More Marketability Misconceptions

Once the appraiser decides that an adjustment for lack of liquidity/adjustment for difference in degree of marketability (the marketability discount) is necessary, the next step is to estimate the size of the discount. Usually these discounts are expressed as a percentage taken away from the “as if freely traded” value of the enterprise, so a 25% marketability discount indicates the closely held subject interest is worth 75% of its “as if freely traded” value.

Two Common Methods. There are two commonly applied techniques for estimating the size of the marketability discount: 1) benchmarking, and 2) a Quantitative Marketability Discounting Method (QMDM). Both are widely used by appraisers, and both have their advocates and critics. Neither is perfect.

Benchmarking. The principle behind the benchmarking method is to study the nature and extent of discounts observed in the real-world and apply this observed benchmark data to the subject by analogy. Most of the real-world data on marketability discounts consists of research studies that review the price paid for so-called restricted stock, i.e., stock that cannot be sold for a period of time due to SEC regulations or agreement with the issuer. A number of researchers have conducted these studies over the years, and there is a current series of studies available to the appraiser.

These studies might indicate, for example, an average in 2000, shares of restricted stock sold for 65% of the freely trading shares in the same company, on a certain date. Other studies look at the price paid in a private transaction, and the price paid shortly after the same stock was registered and sold in an Initial Public Offering (IPO), this difference imputed to reflect the increase in value attributable to the change in liquidity. Once these figures have been observed, the appraiser applies these benchmarks, sometimes with qualitative or subjective adjustment, to the subject shares.

QMDM. The QMDM is a theoretical method that requires the appraiser to estimate the period of time between the date of valuation and the time the subject stock would likely be sold, and with this information, calculate the present value of the stock. The discount for the amount of time between the date of valuation and the likely sale date is said to reflect the cost of illiquidity relative to immediately liquid shares.

Neither Method is Perfect. Both of these methods have some degree of difficulty. The benchmarking method relies on an analogy that may apply better in some circumstances than others. The QMDM requires the appraiser to know when in the future the owner of the closely held shares will sell them, and how much he will sell them for at some distant time in the future. It’s the appraiser's job to select the better method for the particular assignment, and to follow the most objective procedure for applying it to the closely-held subject property.