Issue: In recent conversations regarding valuation discounts applied to business interests that are not actively traded on a major exchange or over the counter, I have noticed a great deal of confusion regarding when and how these discounts should be applied. Should a minority interest discount be applied to all valuations representing a minority ownership position? Are discounts for lack of marketability always appropriate for privately-held securities? This three-part article explores the two major discounts often applied to the valuation of privately-held securities (see parts one and two).
The Internal Revenue Service recognized the need to reduce the value of an interest in a corporation where the shares were restricted in their marketability, and issued Revenue Ruling 77-287 “Valuation of Restricted Stock.” This ruling states in Section 2, “It frequently becomes necessary to establish the fair market value of stock that has not been registered for public trading when the issuing company has stock of the same class that is actively traded in one or more securities markets,” and in Section 6.04, “Whether the shares are privately held or publicly traded affects the worth of the shares to the holder. Securities traded on a public market generally are worth more to investors than those that are not traded on a public market.“
According to SEC Accounting Release No. 113, restricted securities are often purchased at a discount from the market price of outstanding unrestricted securities of the same class, reflecting the fact that securities that cannot be readily sold in the public marketplace are less valuable. Eight other independent studies support a long-term historical average discount of approximately 35% for transactions in restricted stock compared with the prices of their freely traded counterparts (see table below).
The Silber Study found that: “The discount on restricted stock varies directly with the amount of restricted stock relative to publicly traded stock and inversely with the credit worthiness of the issuing company. That credit-worthy companies must offer price discounts of more than 30% to sell a significant block of restricted stock illustrates the importance of liquidity to the valuation of common stock.”
In an update to the SEC Study, FMV Opinions, Inc. examined more than 100 restricted stock transactions from 1979 through April 1992. The FMV study corroborates the conclusions of the SEC study that the size of the marketability discount for restricted stock is often a function of the company’s revenues, earnings, trading activity and the exchange on which the stock was traded. The study also found marketability discounts were in the 30-40% range for corporations with market capitalization of less than $50 million.
Conclusion: The application of supportable discounts depends on the starting point of the valuation numbers and the facts and circumstances of each assignment. Making broad assumptions concerning the application of these major discounts is very unwise. Consult with your valuation professional for the specifics of each case.