1 Business Valuation Resources Teleconference April 25 th, 2007 – Defining, Measuring & Defending Discounts for Lack of Liquidity Defining, Measuring &

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Business Valuation Resources Teleconference April 25th, 2007 – Defining, Measuring & Defending Discounts for Lack of

Liquidity

Defining, Measuring & Defining, Measuring & Defending Discounts Defending Discounts for Lack of Liquidityfor Lack of Liquidity

A Teleconference from Business Valuation Resources

1-888-BUS-VALU (287-8258)

www.bvresources.com

[email protected]

April 25, 2007

Moderator: Shannon Pratt, CFA, FASA, MCBA, CM&AA, of Shannon Pratt Valuations, LLC

Panelists: Ashok Abbott, M.B.A., Ph.D. of Business Valuation, LLC

Rob Schlegel, ASA, MCBA of Houlihan Valuation Advisors

© Ashok Abbott, presentation created in collaboration with BVR© Ashok Abbott, presentation created in collaboration with BVR

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Liquidity

Ancillary Reading Materials• Defining, Measuring & Defending Discounts for Lack of Liquidity

PDF and PowerPoint Presentation

• Does the ‘Myth of Liquidity’ Lead to Incorrect Discounts? special

report from the December 2006 Business Valuation Update

• Full court decisions and Business Valuation Update abstracts for

related tax cases listed on slides 62 & 63 (abstract and decision

not available for Barnes v. Commissioner and abstract not

available for Estate of Berg v. Commissioner)

• All downloads and links available at the BVR Teleconference pre-

conference reading page:

http://www.bvresources.com/defaulttextonly.asp?

f=tcreading042507

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Liquidity

Learning Objectives• Learn the distinguishing features between liquidity and

marketability

• Learn how to measure discounts for lack of liquidity and the cost of

going public

• Learn how to apply our model using recent court cases

• Understand how to utilize this area’s new research in your practice

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Liquidity

Submitting Questions• Email [email protected] at any time during the

Teleconference

• The final 20-30 minutes is dedicated to telephone questions; the

conference operator will announce Q&A time and provide

instructions on how to join the queue

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Liquidity

IntroductionIntroduction

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Liquidity

Introduction• Traditionally, appraisers have cited studies of pre-initial public

offering and restricted stock to conclude discounts for lack of

marketability in the 20-50% range

• Over the last three years, the Tax Court has rejected discounts

for lack of marketability based on the average discount found in

restricted stock studies

• The latest rejection of the Quantitative Marketability Discount

Model (QMDM) was in the Estate of Temple (March 2006)

• There is a trend towards courts rejecting averages, and

requiring specific transactions that are as close as possible to

the subject company, and specific evidence of similar

characteristics

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Liquidity

Levels of Value

Notes:· Control shares in a privately held company may also be subject to some discount for lack of marketability, but usually not nearly as much as minority

shares.· Minority and marketability discounts normally are multiplicative rather than additive. That is, they are taken in sequence:

$10.00 Control Value- 2.00 Less: Minority interest discount (.20 x $10.00)

$ 8.00 Marketable minority value- 3.60 Less lack of Marketability discount (.45 x 8.00)$ 4.40 Per-share value of non-marketable minority shares

Value of non-marketable minority (lack of control) shares

Value of restricted stock of public company

“Publicly traded equivalent value” or “Stock Market value” of minority shares if freely traded

Value of control shares

Synergistic (Strategic) Value

$4.40 per share

$6.00 per share

$8.00 per share

$10.00 per share

$12.00 per share

Control Premium

Minority Discount

Discount for restricted stock of public company

Additional discount for private company stock

20% strategic acquisition premium

20% minority interest discount; 25% control premium

25% discount for lack of marketability for restricted stock

Additional 20% discount for private company stock (taken from publicly traded equivalent value $8 per share)

45% total discount for lack of marketability (25% + 20% may be taken additively)

A combined 20% discount and a 45% discount for lack of marketability equals a total of 56% discount from value of control shares

Source: Guide to Business Valuations, Exhibit 8.8; it also appears in Standards of Value: Theory and Applications by Jay Fishman, Shannon Pratt and William Morrison, page 132

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Liquidity

Discount Landscape• Subjective discounts are not acceptable

• Courts have clearly indicated that they are looking for firm

specific measures, supported by clear, relevant, empirical

analysis

• Scientific method is required to identify and substantiate

discounts

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Liquidity

Core Concepts

• Marketability

• Liquidity

• Holding period

• Liquidation period

• Price pressure

• Price risk/volatility

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Liquidity

Formal Definitions• Marketability versus liquidity: ASA definitions adopted July 2004

• Marketability: The capability and ease of transfer or salability of

an asset, business, business ownership interest or security

• Liquidity: The ability to readily convert an asset, business,

business ownership interest or security into cash without

significant loss of principal

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Liquidity

Marketability & Liquidity: What’s the Difference?• Marketability denotes the right to sell an asset in an established

and efficient capital market (public or private), within a

reasonable time, with relatively low transaction costs, and with

minimal effect on that security’s public market price

• 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.g., bid-ask

spread)

• A block with low liquidity will have opposite characteristics

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Liquidity

• Registered stock in an Exchange-listed publicly traded firm

• Registered stock in an Exchange-listed publicly traded firm subject

to Reg. 144 restrictions

• Unregistered stock in an Exchange-listed publicly traded firm

• Unregistered stock in a closely held unlisted large firm (potential

to go public)

• Unregistered stock in a closely held unlisted small firm

Marketability

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Liquidity

Liquidity Differences within Marketability Classes• Liquidity can differ significantly within each marketability class,

based on the attributes of the asset

• A significant block of Dow Jones Industrial Average included firm

can be liquidated relatively easily, while stock of a small over the

counter (OTC) firm may find few buyers in the short run without

offering significant discounts

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Liquidity

Publicly Traded Publicly Traded Equivalent ValueEquivalent Value

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Liquidity

Publicly Traded Equivalent Value• Capital Asset Pricing Model (CAPM), Ibbottson premiums, or build-

up rates using capital market proxies (e.g., small stock premium)

provide an estimate of the publicly traded equivalent value

(“PTEV”) of a privately held company

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Liquidity

Liquidity Assumptions of the Publicly Traded Equivalent Value

Finance literature recognizes four dimensions of liquidity:

• Width (availability of a large number of buyers)

• Depth (ability to absorb large volume)

• Immediacy (ability to complete the transaction quickly)

• Resiliency (absorbing large volume of trades without moving the

price)

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Liquidity

Core Issue in Liquidity: Immediacy • Assumption: Market orders have immediate execution

• Reality: Small at-the-market transactions of high trading

volume public securities approach immediate execution

• Large block transactions of thinly traded public securities are

likely to occur off the floor or may need to dribble out

• Even for actively traded shares, orders for above 10,000 shares

may not be subject to the current bid-ask quote

• Either way, a substantial delay and blockage discount may be

relevant

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Liquidity

Effect of Liquidity on Security Pricing & Returns

• Research shows significant difference between returns on liquid

and illiquid publicly traded securities:

• Brennan and Subrahmanyam (1996) show the return difference

of the most liquid and least liquid shares on the New York Stock

Exchange is 6.62% per year

• This difference roughly translates to a discount for lack of

liquidity (DLOL) of 35.5%

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Liquidity

Bid-ask Spread & Liquidity• Amihud and Mendelson (1986) demonstrate that stocks with

higher bid-ask spreads have longer holding periods, thus lower

trading activity

• Stoll (1978) and Stoll (2000) suggest that trading activity plays an

important role in explaining the cross-sectional variation in bid-ask

spreads

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Liquidity

Recent Changes in Market Liquidity• Difference between liquidity of large market cap stocks and small

market cap stocks has increased

• The holding period for SEC Rule 144 securities has been reduced

from two years to one year

• Bid and ask spreads have declined with the change from fraction-

of-a-dollar prices to decimal prices

• Overall market trading volume has gone up several-fold in recent

years; this is partly attributable to program trading strategies

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Liquidity

Changes in Market Changes in Market Liquidity & Private Liquidity & Private CompaniesCompanies

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Liquidity

Changes in Market Liquidity& Private Companies• Minority interests in private companies have not benefited from

the increased liquidity in the public markets

• Consequently, the value difference between closely held minority

interests and their assumed publicly traded counterparts has

widened in recent years

• SEC empirical studies covered larger publicly traded firms during

years in which the public markets were less liquid; these studies

may understate the actual discount for lack of marketability and

ignore the potential discount for lack of liquidity for smaller firms

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Liquidity

Market Profile : Large StocksAverage market Capitalization $22,856 Million

Variable Mean Std Dev t Pr > |t|

No Trade days 0.09% 3.03% 48.5 0.0001

Bid ask spread 3.24% 3.82% 1357.92 0.0001

Cost to trade* 0.49% 142.36% 5.48 0.0001

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Liquidity

Market Profile: Small Stocks Average market Capitalization $17.70 Million

Variable Mean Std Dev t Pr > |t|

No Trade days 23.88% 42.63% 848.32 0.0001

Bid ask spread 13.78% 14.40% 1449.00 0.0001

Cost to trade* 10.45% 13.47% 1174.67 0.0001

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Liquidity

Security Markets LiquidityDifferences Between Small and Large Stocks

• There are significant differences among publicly traded firms of

different sizes

• Among the smaller stocks, 24% do not trade at all on a given day

• The observed bid-ask spread is around 14%

• The measured cost of trading for small lots for smaller firms is

around 10%

• Largest firms are much more liquid, have lower spreads and are

less costly to trade

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Liquidity

Holding Period Vs. Holding Period Vs. Liquidation PeriodLiquidation Period

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Liquidity

Holding Period• Holding period is discretionary

• Investors elect to hold an asset for a certain period based on their

investment preferences and expected returns

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Liquidity

Liquidation Period• Liquidation period is determined by the prevailing market

conditions

• Liquidation period the time needed to liquidate a position in a

manner that minimizes the total cost of the price pressure and

price risk faced by the seller in response to the market availability

of buyers and sellers

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Liquidity

Discount for Lack of Liquidity Function of Liquidation Period

• Discount for lack of liquidity is tied to the anticipated liquidation

period, not the discretionary holding period

• A willing buyer will demand a discount to acquire an asset that

cannot be liquidated immediately

• An existing owner will be willing to discount the asset only to the

extent of the anticipated loss of value during the liquidation period

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Liquidity

Mean Liquidation Period: Small Firms

Mean Liquidation Period ( Months) for Small Firms

0

50

100

150

200

250

MLP

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Liquidity

Mean Liquidation Period: Large Firms

Mean Liquidation Period(Months) for Large Firms

0

20

40

60

80

100

120

140

Time

Liq

uid

ati

on

Pe

rio

d (

Mo

nth

s)

MLP

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Liquidity

Price Pressure• Bid-ask spread

• Listing price (ask)

• Selling price (bid)

• Liquidity can be stimulated by applying price pressure

• Selling pressure results in lower bid price

• Buying demand results in higher ask price

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Liquidity

Market Failure• Frequently the price impact particularly for small firms or large

blocks of large firms, is severe enough to result in a market failure

• Sellers are not willing to sell at the offered low bid price

• Buyers are not willing to buy at the high ask price

• In such cases an orderly liquidation or dribble out is appropriate

• Market failure is not a concept in appraisals because we have to

state a given value on a specific date (there are no reserve bids)

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Liquidity

Price Risk• Orderly liquidation exposes the holder to price risk

• Longer liquidation period for volatile assets creates loss of ability

to sell at favorable prices

• Regulatory restraints (e.g.,Reg. 144) can require long liquidation

periods

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Liquidity

Marketability Discount Marketability Discount ApproachesApproaches

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Liquidity

Marketability Discount ApproachesEmpirical Studies

• IPO studies

• Restricted stock studies

Theoretical/Quantitative Models:

• Mercer’s QMDM Model

• (Adaptation of Discounted Cash Flow model incorporating an

assumed liquidity horizon)

Option Pricing Models:

• Black Scholes Put option

• Look back Put option

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Liquidity

Empirical StudiesIPO Studies:

• New issue hype

• Data based on insider transactions

• Unpublished studies with noisy data

• Does not address liquidity, only marketability

• Lack of adequate analysis in the valuation report

Restricted Stock Studies:

• Limited and defined holding period

• Established public market

• Transparent financial disclosure

• May or may not address liquidity

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Liquidity

Quantitative Marketability Discount Model• Discounted Cash Flow model

• Depends on holding period

• Required rate of return

• Growth rate

• Assumptions influence results

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Liquidity

Is Bajaj Right?• Marketability or liquidity?

• Pricing marketability assuming liquidity

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Liquidity

Put Option Based Models• Black-Scholes Put

• Factors

• Time to maturity

• Variance of returns

• Risk-free rate

• Exercise Price

• Asset price

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Liquidity

Look Back PutMeasures price risk during period of liquidation

• Ultimate no regret contract

• Estimation requires two parameters


• Volatility

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Liquidity

Issues for ConsiderationIssues for Consideration

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Liquidity

Issues for Consideration• Two components of the discount

• DLOM: the cost of going public

• DLOL: the cost of illiquidity (blockage)


• Price risk

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Liquidity

Abbott Index: Cost of IPO and DLOL

Discount for lack of liquidity

Cost of IPO(Discount for lack of marketability)

Discount for lack of marketability

& liquidity

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Liquidity

Marketability: Cost of IPOIdentify determinants of IPO cost (based on the characteristics of the

subject firm):

• Size of the firm

• Size of the block

• Capital market conditions/liquidity/capacity of market to absorb

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Liquidity

Qualitative Costs of an IPO• The IPO is a costly and risky approaches to raising capital

• Significant expenses are incurred with no assurance that the IPO

will be successful

• It is not uncommon for changing market conditions to cause

underwriters to cancel the IPO at the eleventh hour

• Insiders/affiliates are subject to significant holding period

requirements under SEC Rule 144 and/or underwriter restrictions

• Insiders/affiliates are subject to significant trading restrictions

based on SEC/company restrictions on trading during blackout time

periods

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Liquidity

Reported Costs of an IPO

SDC Platinum IPO data (1993-2003) used to estimate the cost of

going public:

• Large sample size analyzed - 7,824 IPO’s

• IPO costs documented as

Accounting fees and expenses:

• Legal fees and expenses

• Underwriting fees

• Financial advisor fees

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Liquidity

IPO Sample ResultsIPO costs observed (as a percentage of IPO proceeds):

• 6.05% Trimmed mean

• 6.00% Trimmed median

• 0.42% Trimmed minimum

• 11.20% Trimmed maximum

• 1.79% Standard deviation

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Liquidity

IPO Costs: Explanatory Factors • IPO costs, as a percentage of the offering proceeds, decline with

increasing values for:

• Issuing firm size

• Total offering size

• Percentage Firm ownership offered in IPO

• Observed market liquidity

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Liquidity

Regression Results: IPO CostsPercentage Cost of IPO:

• 4.305% + variable based on total market capitalization rank

• Analysis is broken into deciles based on total market

capitalization

Total market capitalization variables:

• 5.663% - total market capitalization rank = 0)






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Liquidity

Regression Results: IPO CostsTotal market capitalization variables (continued):





Other variables:

• -3.311% x market liquidity for capitalization size category =

• -0.00593 x percentage of firm offered

• -0.00014 x amount of offering in millions of dollars

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Liquidity

Average Market Capitalization for Decile Rankings

• Rank 0 = $17.7 million







• Rank 7 = $1,295.5 million

• Rank 8 = $2,837.8 million

• Rank 9 = $22,856.2 million

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Liquidity

Cost of IPO: Example• Total PTEV of equity of company is $180 million

• Subject block is 25% of total outstanding shares

• $45 million in PTEV

• Market capitalization decile is rank 3

• Market liquidity for capital size category 3 = 0.0656

• Cost of IPO equation:

4.305% + 3.051% + (-3.311% x 0.0656) +

(-0.00593 x 25.0%) + (-0.00014 x 45) = 6.795%

• Total discount for lack of marketability = 6.795%

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Liquidity

Cost of Liquidity: Cost of Liquidity: Discount for Lack of Discount for Lack of LiquidityLiquidity

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Liquidity

Cost of Liquidity: Discount for Lack Of Liquidity

• Identify determinants of liquidity (based on the characteristics of

the appropriate publicly traded guideline companies):

• Stock trading volume

• Stock price volatility

• Estimated liquidation holding period (a function of trading

volume and price volatility)

• Develop an objective and statistically supportable metric for

estimating risk exposure and the liquidation holding period

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Liquidity

Longstaff Look Back PutLongstaff 1995

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Liquidity

Block Size and DLOL

Discount for Lack of Liquidity

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Time

Dis

co

un

t P

erc

en

tag

e

Block 5%

Block 10%

Block 20%

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Liquidity

Large-Firm DLOL EstimationDiscount for Lack of Liquidity for Large Firms

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

Time

Dis

co

un

t P

erc

en

tag

e

5% Block

10% Block

20% Block

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Liquidity

Small Firm DLOL EstimationDiscount for Lack of Liquidity for Small Firms

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

Time

Dis

cou

nt

Per

cen

tag

e

5% Block

10% Block

20% Block

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Liquidity

Applying the TheoriesApplying the Theories

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Liquidity

Applying the Theories• One size does not fit all

• Blanket approaches using historical averages are not sustainable

• Case-specific analysis needed

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Liquidity

Tax Cases Phase I• Estate of Berg v. Commissioner

• Mandelbaum v. Commissioner

• Barnes v. Commissioner

• Estate of Davis v. Commissioner

• Furman v. Commissioner

• Estate of Hendrickson v. Commissioner

• Estate of Weinberg v. Commissioner

• Knight v. Commissioner

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Liquidity

Tax Cases Phase II• Gross v. Commissioner

• Lappo v. Commissioner

• McCord v. Commissioner

• Okerlund v. United States

• Peracchio v. Commissioner

• Thompson, Estate of Josephine, v. Commissioner

• Temple v. United States 2006

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Liquidity

Where Do We Go From Here?• Develop testable models

• Empirically validate models

• Apply these models to case-specific situations

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Liquidity

Questions?• Email [email protected] at any time during the

Teleconference

• The conference operator will provide instructions on how to ask live

questions

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Liquidity

Thank You for Attending!• Visit www.bvresources.com/conferences for a schedule of exciting upcoming

sessions, as always, Teleconferences are good for two CPE credits

• May 2nd, 409a Compliance featuring Bob Duffy, Scott Beauchene and Joel Johnson

• May 23rd, Playing and Prospering By the New Valuation Rules featuring Al King and Matt Crow

• May 24th, Overview of Buy-Sell Agreements (part 1 of 3) featuring Chris Mercer

• May 31st, Lost Profit Damages featuring Nancy Fannon, Robert Gray and Thomas Burrage

• June 14th, Application of Buy-Sell Agreements (part 2 of 3) featuring Chris Mercer

• June 26th, Recruiting in the BV Profession featuring Jim Alerding, Megan Nail and Ron Seigneur

• June 28th, ESOP Valuation featuring moderator Robert Reilly

• July 19th, Buy-Sell Agreements and Valuation Related Issues (part 3 of 3) featuring Chris Mercer

• July 25th, Electronic Discovery featuring Ron Seigneur, Melinda Harper and Shari Lutz

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Liquidity

CPE Credits• All BVR Teleconferences are worth two interactive CPE credits

• Be sure to complete the post-conference survey within five

business days: http://www.bvresources.com/defaulttextonly.asp?

f=tcsurvey042507

• You should receive your CPE certificate via email within one week

Business Valuation Resources

1000 SW Broadway, Ste. 1200, Portland, OR 97205

1-888-BUS-VALU (287-8258) / Fax: 503-291-7955

www.bvresources.com

[email protected]

1 Business Valuation Resources Teleconference April 25 th, 2007 – Defining, Measuring & Defending Discounts for Lack of Liquidity Defining, Measuring &

Documents

defending discounts

lack of liquidity pdf

lack of marketability

incorrect discounts

bvr slide

myth of liquidity lead

practice slide

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