, John D. Jr. "The Value of Marketability as
Illustrated in Initial Public Offerings of Dot-Com Companies May 1997
through March 2000," Business Valuation Review, September 2000,
p. 111-121. <a href="#3a">Return to article</a>

<a name="4">4</a> Emory, John D. Sr., ASA,
Dengel, F.R. III, and Emory, John D. Jr., "Expanded Study of the Value
of Marketability as Illustrated in Initial Public Offerings of Common
Stock May 1997 through December 2000," Business Valuation Review,
December 2001, p. 4-20. <a href="#4a">Return to article</a>

<a name="5">5</a> Pearson, Brian K.,
CPA/ABV/PFS, ASA, "1999 Marketability Discounts as Reflected in Initial
Public Offerings," CPA Expert, Spring 2000, p. 1-6. <a href="#5a">Return to article</a>

<a name="6">6</a> Pearson, Brian K.,
CPA/ABV/PFS, ASA, "2000 Marketability Discounts as Reflected in Initial
Public Offerings," Shannon Pratt's Business Valuation Update,
September 2001, p. 1, 4-7. <a href="#6a">Return to article</a>

<a name="7">7</a> Pearson. Brian K.,
CPA/ABV/PFS, ASA, The 2001 Marketability Discount Study (2002).
Retrieved Aug. 19, 2003, from <a href="http://www.valuationpros.com/ipo.html">http://www.valuationpros.com/ipo…;.
<a href="#7a">Return to article</a>

Journal Authors

Robert F. Reilly

Journal Date

Wednesday, June 1, 2005 - 12:00

Bankruptcy Rule

valuation

2005

none