Minimum Marketability Discounts

MINIMUM MARKETABILITY DISCOUNTS

by Robert R. Trout, PhD, CFA

Introduction:

John Kania recently provided BVR readers with an instructive review of prior theories about measuring marketability discounts.   Kania concludes that a fourteen percent discount would be appropriate as an estimate for a marketability discount, based on the results of empirical studies by Hertzel and Smith, and by making adjustments to other well known studies of discounts associated with purchasing restricted stock.  While the logic of his arguments appears appropriate, the results does not correlate well with other market data not analyzed by Kania, or by other economists.

Insuring Against a Price Decline:

The reason a marketability discount exists at all is because a buyer of a security that lacks marketability (such as stock in a privately held company) is subject to a potential loss of equity value during a time period when the stock cannot be sold.  In the case of the restricted stock proxy, this time period is one to two years, while in the case of owning stock in a privately held company the time period could be very long.  If a buyer of such a security could insure against this event then no discount would be necessary if the seller would insure against this event, or the discount would exactly equal the cost of the insurance policy to the buyer.  There is a second detriment to holding a financial asset which has no current liquidity and that is related to the need for money in the short run.  The owner of a financial asset can often use the financial asset as collateral and borrow against it to obtain short term funds, so that factor is not evaluated in this paper.

Buyers of certain securities can insure against price declines by purchasing protective puts on the underlying security, if they are available.  Clearly puts are not available for most common stocks, and they are certainly not available for unlisted privately held common stock.  Nonetheless, considering the insurance characteristics of puts provides some information as to the minimum discount necessary for buyers to purchase stock that is restricted as to resale for some time period, or is unmarketable in the short run.  Most put options are short term; however, there are longer term put options called long term equity anticipation securities, or LEAPS for short.  These options offer price protection for up to two years into the future.  While this is not a long time, it is at least as long a period as the restrictions originally placed by the SEC on unregistered securities, which formed the basis of many of the studies used to estimate a marketability discount. 

LEAPS as Insurance - The Evidence:

An investor can purchase a LEAP put that effectively insures against a price drop during the time period of the option contract.  I examined the costs of buying LEAP puts and determined the relative insurance cost by dividing the put cost by the underlying stock price.  I examined LEAP puts where the current stock price was close the strike price, so that the contract on that date was providing an insurance coverage that was equal to about 100 percent of the investment.

Date for LEAP puts in mid-August 2001 appear in Table 1.  The LEAPS all expire in January 2003, a period of about 17 months in the future.  The average and median insurance costs appear to be about 21 percent, where the insurance cost was computed as the ratio of the option price to the stock price.  The relationship between the premiums and stock prices is shown graphically in Exhibit 1.  Note the relative decline in premium percent as the stock price increases.  This finding is consistent with the long observed fact that option prices as a percent of the underlying security tend to decline as security prices increase.

A more recent analysis of LEAP put prices appears in Table 2, which shows LEAP prices in early March 2003, and expiring in mid-January 2003, a time period of about twenty-two months.  The average and median premium percentages are about 23 to 24 percent, slightly higher than observed in August 2001.  The slight increase in the premium percentage might be attributable to the general increase in stock price volatility in recent years, and also to the slightly longer period of insurance overage (17 months to 22 months).  The relationship between the premiums and stock prices is shown in Exhibit 2.  

The data concerning the relative cost of puts as an insurance premium indicate an insurance premium cost equal to about 24 percent of the price.  This finding suggests that the minimum discount that one should assign for the lack of marketability of holding privately held stock is at least 24 percent.  This finding is consistent with many of the prior studies of discounts for purchasing restricted stock, which have been in the mid twenty percent to mid thirty percent range.

This finding does not support the determination by Kania that fourteen percent is an appropriate discount for lack of marketability, as expressed by him in his aforementioned article.