A look at recent private placement transactions suggests the answer is “yes”
What factors impact marketability discounts in restricted stock transactions? Typically, an investor's expected holding period is the primary determinant of the size of the marketability discount. But the regulations governing restricted stock have eased significantly since 1990. Effective Feb. 15, 2008, the minimum holding period was reduced from one year to six months. Our firm, Stout Risius Ross (SRR) studied this shorter holding period to quantify how this change impacts discounts as well as to analyze the effect of certain company-specific factors on discounts.
We think that a discount study involving short holding periods is useful in the context of valuing closely held minority interests in which a liquidity event is imminent, such as a sale of the company or a pending initial public offering. Similarly, our study may be relevant in estimating discounts applicable in valuing hedge fund interests with short holding periods. Often, once the initial lockup period is satisfied, hedge funds maintain notice periods that limit redemptions to certain time intervals, such as quarterly or semiannually, during which period of time the investor is subject to market risk. Despite these short holding periods, empirical evidence suggests substantial discounts may be warranted.
Prior to 1990, institutional investors that purchased restricted stock without registration rights had a minimum holding period of two years before the stock could be sold in the public market. Average restricted stock discounts reflected in pre-1990 studies generally ranged from 30 percent to 35 percent.
In 1990, the Securities and Exchange Commission adopted Rule 144A of the Securities Act of 1933. Rule 144A enhanced the liquidity of restricted stock by permitting qualified institutional investors to trade unregistered securities among themselves. The increased liquidity resulted in lower negotiated restricted stock discounts. Average restricted stock discounts following Rule 144A generally ranged from 20 percent to 27 percent.
In 1997, the SEC reduced the required holding period imposed by Rule 144 from two years to one year. Although there are few post-1997 empirical studies of restricted stock, the limited data available suggests that average restricted stock discounts were lower relative to previous studies. (See “Studies Pre- and Post-1997,” p. 48.) Given the most recent change in 2008, sufficient data now exists to analyze transactions subsequent to this amendment.
SRR Restricted Stock Study
Our study includes transactions from September 2005 through May 2010. This time period incorporates transactions in the few years before and after the most recent 2008 change to Rule 144. Our goal was to provide a more comprehensive study by including multiple ways to analyze factors such as size, growth, profitability, risk and financial market conditions to determine which attributes are most highly correlated with the magnitude of restricted stock discounts.
Our basic search criteria included screening for transactions of private placements of restricted common shares of companies domiciled in the United States and traded on a U.S. exchange. We carefully analyzed each transaction to determine if there were material reasons why the implied restricted stock discount could be attributable to factors other than lack of marketability. Certain studies have shown that companies with limited tangible assets, companies engaged in speculative development of new products and companies in financial distress often undertake private placements. The indicated discounts tended to be higher for these types of companies and some experts speculate that these higher discounts are required to serve as compensation for the higher information and monitoring costs associated with these investments. This argument has been the source of a common attack on the use of restricted stock studies in estimating lack of marketability discounts. In addition, we observed other studies performed subsequent to the 2008 Rule 144 holding period change, which failed to properly screen transactions with these attributes and may thus produce unreliable conclusions. To mitigate these concerns in our study, we excluded:
- Development-stage companies;
- Companies with very low stock prices to remove those trading at a speculative price;
- Financially distressed companies;
- Thinly traded companies;
- Transactions between related parties;
- Transactions involving financial institutions to avoid including companies issuing restricted shares under duress to satisfy regulatory capital requirements; and
- Transactions involving significant control attributes (such as board seats).
Based on these criteria, we selected 98 transactions involving companies in a variety of industries. We compared the price at which transactions were consummated, with the price one day prior to the transaction announcement date. These transactions exhibited average and median discounts of 10.9 percent and 9.3 percent, respectively. (See “SRR Study: A Summary of Results,” p. 49.)
Quantity of Transactions
Private placement transactions allow companies to raise capital for operating and investing needs. During periods of market turmoil, companies often find these transactions difficult to complete as there are fewer interested investors. During the financial crisis that primarily occurred during the fourth quarter of 2008 and first quarter of 2009, no transactions occurred that satisfied our screening criteria. (See “Private Placements Over the Past Five Years,” this page.) While several transactions did occur, many of these involved financial institutions that were seeking equity capital to satisfy regulatory capital requirements and prevent bankruptcy or seizure by regulatory authorities.
Before and After Rule 144
Since the holding period before investors could begin receiving liquidity was shortened from one year to six months, we expected the discounts after the Rule 144 change to be less than the discounts prior to such change. However, for 73 transactions occurring prior to the 2008 amendment, median and average discounts were 9.3 percent and 10.6 percent, respectively. For 25 transactions occurring after the 2008 amendment, median and average discounts were 11.1 percent and 11.5 percent, respectively. What additional factors may have been responsible for this trend? First, transaction activity declined significantly during the financial crisis beginning in 2008. As a result, we considered significantly more transactions prior to the Rule 144 change than after. Therefore, the smaller sample size makes it challenging to draw effective conclusions. Second, the volatility of the overall stock market and the companies subject to this study increased significantly subsequent to the Rule 144 change. It's plausible that any decrease in the implied discount attributable to the rule change was more than offset by increased market volatility. See “The VIX,” p. 50, which depicts the market volatility over our observed time period, as measured by the Chicago Board of Exchange Volatility Index (VIX).
Finally, and perhaps most importantly, nearly every transaction considered in our study included registration rights granted to the acquirer. The presence of registration rights mitigates the impact of the change in the Rule 144 holding period. Registration rights grant the holder of restricted stock the ability to gain liquidity prior to the conclusion of the Rule 144 holding period by either providing the holders with a defined period when the stock will be registered (and thus, become freely tradable) or granting them the ability to force the issuing company to register the shares. For example, a holder who has been granted registration rights that allow his shares to be registered within three months would likely ascribe no value to the Rule 144 change since his holding period prior to the change and after the change would likely have been three months in both scenarios.
We performed statistical analyses to determine the relationships among certain company-specific factors and market variables and the influence of these factors on restricted stock discounts. First, by performing a linear regression analysis, we determined the factors that were statistically significant at the 5 percent level, which were deemed to be factors exhibiting a “very strong” relationship.1 Since private placement transactions are typically influenced by several factors, it was difficult to isolate more than a few factors that were significant at the 5 percent level. However, additional conclusions can be drawn even from factors not deemed to be significant at the 5 percent level. Therefore, as a second approach, we performed a quartiles analysis to determine if there were any apparent linear relationships.
We sought to measure the impact that the following factors had on the discounts exhibited in the private placement transactions:
- Subject company size
- Subject block size
- Subject company volatility
- Market volatility
- Volatility of the subject company's financial results
- Trading market
- Subject company stock price performance
- Subject company liquidity
We performed a linear regression analysis and quartiles analysis to the data derived from 98 transactions. For each factor, we classified the relationship based upon the following categories and criteria:
- Very strong relationship: Factors exhibiting a very strong relationship include those that were determined to be significant at the 5 percent level in our linear regression analysis.
- Strong relationship: Factors exhibiting a strong relationship include those that weren't significant at the 5 percent level in our linear regression analysis but were still determined to show a consistently increasing trend in our quartiles analysis (that is, each subsequent quartile exhibited an equal or greater average discount than the prior quartile).
- Moderate relationship: Factors exhibiting a moderate relationship include those that exhibited a generally increasing trend in our quartiles analysis (that is, the third and fourth quartiles exhibited larger average discounts than the first and second quartiles).
- Inconclusive relationship: Factors that didn't exhibit any clearly observable relationships were deemed to be inconclusive.
Very Strong Relationship
Subject company volatility — We computed the subject company's annualized volatility (derived from weekly stock price observations) in the year preceding the announcement of the transaction, with the hypothesis that investors would demand larger discounts for companies exhibiting greater volatility, since volatility is often synonymous with risk.
We determined volatility to be significant at the 5 percent level. Additionally, the discounts exhibit a consistently increasing trend from the first quartile to the fourth quartile, increasing from 6.3 percent to 16.6 percent. (See “Annualized Volatility,” p. 51.)
Subject block size — To determine the impact of the subject company's block size on the transaction discount, we considered the shares placed as a percentage of shares outstanding, with the hypothesis being that larger interests (without control attributes) would take longer for an investor to liquidate after the expiration of the Rule 144 holding period and that investors would seek a greater discount to compensate for this increased holding period.
We determined block size (as measured by the shares placed as a percentage of shares outstanding) to be significant at the 5 percent level and it exhibited a very strong linear relationship. (See “Block Size,” this page.)
Dividends — All else being equal, we hypothesized that transactions involving dividend-paying companies would feature lower discounts. Consistent, meaningful dividends provide a current return to investors and reduce the importance of an uncertain future liquidity event (for example, sale, recapitalization, liquidation, etc.) to an investor's overall return. In effect, dividends shorten the duration of a security, as current income “frontloads” some of the economic benefits a security holder can expect to receive.
We analyzed the subject companies' dividend yields as of the transaction announcement date to determine the relationship. The companies that paid a dividend traded at an average discount of 7.4 percent, while discounts for non-dividend paying companies were higher at 11.9 percent. We deemed the results significant at the 5 percent level. (See “Yields,” this page.)
Profitability — Companies with high degrees of profitability are frequently viewed as more stable than their less-profitable counterparts. It seems that investors require a smaller discount for companies with larger profit margins, as measured by latest 12-month (LTM) earnings before interest, taxes, depreciation and amortization (EBITDA) and net income. (See “Companies With a High Degree of Profitability,” and “Net Income Margin,” both p. 52.)
In addition to the factors presented above, we considered measures of long-term profitability, including average net income, operating income and EBITDA margins over three-year, five-year and 10-year periods. While these measures indicated some relationship, the short-term profitability presented in “Companies With a High Degree of Profitability” and “Net Income Margin” exhibit the strongest relationship.
Growth — We considered the growth of various financial results metrics, such as revenue, net income and EBITDA over varying observation periods ranging from one-year to 10-year periods. In total, we considered 21 growth factors in our quartiles analysis. Nearly every growth factor exhibited a moderate relationship. The strongest relationship relates to EBITDA growth for the subject companies over the last fiscal year. (“See EBITDA,” this page.)
Intuitively, companies with higher growth are expected to exhibit lower discounts since investors are compensated for their longer holding periods with growth during that time period.
Size — We considered various size metrics, including revenues, earnings (EBITDA, operating income and net income), enterprise value, book value of equity, market capitalization and total assets. We hypothesized that size would be an important factor since larger companies may be subject to less risk since they have established products and customers and greater liquidity. The majority of these size metrics resulted in a moderate relationship with the transaction discount.
Leverage — To assess the impact of leverage, we considered various leverage ratios, including interest coverage (earnings before interest and taxes (EBIT) divided by interest expense) and debt/EBITDA. The majority of the leverage ratios predicated on interest coverage resulted in a moderate relationship, with the three-year average interest coverage ratio exhibiting the strongest relationship. (See “The Impact of Leverage,” p. 53.)
Recent price performance — We considered the price performance of the subject companies' publicly traded stock, as well as the performance of the S&P 500 and Russell 2000 indexes, in the one-year period prior to the transaction announcement date. We expected that companies experiencing an increase in their stock prices were being viewed more optimistically by investors and consequently would exhibit lower discounts. Additionally, we expected to see lower discounts during time periods of increasing index values. Our quartiles analysis results, however, were inconclusive.
Registration rights — As previously mentioned, nearly every transaction considered in our study included registration rights granted to the acquirer. The registration rights may be in the form of a guarantee to register the shares within a certain time period, the ability for the acquirer to demand the registration of the shares (usually after a certain time period), certain “piggyback” rights that require the shares to be registered if other shares are registered or any combination thereof. Once the shares are registered, and the registration is declared effective, the shares become freely tradable. Therefore, registration rights effectively reduce the acquirer's expected holding period, although uncertainty exists over the actual timing of the registration. It's not uncommon for a significant period of time to elapse between the filing of a registration statement and when it's ultimately declared effective. To gain a better understanding of this timeframe, for each of the transactions selected, we calculated the average amount of time elapsed between the closing date of the private placement transaction and the date the registration statement ultimately became effective. We found that the effective holding period was approximately four months or slightly shorter than the Rule 144 minimum six- month holding period.
Our study shows that several factors provided better indications of restricted stock discounts than others. We found that the most reliable factors influencing the discounts were:
- Subject company volatility;
- Subject block size;
- Growth; and
We were curious to see the impact on discounts based on a cross-section of the two most significant factors, subject company volatility and block size. In our data set, eight transactions occurred in which the subject companies ranked in the fourth quartile in both of these categories — subject company volatility exceeding 68.9 percent and block size exceeding 19.3 percent. As we suspected, the average and median discounts indicated by these eight transactions were materially higher, at 19.9 percent and 19 percent, respectively.
The 2008 Rule 144 change appears to have had minimal impact on private placement discounts, perhaps due to the abundance of registration rights attached to the transactions considered. That's not to say that investors are indifferent to a shorter holding period. Rather, it simply indicates that the effective holding period didn't materially change investors' perspectives during this time period.
We recognize that restricted stock studies are most commonly used for estimating discounts for lack of marketability applicable to closely held minority interests subject to long or uncertain holding periods. It's important to emphasize that the older studies associated with greater illiquidity attributes (and higher indicated discounts) should be used in situations with this fact pattern given that they are more relevant.
The SRR Restricted Stock Study serves as a reasonable basis for applying discounts for lack of marketability to investments that lack liquidity over a relatively short holding period or other securities with temporary trading restrictions. We can use the factors identified in this study to provide quantitative evidence for the company-specific factors that impact the magnitude of the applicable discount — and to the extent the facts and circumstances warrant it — rather substantial discounts may apply, even for very short holding periods.
In statistics, the result of an analysis is considered “significant” if it's unlikely to have occurred by chance. Statistical significance is measured in this instance by comparing the p-value determined from a linear regression to the level of significance (for example, 5 percent in this instance). If the p-value is less than the level of significance, then we can reject the null hypothesis (that is, we can reject the hypothesis that the factor has no influence on the discount).
Aaron M. Stumpf is a director in the valuation and financial opinions group at Stout Risius Ross in Detroit
Endnotes for above studies
- “Discounts Involved in Purchases of Common Stock (1966-1969),” Institutional Investor Study Report of the Securities and Exchange Commission, H.R. Doc. No. 64, Part 5, 92nd Congress, 1st Session, 1971, at pp. 2444-56.
- Milton Gelman, “An Economist-Financial Analyst's Approach to Valuing Stock in a Closely Held Company,” Journal of Taxation, June 1972, at p. 353.
- Robert R. Trout, “Estimation of the Discount Associated with the Transfer of Restricted Securities,” Taxes, June 1977, at pp. 381-85.
- Robert E. Moroney, “Most Courts Overvalue Closely Held Stocks,” Taxes, March 1973, at pp. 144-55.
- Michael J. Maher, “Discounts for Lack of Marketability for Closely Held Business Interests,” Taxes, September 1976, at pp. 562-71.
- William F. Pittock and Charles H. Stryker, “Revenue Ruling 77-276 Revisited,” SRC Quarterly Reports, Spring 1983, at pp. 1-3.
- Shannon P. Pratt, Robert F. Reilly and Robert P. Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 4th ed. (New York: McGraw-Hill 2000), at p. 404.
- William L. Silber, “Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices,” Financial Analysts Journal, July-August 1991, at pp. 60-64.
- Robert P. Oliver and Roy H. Meyers, “Discounts Seen in Private Placements of Restricted Stock: The Management Planning, Inc. Long-Term Study (1980-1996),” in Robert F. Reilly and Robert P. Schweihs (eds.) The Handbook of Advanced Business Valuation (New York: McGraw-Hill 2000).
- FMV Opinions, Inc., Determining Lack of Marketability Discounts: A Companion Guide to The FMV Restricted Stock Study (Irvine, Calif.: FMV Opinions, Inc. 2001).
- Bruce A. Johnson, “Quantitative Support for Discounts for Lack of Marketability,” Business Valuation Review, December 1999 (American Society of Appraisers).
- Kathryn F. Aschwald, “Restricted Stock Discounts Decline as a Result of 1-Year Holding Period,” Business Valuation Update, May 2000 (Business Valuation Resources), at p. 1.
— Aaron M. Stumpf
SRR Study: A Summary of Results
Discounts based on restricted stock compared to freely traded price
— Aaron M. Stumpf
A subject company's shares placed as a percentage of shares outstanding has a significant impact on transaction discount
|Shares placed as a percent of shares outstanding|
|to 13.3%||to 19.3%|
— Aaron M. Stumpf
Discounts consistently increase from the first quartile to the fourth quartile
|1-year annualized volatility (weekly basis)|
|to 47.9%||to 68.9%|
— Aaron M. Stumpf
Discounts are higher for non-dividend paying companies
|Average dividend yield||5.2%||0.0%|
— Aaron M. Stumpf
Companies With a High Degree of Profitability
Investors require smaller discounts
|Latest 12-month EBITDA margin|
|to 30.2%||to 11.9%|
— Aaron M. Stumpf
Higher growth results in lower discounts
|Last fiscal year EBITDA growth|
|to 88.4%||to 32.0%|
— Aaron M. Stumpf
Net Income Margin
The larger the profit, the smaller the discount
|Latest 12-month net income margin|
|to 10.2%||to 3.8%|
— Aaron M. Stumpf
The Impact of Leverage
The three-year average interest coverage ratio exhibits the strongest relationship
|3-year average EBIT/interest expense|
|to 13.2x||to 2.8x|
— Aaron M. Stumpf