The Liquidity Discount in Valuing Privately Owned Companies

Headnote

While it is well accepted that a privately held company's value should be reduced for lack of marketability, assigning the value of the discount is a difficult matter. Research in the past four decades has relied on restricted stock studies and pre-IPO studies. Both approaches have inherent drawbacks and require better methodology. This study follows the approach of Koeplin, Sarin, and Shapiro (2000) in comparing privately traded firms 'valuation to publicly traded firms in the same industry over a comparable time period. For 91 public and private firms between 1999 and 2006, the average discount is 20%-25%. This study is unique in that it breaks down the discount by industry, with the highest discount found in manufacturing and the lowest in financial firms. [G32]

Even the most sophisticated discounted cash flow or enterprise value/EBITDA analysis may not yield the true value of a firm when it is privately held. Clearly, in a transfer of ownership, estate valuation, or a divorce settlement, lack of liquidity must be taken into consideration. Similarly, a lender who is using a closely held firm's stock as collateral for a loan will not accept its face value in determining the acceptable size of the loan.

Most students of finance learn mainly about publicly traded firms. They may complete a course in financial management or investments, and never deal with the thorny issue of illiquidity for privately held firms. This article may potentially serve as a supplement to traditional material.

I. Approaches to Determining the Liquidity Discount

Two basic approaches to decide the appropriate size of the liquidity discount have been developed. After carefully reviewing the literature on each, I will demonstrate a third approach that draws on the previous methods, but expands the horizon for analysis.

The two basic approaches relate to restricted stock studies and pre-IPO public offerings.

A. Restricted Stock Studies

Restricted stock refers to stock held in a publicly owned company, sometimes referred to as "letter stock." The restriction applies for a certain period of time in which it cannot be sold (such as one or two years). Restricted or letter stock arises in acquisitions or in raising capital because the time and cost of registering the new stock with the sec would make registration at...