Discount lack marketability put option

Calculating Discounts Accurately Depends a Lot on Company Specifics. Dennis Bingham and KC Conrad provide a thorough look at options for calculating a discount for lack of marketability DLOM , including restricted stock studies, pre-IPO studies, theoretical and option pricing models, discounted cash flow DCF , Mandelbaum factors, and more.

Valuation analysts frequently estimate a discount for lack of marketability DLOM based on one model or study. However, the current trend is to discuss the general empirical information and range of probable discounts based on multiple models or studies.

This includes discussing the strengths and weaknesses of the selected models or studies. This article discusses a number of models and studies available for valuation analysts to utilize when estimating a DLOM for a minority interest in a closely held company.

All of the models and studies discussed are based on public market data. None of the models is perfect. All of the models are sensitive to uncertain assumptions. Market data is subject to many non-DLOM influences and distortions. A DLOM should generally be applied to the marketable value of any ownership interest that cannot be easily sold in a timely manner.

Such discounts therefore are applicable to most equity investments not listed on an organized exchange or traded in an active over-the-counter market. A DLOM is defined as: An amount or percentage deducted from the value of an ownership interest to reflect the relative lack of marketability. At the present time, no direct evidence is available regarding the magnitude of a DLOM for closely held operating companies.

A discount is usually estimated by analyzing public equity market data and models. The two types of models that use public equity market data as their primary sources are empirical and theoretical models. Empirical models are based on actual transactions that have occurred in the marketplace while theoretical models are based on economic formulas.

Liquidity is defined as: The ability to quickly convert property to cash or pay a liability. Minority private equity interests are generally much less liquid than thinly traded New York Stock Exchange NYSE shares, and have benefited from none of the liquidity enhancements. Restricted Stock Studies Restricted stocks are identical in all respects to the freely traded stocks of public companies except they are restricted from trading on the open market for a certain time period.

Marketability is the only difference between a restricted stock and its freely traded counterpart. These studies have attempted to find differences in the price at which restricted stock transactions would take place compared with open market transactions in the same stock on the same date.

Restricted securities are stocks, warrants, or other securities that are acquired directly or indirectly from a public or private company or from an affiliate of the company for example, a gift , in a transaction that is not registered by the SEC, also known as a private offering.

For example, restricted stock can be acquired through corporate mergers, stock options, bonus shares, or compensation for services provided, but not through a public offering. Restricted stock studies have historically been the most frequently referenced source of DLOM data because some of the restricted stock studies provide detailed information on the transactions allowing comparison with companies subject to valuation.

Exhibit 1 summarizes the results of twenty restricted stock studies. The restricted stock studies conducted up to varied in their methodology and sample size, but generally found transactions covering a wide range with average discounts from 13 to Since , average discounts have fallen into the 20s. Therefore, many professionals believe the earlier studies are a better indicator than the more recent studies of the discount for lack of marketability that is applicable to closely held companies.

There are four major problems associated with the restricted stock studies. First, shares analyzed in the restricted stock studies differ from shares in closely held companies in a number of important ways, including: Second, the discounts identified in the studies fell in a very wide range for example, the Management Planning study discounts ranged from zero to Third, many of these studies do not provide detailed information on each of the transactions included in the study.

Lastly, a number of these studies are more than 30 years old. This study found discounts covering a wide range, from a low of a negative 5. Discounts are based on a comparison of the price, at which transactions were consummated, with the price one day prior to the transaction announcement date. Pre-IPO Studies Pre-IPO studies compare: Emory Business Valuation, Willamette Management Associates, and Valuation Advisors are the primary organizations responsible for the development of pre-IPO data.

Of these studies, only Emory provides detailed information on the transactions used in arriving at an average discount.

Pre-IPO transactions occur for a variety of reasons including: Exhibit 2 summarizes the Emory Studies. The study was of dot.

How To Determine Discount For Lack Of Marketability

The major issues concerning the pre-IPO studies are: At the present time, there is no published information concerning the issue of compensation. An unscientific method of evaluating the issue of compensation is to compare the DLOM for options granted to directors, officers, and employees, issued to lenders, and issued for services versus sales to outsiders. The total number of transactions comprising each group was very similar option transactions and sale transactions.

This analysis indicates the discounts associated with insider transactions are lower than sales to outsiders. A more comprehensive method of testing the insider compensation assumption is to review SEC filings to determine if the SEC required a company to make an adjustment to its financial statements for excess compensation.

Critics suggest the size of the reported pre-IPO study discount is overstated by not adjusting the private transaction price for the time value of money. There is no published analysis of the time value of money and the DLOM. However, a review of the mean and median discounts versus the time between transactions and the IPO indicate that as the days between transaction and IPO increase the size of the discount increases See Exhibit 3. Another explanation for this increase in discounts may be event signaling.

Stanley Feldman reviewed two studies moving from the OTC to the NYSE, and moving from the NASDAQ to the NYSE to estimate the impact of event signaling on discounts for closely held stocks. This means a closely held stock would sell at a Flotation Cost Model The flotation cost model estimates a DLOM by measuring the cost of creating marketability. Flotation costs represent the cost of going public. Flotation costs include both fixed and variable costs. The major fixed costs are audit fees, legal fees, and printing costs.

Expressed as a portion of gross proceeds, costs generally increase as risks associated with the issue increase, or the size of the offering decreases. The major issue concerning flotation cost is the characteristics of the companies included in the models. These companies are significantly larger and have a higher expectancy of being a successful public company than the majority of closely held companies. Option-pricing Models Option-pricing models were originally developed for use in estimating the value of exchange traded stock options.

An exchange-traded stock option is traded on a regulated exchange where the terms of each option are standardized by the exchange. The contract is standardized so the underlying asset, quantity, expiration date, and the strike price are known in advance.

Three frequently referenced option-pricing models are the Chaffee, Longstaff, and Finnerty models. Chaffee European Put Option Model Chaffee relies on the Black-Scholes option-pricing model to estimate a DLOM by calculating a theoretical put option price for a closely held stock. A put option is: An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. The Black-Scholes model has historically been the most frequently used model to value exchange-traded options.

Black-Scholes was designed to measure European-style options options that can be exercised only on the expiration date. The basic inputs for the Black-Scholes model include: The strike price is typically set to be equal to the market value of the underlying stock as of the valuation date. Exhibit 4 presents an example of the Black-Scholes model. Chaffee notes the use of European-style options results in lower option prices than if American-style options options exercisable at any time are used.

The use of lower option prices results in a lower DLOM. There are three problems associated with put option analysis.

First, the Black-Scholes model assumes continuous trading of the stock. Second, hedging methods are not available for stock in closely held companies. Finally, this methodology requires the use of comparable publicly traded companies which often do not exist to estimate volatility. Critics of put option analysis argue the value derived is not indicative of marketability. Intrinsic value is the positive amount by which the underlying stock price exceeds the strike price of an option.

The illustrated range of volatility was based on typical stock return volatilities. The estimated DLOM ranges from The holding period represents the time required to sell the stock. Finnerty Average-Strike Put Option Marketability Discount Model This model 9 estimates marketability discount as the value of an average-strike put option. The investor is not assumed to have any special market-timing ability; instead, Mr. Finnerty assumes that the investor would, in the absence of any transfer restrictions, be equally likely to sell the shares any time during the restriction period.

The cost of transfer restrictions can be priced as the value of an average-strike put option. The average-strike put option model fits empirically observed discounts better than the look back put option model, which substantially overstates the discount, according Finnerty.

Assuming a two-year holding period the DLOM varies between 3. A somewhat lower discount applies to dividend paying stocks Panel B. Long-Term Equity Anticipation Securities LEAPS LEAPS are identical in all respects to short-term options except they have a later expiration date positions can be maintained up to three years. This cost of insurance represents a minimum DLOM that is required.

The Seaman study sorted 1, LEAPS by revenue and book value size using the prices of LEAPS. The study showed that as company size decreased either in terms of revenue or book value , the size of the required discount increased. The average discount for all 1, companies was As revenue size decreased, the average DLOM increased from As book value decreased, the average DLOM increased from The major results of this study were: There are three problems associated with LEAPS. First, not all publicly traded companies trade LEAPS.

Second, it is difficult to find LEAPS generally similar to the closely held company being valued either in terms of business or industry type. Third, companies having LEAPS are generally larger than nearly all closely held businesses. Discounted Cash Flow Model Discounted cash flow models are based on the underlying premise that an investment in a business is worth the present value of all the future benefits it will produce for the owner s.

Valuation Company St. Louis: What are Valuation Discounts or DLOM?

The Quantitative Marketability Discount Model QMDM by Christopher Mercer is the most frequently referenced discount cash flow model for estimating DLOM. The application of this model requires a determination of the following elements: Exhibit 7 presents an example of a DLOM analysis using QMDM. The two major criticisms of this model center on the selection of the holding period.

The first criticism is that the holding period cannot be determined with any degree of assurance. This is because the terminal value incorporates the present value of all future cash flows. At the present time, while many business valuation professionals are using QMDM, the tax court has generally not accepted this methodology as empirical evidence to quantify a DLOM. To determine an indication of a DLOM, Wruck studied the difference in the price between unregistered and registered shares.

This difference is assumed to be due to the lack of marketability. In this study, the authors identified transactions involving private placements from to The mean discount was The authors then performed a multivariate regression to control for possible non-marketability factors involved in private placement discounts.

The calculated difference between registered and unregistered shares was The private placement study sampled 88 private placements from to The number of shares offered as a percent of total shares after issue was Exhibit 8 presents summary information concerning the characteristics of the private placements included in the private placement study Source: Exhibit 9 summarizes the discounts on private placements. The discounts covered a very wide range from a negative The private placement study indicates these discounts include factors other than marketability such as, fraction of total shares offered in the private placement, business risk, financial distress, and total proceeds from the placement.

Excluding these other factors, the average DLOM is 7. First, the restricted stock and pre-IPO studies measured a lack of marketability while the private placement study measures a lack of liquidity. Liquidity denotes the ability to convert an asset into cash without diminishing its value. Liquidity is a spectrum. A block with high liquidity will have low transaction costs, a short liquidation period and minimal discounts e. A block with low liquidity will have opposite characteristics.

Second, the discounts reported in the restricted stock and pre-IPO studies related to minority interests in operating companies. This is not the case in the private placement study. According to the authors of the private placement study:.

In our opinion, when valuing an operating company that is privately held or its securities , the appropriate benchmark for discounts is provided by the total private placement discount or the discount observed in the acquisition approach. This is because, whether it is marketability restriction per se or other factors, the relevant analysis aims to determine the total valuation discount.

However, when it is appropriate to only consider the effect of marketability restrictions, as is the case in valuation of non-controlling interests in a non-operating partnership, which holds assets of known value e. In such cases, the applicable discount is only for the lack of liquidity. Therefore, for most business valuations of minority interests in privately held companies, the appropriate DLOM starting point is The average discount would be There are two problems associated with the academic studies.

First, since the transaction data has never been published, the data is not verifiable, and there is no good method for comparing specific companies with those used in this study. Second, there is a wide range of discounts identified in these studies. There are two problems associated with these factors. First, several of these factors e. Therefore, these factors should have no impact on the size of the DLOM or there may be a problem with double counting.

Second, some of the factors are subjective e. Judges need to know these weaknesses to better understand the full breadth in rendering a decision. More than one model should be used for example: Then adjustments should be considered to recognize the unique circumstances of each individual situation, because the factors causing an extremely high or low discount may or may not be present in the subject company. Dennis Bingham, MCBA, BVAL is President of Corporate Appraisal.

Dennis has over 37 years experience in business appraisals, accounting, financial analysis, and merger and acquisition activities. Dennis is an instructor and course author for The Institute of Business Appraisers and has served on the Qualifications Review Committee for IBA.

Dennis has been a speaker at the National Conference of the IBA and has been published in the Journal of Business Appraisal Practice, Family Law , and Valuation Viewpoint. Dennis can be reached at dennisbingham me. KC Conrad, CBA, CMEA, ABAR, ASA is a principal in American Business Appraisers, a firm located in metro Phoenix, AZ. He performs valuations for a variety of purposes; estate and gift tax, buy-sell transactions, lender financing, partnership, and corporate disputes.

What is a Discount for Lack of Marketability (DLOM)? - eShares Help Center

KC can be contacted at kc abavalue. This piece was originally published in Business Appraisal Practice BAP , 3rd Quarter, The National Association of Certified Valuators and Analysts NACVA supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines. Become a Financial Super Consultant Subscribe to the QuickRead Most Recent Posts Build to Serve or Build to Sell?

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