Reference no: EM13963215

In Practice: Illiquidity Discounts in Private Firm Valuation

If you buy stock in a publicly traded firm and then change your mind and decide to sell, you face modest transaction costs. If you buy a private business and change your mind, it is far more difficult to reverse your decision. As a consequence, many analysts valuing private businesses apply an illiquidity discount that ranges from 20 to 40 percent of the value to arrive at a final value. Although the size of the discount is large, there is surprisingly little thought that goes into the magnitude of the discount. In fact, it is almost entirely based on studies of restricted stock issued by publicly traded firms. These stock are placed with investors who are restricted from trading on the stock for two years after the issue, and the price on the issue can be compared to the market price of the traded shares of the company to get a sense of the discount that investors demand for the enforced illiquidity. Because there are relatively few restricted stock issues, the sample sizes tend to be small and involve companies that may have other problems raising new funds.

Although we concede the necessity of illiquidity discounts in the valuation of private businesses, the discount should be adjusted to reflect the characteristics of the firm in question. Other things remaining equal, we would expect smaller firms with less liquid assets and in poorer financial health to have much larger illiquidity discounts attached to their values. One way to make this adjustment is to take a deeper look at the restricted stock issues for which we have data and look at reasons for the differences in discounts across stocks.33 Another way is to view the bid-ask spread as the illiquidity discount on publicly traded companies and extend an analysis of the determinants of these spreads to come up with a reasonable measure of it or illiquidity discount of a private business.