What is the “discount for lack of marketability”?
The discount for lack of marketability is also often referred to as the DLOM, the marketability discount, or the illiquidity discount. It refers to the difference in the fair market values between two otherwise-identical securities, one that is fully liquid and one that suffers from some degree of illiquidity.
Why are illiquid assets and securities always worth less than fully-liquid ones?
The theoretical underpinnings of the illiquidity discount is actually not very well understood. One Tax Court opinion merely states that it is “axiomatic” that investors always pay less for illiquid securities. Conceptually, investors value liquidity and would be concerned about possible losses if forced to hold a security, in particularly a risky security.
What are the methods used to determine discounts for lack of marketability?
The illiquidity discount can be determined through theoretical models or a review of empirical discount studies and data. For a more thorough discussion of the strengths and weaknesses of each method, please go to our Press Room . The empirical data analyzed are based on either restricted stock transactions or pre-IPO transactions. The pre-IPO transactions have significant biases that have been discussed in published research and highlighted in the McCord Tax Court decision. Prior to the launch of Pluris and the creation of the LiquiStat ™ database, all published restricted stock studies were studies of private placements. Unfortunately, all private placement studies in peer-reviewed academic financial journals have explained private placement discounts as having little or nothing to do with illiquidity. While this debate is clearly still unresolved, we believe that the pricing of private placements is subject to too many factors that are unrelated to the liquidity of the shares sold. So while these older studies are a reasonable starting point for any analysis, better transaction data is required. To discuss the various methods for determining illiquidity discounts and how we apply the LiquiStat data in our work, please e-mail us .
What are restricted stock private placement studies?
All “restricted stock studies” published up until the creation of the LiquiStat ™ database are, in reality, private placement studies. The peculiarities of the private placement process produce pricing effects that may be unrelated to illiquidity. For a discussion on the strengths and shortcomings of using private placement data to determine marketability discounts, please go to our Press Room, or e-mail us if you have any questions.
What is restricted stock?
Restricted stock is stock held by an affiliate of the issuer or stock that has been sold by the issuer or an affiliate of the issuer, without registration. Such stock can be sold only if an exemption from the registration requirement can be found. Restricted stock can only be sold in the public markets by complying with Rule 144 of the SEC. This requires, at a minimum, a holding period of six months. However, restricted stock can be sold prior to the expiration of the holding period in private transactions.
How are pre-IPO studies and restricted stock private placement studies different?
Pre-IPO studies analyze the difference in stock prices between stock issued by private companies and stock subsequently issued in initial public offerings (IPOs) by the same companies. This analysis has several problems, as highlighted in a paper by Dr. Bajaj [Mukesh Bajaj, David J. Denis, Stephen P. Ferris and Atulya Sarin: “Firm Value and Marketability Discounts,” Journal of Corporation Law, Fall 2001].
Anyone who is allowed to purchase common shares in a pre-IPO company is likely to be an insider or someone else who provides services to the firm. The only arm’s-length transactions in pre-IPO shares are typically between the issuing firm and certain venture capital investors. Those investors generally buy preferred shares, not common shares. In addition, the pre-IPO transaction sample is inherently biased, because it only includes firms that successfully complete their IPOs. These arguments were reviewed and accepted by the Tax Court in the McCord decision.
How is the LiquiStat™ database unique?
The LiquiStat™ database is the first-ever study of illiquidity discounts in transactions between individual shareholders. Because these transactions do not involve the issuer at all (they are not private placements), the pricing of securities in these transactions is less subject to factors other than the intrinsic characteristics of the shares sold.
As a result, the difference in price between the restricted stock sold and the exact same security trading in the financial markets should be due almost exclusively to the illiquidity of the restricted stock, rather than other factors. Other factors that affect price in private placement studies include:
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- Information asymmetry (the “lemons problem” arising when insiders try to sell something to outsiders)
- Capital scarcity (the fact that most companies doing private placements are in dire straits financially and desperately need cash)
- Control and monitoring effects (the positive effect on the firm’s value from the monitoring services performed by very large shareholders)
These factors, which are unrelated to the illiquidity of the stock, are all present, to a lesser or greater extent, in private placements, but not in arm’s-length investor trades between two investors that are unrelated to the stock’s issuer. The transactions in the LiquiStat™ database are all arm’s-length transactions from the SecondMarket trading platform.
What is the SecondMarket trading platform?
The SecondMarket trading platform, which is used to trade illiquid assets, is operated by SecondMarket, of New York, NY.
How many transactions are in the LiquiStat database?
The LiquiStat database includes thousands of transactions, which is significantly more than the number used in most valuation studies. With dozens of transactions being added each month, the database is growing rapidly.
What are the main conclusions you have drawn from analyzing the LiquiStat database?
Please visit our Press Room for articles, white papers and other information on the results of our analysis.
Briefly, our analysis to date has modeled restricted-stock discounts based on factors such as the volatility (variance) of the stock price, the size of the block of shares sold, the stock’s trading price in the market and — very importantly — the time period left until the restrictions on the stock expire.
The research has revealed an upward-sloping, but concave, relationship between the number of days of illiquidity remaining and the discount. For warrants, our research has modeled both discounts from the total warrant Black-Scholes model value and discounts from the Black-Scholes model time premium. The discounts have been modeled on factors such as the volatility of the stock, the delta of the warrant, a measure of how far the option is in or out of the money, the market value of the issuing firm, block-size measures and other factors. For questions regarding the latest research on the LiquiStat™ database transactions, please e-mail us.