Of all the “small bombs” dropped at DLOM Summit II (the 2nd Annual Business Valuation and Tax Conference, held at the University of San Diego Law School on October 9th), one that drew the most comments related to the observation that marketability discounts don’t always correlate to size (revenues), earnings, or other performance measures (see last week’s BVWire™).
Why might that be? “For the most part, the buyers in the restricted stock studies have been institutional investors, who had the opportunity to purchase public shares in the marketplace but chose to acquire restricted shares of the same public companies,” comments Z. Christopher Mercer (who did not attend the Summit). The institutional investors required compensation for the risks related to the restrictions, including:
- Having to hold the shares during the applicable Rule 144 period;
- Being subject to “dribble-out” provisions after Rule 144 requirements elapsed;
- Earning no or few dividends during the period of illiquidity; and
- Not knowing how long it would take to achieve liquidity.
“With all these uncertainties being baked into the pricing recipe, it’s not surprising that there may be little correlation to revenue or earnings,” Mercer says. Not to mention that the benchmarking studies and others are aged. “One has to question what relevance guideline company pricing [in 1997, e.g.], regardless of how comparable, would have to transactions occurring in 2009?”
Bottom line. “Real life investors make decisions based on the expected risks of the investment, expected cash flows (including interim distributions and ultimate liquidity), and expected holding periods (or a possible range),” Mercer says. Thus analysts may want to assess how actual investors reach their pricing (i.e., discount) decisions. For example, what expected returns were available from publicly traded shares? What incremental return did investors require in restricted shares? What expected return? “That’s a lot of questions,” Mercer admits, but like all the good discussion that came out of DLOM II, they may lead to more support for defensible discounts.
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