Discount and Premium
The valuation approaches yield the fair market value of the Company as a whole. In evaluating a minority, non-controlling interest in a business, however, the valuation professional must believe the applicability of discounts that affect such interests. Discussions of discounts and premiums oftentimes begin with a review of the levels of value. There are 3 common levels of value: marketable minority, non-marketable minority and controlling interest The intermediate level, marketable minority interest, is lower than the ascertaining interest level and higher than the non marketable minority interest level. The marketable minority interest level represents the comprehended value of equity interests that are traded in a free manner without any restrictions. These interests are in general traded on the New York Stock Exchange, NASDAQ, AMEX and other exchanges where there is a ready market for equity securities. These values represent a minority interest in the subject companies, small blocks of stock that show less than 50% of the equity of company, and by and large much less than 50%. Controlling interest level is the value that an investor would be inclined to pay to acquire more than 50% of a company's stock, thereby gaining the attendant prerogatives of control. Some of the perquisites of control include: hiring firing,electing directors of the management of the company and determining their compensation, determining the company's strategy, declaring dividends and distributions and line of business, selling, acquiring, or liquidating the business. This level of value in general contains a control premium over the intermediate level of value, which typically ranges from 25% to 50%. An additional premium may be compensated by strategic investors who are prompted by synergetic motives. Non marketable, minority level is the lowest level on the chart, representing the level at which non-controlling equity interests in private companies are in general valued or traded. This level of value is discounted since no ready market exists in which to purchase or sell interests. Private companies are less liquid as compared to publicly traded companies. Transactions in private companies take longer and are more uncertain. Among the intermediate and lowest levels of the chart, there are restricted shares of publicly traded companies. Despite a growing inclination of the IRS and Tax Courts to challenge valuation discounts, Shannon Pratt suggested in a scholarly presentation recently that valuation discounts are actually raising as the differences among public and private companies is widening . Publicly traded stocks have developed more liquid in the past decade due to rapid electronic trading, reduced commissions, and governmental deregulation. These growths have not improved the liquidity of interests in private companies, all the same. Valuation discounts are multiplicative, so they must be believed in order. Control premiums and their reverse, minority interest discounts, are believed before marketability discounts are applied.
Discount for lack of control
The first discount that must be believed is the discount for lack of control, which in this instance is also a minority interest discount. Minority interest discounts are the reverse of control premiums, to which the following numerical relationship exists: MID = 1 - [1 / (1 + CP)].
The most popular source of data considering control premiums is the Control Premium Study, released annually by Mergerstat in year 1972. Mergerstat compiles data regarding publicly announced mergers, acquisitions and divestitures involving 10% or more of the equity interests in public companies, where the purchase price is $1 million or more and at least one of the parties to the transaction is a U.S. entity. Mergerstat defines the "control premium" as the percentage difference among the acquisition price and the share price of the freely traded public shares five days prior to the announcement of the M&A transaction. While it is not without valid criticism, Merger stat control premium data is accepted broadly within the valuation profession.
Discount for lack of marketability
Another factor to be believed in evaluating closely held companies is the marketability of an interest in such businesses. Marketability is outlined as the ability to convert the business interest into cash quickly, with minimum transaction and administrative costs, and with a high degree of foregone conclusion as to the amount of net proceeds. There is by and large a cost and a time lag associated with locating interested and capable buyers of interests in privately held companies, since there is no established market of readily available buyers and sellers. All other components being equal, an interest in a publicly traded company is worth more since it is readily marketable. With the terms of the relation reversed, an interest in a private held firm is worth less as no established market exists. The IRS Valuation Guide for Income, Estate and Gift Taxes, Valuation Training for Appeals Officers acknowledges the relationship among value and marketability, stating: "Investors opt an asset which is easy to trade, that is, liquid." The discount for deficiency of control is clear-cut and is distinguished from the discount for deficiency of marketability. It is the evaluation professional's task to quantitative the deficiency of marketability of an interest in a privately held company. Since, in this case, the subject interest is not a controlling interest in the Company, and the owner of that interest cannot compel liquidation to convert the subject interest to cash quickly and no established market subsists on which that interest could be dealt, the discount for lack of marketability is appropriate. Several empiric studies have been issued that attempt to quantify the discount for deficiency of marketability. These studies include the restricted stock studies and the per-IPO studies. The aggregate of these studies demonstrates average discounts of 35% & 50% respectively. Some experts believe the Lack of Control and Marketability discounts can aggregate discounts for as much as 90% of a business firm's fair market value, in distinction from others, with family owned companies.
Restricted Stock Studies
Restricted stocks are equity securities of public companies that are similar in all respects to the freely traded stocks of those companies except that they carry a restriction that prevents them from being traded on the open market for a certain period of time, which is by and large one year (two years prior to 1990). This restriction from active trading, which amounts to a lack of marketability, is the only distinction among the restricted stock and its freely traded counterpart. Restricted stock can be dealt in private transactions and by and large do so at a discount. The restricted stock studies attempt to verify the difference in price at which the restricted shares trade versus the price at which the similar unrestricted securities trade in the open market as of the similar date. The fundamental information by which these studies attain at their conclusions has not been made public. Consequently, it is not possible when evaluating a particular company to compare the characteristics of that company to the study data. Still, the existence of a marketability discount has been recognized by evaluation professionals & the Courts, and the restricted stock studies are oftentimes cited as empirical evidence. The lowest average discount notifiable by these fields of study was 25% and the highest average discount was 40%.
Option Pricing
In addition to the limited stock studies, U.S. publicly traded companies are able to trade stock to offshore investors without registering the shares with the Securities and Exchange Commission. The offshore purchasers may resell these stocks in the U.S., still without need to register the shares, after holding them for just 40 days. Typically, these shares are sold for 20% to 30% below the publicly traded share price. Some of these business dealings have been accounted with discounts of more than 30%, leading from the lack of marketability. These discounts are similar to the marketability discounts inferred from the restricted and per-IPO studies, despite the holding period being just 40 days. Studies established on the prices paid for alternatives have also confirmed similar discounts. If one adjudges restricted stock and purchases an option to sell that stock at the market price the holder has, in effect, purchased marketability for the shares. The price is equal to the marketability discount. The range of marketability discounts obtained by this study was 32% - 49%. However, ascribing the entire value of a put option to marketability is misleading, since the primary source of put value comes from the downside price protection. A correct economic analysis would employ deeply in-the-money puts or Single-stock futures, demonstrating that marketability of restricted stock is of low value since it is easy to hedge using unrestricted stock or futures trades.
Another approach to criterion the marketability discount is to compare the prices of stock offered in initial public offerings to transactions in the same company's stocks prior to the IPO. Companies that are going public are required to disclose all transactions in their stocks for a period of 3 years prior to the IPO. The pre-IPO studies are the leading substitute to the limited stocks in quantifying the marketability discount. The pre-IPO studies are on certain occasions criticized since the sample size is relatively small, the pre-IPO transactions may not be arm's length, and the financial structure and product lines of the studied companies may have altered during the three year pre-IPO window.
The studies of business firm what the marketplace knows intuitively. Investors envy loathe and liquidity obstacles that impair liquidity. Prudent investors buy illiquid investments only when there is a adequate discount in the price to increase the rate of return to a level which brings risk reward back into balance. The referenced studies demonstrate a reasonable range of valuation discounts from the mid 30%s - low 50%s. The more recent studies appeared to yield a more conservative range of discounts than older studies, which may have abide from lower sample sizes. In addition to a former method of quantifying the lack of marketability discount is the Quantifying Marketability Discounts Model.
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