Valuation Advisors has released today an major additional dataset for transactions where the pre-IPO timeframe is two years or longer. Why?
It takes most closely held businesses a long time to find a buyer for a 100% interest. For interests less than 100%, the timetable is even longer. Currently there are no definitive studies on an exact timetable to liquidity for such interests. Clearly, businesses that are profitable consistently and showing growth are more likely to find buyers, and more rapidly, than businesses with problems.
Why look at Lack of Marketability Discounts beyond two years?
The idea behind capturing discounts beyond two years was to give analysts another source to use in determining a lack of marketability discount based on their professional judgment of the likely timetable to liquidity. If you believe a likely timetable for liquidity is very long or possible never, discounts beyond two years will be relevant to your work.
How is the database best utilized to determine such discounts?
The database can be searched for periods beyond two years, with the largest concentration of new beyond two year discounts in the database in the three to six year timeframe. Similar to discounts in the under two year timeframe, the size of the discounts beyond two years typically increases as the timeframe from the IPO gets longer. Thus, discounts in the five year range are larger than discounts in the four year range, etc. The key is to determine the most likely period of time you believe it will take to sell the ownership interest being valued.
After a presumed timetable to marketability is selected, you can then narrow your search using the usual database functions such as SIC or NAICS code for the industry in which the company operates, size of company (using assets or revenues) and profitability (either by profit margin range or simply selecting profitable or unprofitable). These further subset limits should allow you to target a marketability discount to your subject company.
When are discounts beyond two years more likely?
Clearly, anything that makes a company, either a 100% interest or less, less attractive, increases the likely timeframe to liquidity. The following are just a few issues that may make the timetable to marketability longer
- lack of profitability
- low margins
- significant competition
- low barriers to entry
- little capital requirements
- little knowledge required
- no intellectual property or proprietary products
- significant year to year financial variability
- high employee turnover
- poor industry conditions
- significant legal risks
- possible political regulation
- lack of quality management
- lack of pricing power
- rapidly changing industry conditions
- high annual capital expenditure requirements
- rapid product obsolescence
- no business succession plans, etc.
As the items in the list above grow, so does the likely timeframe to marketability.
Are the results “reliable” if the discounts exceed 60%?
As the likely timeframe to sell the interest being valued exceeds three years, it is not unusual to see discounts beyond 60%. The discounts from the database are based on actual transactions in privately held companies prior to their going public. The values used were based on arm’s length transactions and indicate, in hindsight,
for each transaction, the actual implied discount of lack of marketability. The results are market based, factual and between market participants. Therefore, to use the Fair Value analogy, they are based on level 1-type inputs and not the conjecture of trying to “guesstimate” what the discount “should” be.
In valuation, we work with present value concepts frequently. The present value of something in the future that must be discounted at a high rate of return to determine its value today is worth very little. In essence, this is the issue with any security that likely isn’t marketable for a long period of time. The compounding effect of that risk (holding an illiquid asset) for long periods of time make that asset, in this case closely held stock, worth considerably less. The result in valuation is a larger Lack of Marketability Discount that is borne out by the Valuation Advisors database results.
Do the discount figures include “cheap stock?”
The transaction prices throughout the database, when necessary, were adjusted to account for any SEC mandated “cheap stock” issues or other forms of compensation. Thus, the transactions represent “fair market value” figures, and corresponding discounts.
Aren’t IPO studies biased toward successful outcomes?
The issue is “marketability.” Stated differently, as a shareholder, the key issue is - when will you get cash for your shares. For every IPO, there are literally thousands of privately owned companies that cannot obtain publicly traded market liquidity or “marketability.” Therefore, to use an IPO scenario to calculate lack of marketability discounts may actually understate the discounts, since an unsuccessful outcome (i.e. you cannot be publicly traded) means there is zero immediate liquidity and a likely longer timetable to liquidity than a company that was able to go public.
Thus, the Valuation Advisors pre-IPO study provides lack of marketability discounts where companies that were attractive enough to investors to sell shares publicly had transactions while they were still private, or just like the company or entity you are valuing. Except, is your subject company ever likely to go public? If not, the database discounts are possibly understating the likely discount in a company that will remain private forever.
The above commentary was provided by Brian K. Pearson, CPA/PFS/ABV/CFF, ASA. Copyright © 2011 Valuation Advisors, LLC. All rights reserved