Estimating Illiquidity Discounts
When you take an equity position in an entity, you generally would like to have the option to liquidate that position if you need to. The need for liquidity arises not only because of cash flow considerations but also because you might want to change your portfolio holdings. With publicly traded firms, liquidation is simple and generally has a low cost – the transactions costs for liquid stocks are a small percent of the value. With equity in a private business, liquidation costs as a percent of firm value can be substantial. Consequently, the value of equity in a private business may need to be discounted for this potential illiquidity. In this section, we will consider the determinants of this discount and how best to estimate it.
The illiquidity discount is likely to vary across both firms and buyers, which renders rules of thumb useless. Let us consider first some of the factors that may cause the discount to vary across firms.
1. Liquidity of assets owned by the firm: The fact that a private firm is difficult to sell may be rendered moot if its assets are liquid and can be sold with no significant loss in value. A private firm with significant holdings of cash and marketable securities should have a lower illiquidity discount than one with factories or other assets for which there are relatively few buyers.
2. Financial Health and cashflows of the firm: A private firm that is financially healthy should be easier to sell than one that is not healthy. In particular, a firm with strong income and positive cash flows should be subject to a smaller illiquidity discount than one with negative income and cash flows.
3. Possibility of going public in the future: The greater the likelihood that a private firm can go public in the future, the lower should be the illiquidity discount attached to its value. In effect, the probability of going public is built into the valuation of the private firm. To illustrate, the owner of a private e-commerce firm in 1998 or 1999 would not have had to apply much of a illiquidity discount to his firm’s value, if at all, because of the ease with which these firms could be taken public in those years.
4. Size of the Firm: If we state the illiquidity discount as a percent of the value of the firm, it should become smaller as the size of the firm increases. In other words, the illiquidity discount should be smaller as a percent of firm value for firms like Cargill and Koch Industries, which are worth billions of dollars, than it should be for a small firm worth $15 million.
The illiquidity discount is also likely to vary across potential buyers because the desire for liquidity varies among individuals. It is likely that those buyers who have deep pockets and see little or no need to cash out their equity positions will attach much lower illiquidity discounts to value, for similar firms, than buyers that have less of a safety margin.
How large is the illiquidity discount attached to private firm valuations? This is a very difficult question to answer empirically because the discount itself cannot be observed. Even if we were able to obtain the terms of all private firm transactions, note that what is reported is the price at which private firms are bought and sold. The value of these firms is not reported and the illiquidity discount is the difference between the value and the price.
In fact, much of the evidence on illiquidity discounts comes from examining “restricted stock” at publicly traded firms. Restricted securities are securities issued by a publicly traded company, but not registered with the SEC, that can be sold through private placements to investors, but cannot be resold in the open market for a two-year holding period, and limited amounts can be sold after that. When this stock is issued, the issue price is set much lower than the prevailing market price, which is observable, and the difference is viewed as a discount for illiquidity. The results of three studies that have looked at the magnitude of this discount are summarized.
In summary, then, there seems to be a substantial discount attached, at least on average, when an investment is not liquid. Much of the practice of estimating illiquidity discounts seems to build on these averages. For instance, rules of thumb often set the illiquidity discount at 20-30% of estimated value and there seems to be little or no variation across firms.
Silber (1991) also examined factors that explained differences in discounts across different restricted stock by relating the size of the discount to observable firm characteristics including revenues and the size of the restricted stock offering. He reported the following regression.
LN(RPRS) = 4.33 +0.036 LN(REV) - 0.142 LN(RBRT) + 0.174 DERN + 0.332 DCUST
RPRS = Restricted Stock Price/ Unrestricted stock price = 1 – illiquidity discount
REV = Revenues of the private firm (in millions of dollars)
RBRT = Restricted Block relative to Total Common Stock in %
DERN = 1 if earnings are positive; 0 if earnings are negative;
DCUST = 1 if there is a customer relationship with the investor; 0 otherwise;
The illiquidity discount tends to be smaller for firms with higher revenues, decreases as the block offering decreases and is lower when earnings are positive and when the investor has a customer relationship with the firm.
These findings are consistent with some of the determinants that we identified in the previous section for the illiquidity premium. In particular, the discounts tend to be smaller for large firms (at least as measured by revenues) and for healthy firms (with positive earnings being the measure of financial health). This would suggest that the conventional practice of using constant discounts across private firms is wrong and that we should be adjusting for differences across firms.
If we do decide to adjust the illiquidity discount to reflect the differences across private firms, we are faced with an estimation question. How are we going to measure these differences and build them into an estimate? There are two ways of doing this. The first is to extend the analysis done for restricted securities into the illiquidity discount; in other words, we could adjust the discount factor for the magnitude of a firm’s revenues and whether it has positive earnings. The second is to apply some of the empirical work that has been done examining the magnitude of the bid-ask spread for publicly traded firms to estimating illiquidity discounts.
Consider again the regression that Silber presents on restricted stock. Not only does it yield a result specific to restricted stock, but it provides a measure of how much lower the discount should be as a function of revenues. A firm with revenue of $20 million should have an illiquidity discount which is 1.19% lower than a firm with revenues of $10 million. Thus, we could establish a benchmark discount for a profitable firm with specified revenues (say $100 million) and adjust this benchmark discount for individual firms that have revenues much higher or lower than this number. The regression can also be used to differentiate between profitable and unprofitable firms. Figure 24.1 presents the difference in illiquidity discounts across both profitable and unprofitable firms with different revenues, using a benchmark discount of 25% for a firm with positive earnings and $10 million revenues.
There are clearly dangers associated with extending a regression run on a small number of restricted stocks to estimating discounts for private firms, but it does provide at least a road map for adjusting discount factors.
The biggest limitation of using studies based upon restricted stock is that the samples are small. We would be able to make far more precise estimates if we could obtain a large sample of firms with illiquidity discounts. We would argue that such a sample exists, if we consider the fact that an asset that is publicly traded is not completely liquid. In fact, liquidity varies widely across publicly traded stock. A small company listed over-the-counter is much less liquid that a company listed on the New York Stock Exchange which in turn is much less liquid that a large capitalization company that is widely held. In fact, the difference between the bid price and the ask price that we observe on publicly traded assets can be viewed as a measure of the cost of instant liquidity. An investor who buys an asset, changes her mind and decides to sell the asset immediately will pay the bid-ask spread.
While the bid-ask spread might only be a quarter or half a dollar, it looms as a much larger cost when it is stated as a percent of the price per unit. For a stock that is trading at $2, with a bid-ask spread of 1/4, this cost is 12.5%. For higher price and very liquid stocks, the illiquidity discount may be less than 0.5% of the price, but it is not zero.
What relevance does this have for illiquidity discounts on private companies? Think of equity in a private company as a stock that never trades. On the continuum described above, you would expect the bid-ask spread to be high for such a stock and this would essentially measure the illiquidity discount.
To make estimates of the illiquidity discounts using the bid-ask spread as the measure, you would need to relate the bid-ask spread of publicly traded stocks to variables that can be measured for a private business. For instance, you could regress the bid-ask spread against the revenues of the firm and a dummy variable, reflecting whether the firm is profitable or not, and extend the regression done on restricted stocks to a much larger sample. You could even consider the trading volume for publicly traded stocks as an independent variable and set it to zero for a private firm. Using data from the end of 2000, for instance, we regressed the bid-ask spread against annual revenues, a dummy variable for positive earnings (DERN: 0 if negative and 1 if positive), cash as a percent of firm value and trading volume.
Spread = 0.145 – 0.0022 ln (Annual Revenues) -0.015 (DERN) – 0.016 (Cash/Firm Value) – 0.11 ($ Monthly trading volume/ Firm Value)
Plugging in the corresponding values – with a trading volume of zero – for a private firm should yield an estimate of the bid-ask spread for the firm.