Marketability discount

What Is Marketability Discount?

The marketability discount is an adjustment made in business valuation to reflect the decreased value of an ownership interest in an asset, typically a private company, due to the absence of a ready market for its sale. Unlike shares of publicly traded companies that can be easily bought or sold on organized exchanges, interests in private businesses often lack immediate liquidity. This illiquidity means that converting the ownership interest into cash can take significant time, effort, and cost, thereby justifying a reduction in its theoretical value. This concept is a core element within the broader category of business valuation adjustments. The marketability discount quantifies the inherent disadvantage of holding an asset that cannot be readily converted to cash without incurring substantial transaction costs or delays.

History and Origin

The concept of a marketability discount emerged as financial professionals sought to establish fair and consistent valuation methods for assets that lacked an active trading market. Early empirical studies attempting to quantify this discount began appearing in the 1970s. A significant milestone was the Securities and Exchange Commission (SEC) Institutional Investor Study, published in 1971, which examined transactions involving restricted stock of public companies. This study and subsequent research, often referred to as restricted stock studies, analyzed the price differential between publicly traded shares and their unregistered or restricted counterparts sold in private placements²³, ²⁴.

Another stream of research, known as pre-Initial Public Offering (IPO) studies, compared the prices of shares in private transactions before a company went public with the prices achieved immediately after the IPO. These studies generally demonstrated that privately held shares traded at a notable discount compared to their liquid, publicly traded equivalents²². Over time, various academic papers, such as those by Silber (1991), Hertzel and Smith (1993), and Bajaj et al. (2001), have further explored and quantified the factors influencing the magnitude of the marketability discount¹⁹, ²⁰, ²¹.

Key Takeaways

• The marketability discount reflects the reduced value of an asset due to its lack of ready convertibility into cash.
• It is most commonly applied when valuing interests in private companies, which do not trade on public exchanges.
• Factors like the size of the company, financial transparency, expected holding period, and restrictions on transferability can influence the magnitude of the discount.
• Methods for quantifying the marketability discount include restricted stock studies, pre-IPO studies, and option pricing models.
• The marketability discount is distinct from other valuation adjustments, such as the discount for lack of control.

Interpreting the Marketability Discount

The marketability discount is typically expressed as a percentage reduction from a theoretical marketable value—the value an asset would command if it were freely traded. Interpreting this discount requires understanding the unique characteristics of the asset being valued and the environment in which it operates.

A higher marketability discount suggests greater difficulty and cost associated with selling the ownership interest. Conversely, a lower discount implies relatively easier conversion to cash. Factors that typically lead to a higher marketability discount include:

• Lack of public information: Private company interests often have less financial data and transparency compared to publicly traded companies, increasing buyer risk and the time needed for due diligence.
  ¹⁷, ¹⁸* Absence of a ready market: There is no centralized exchange for private company shares, requiring sellers to actively seek out individual buyers.
  ¹⁵, ¹⁶* Restrictions on transferability: Shareholder agreements or legal regulations may restrict who can buy the shares or when they can be sold.
• Size of the company: Smaller, less established businesses generally face higher marketability discounts than larger, more mature private companies.
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  When a valuation professional applies a marketability discount, they are essentially adjusting the initial valuation (which might be based on comparable publicly traded entities or a discounted cash flow analysis) to arrive at a fair market value that reflects its real-world transferability challenges.
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Hypothetical Example

Consider "Alpha Manufacturing," a privately held company with a projected equity value of $10 million if its shares were freely traded on a public exchange. This initial valuation is based on its financial performance and comparable publicly traded businesses.

However, because Alpha Manufacturing is a private company, selling an ownership stake would involve:

1. Identifying potential buyers through word-of-mouth or brokers.
2. Negotiating a deal directly with a single buyer.
3. Incurring legal and accounting fees for the transaction.
4. Potentially waiting months or even years to find a suitable buyer.

Due to these factors, a business valuation expert determines that a 25% marketability discount is appropriate for Alpha Manufacturing's shares.

The calculation of the non-marketable value would be:

Original Theoretical Value: $10,000,000
Marketability Discount: 25%
Marketability Discount Amount: $10,000,000 * 0.25 = $2,500,000

Adjusted Market Value (after discount): $10,000,000 - $2,500,000 = $7,500,000

Therefore, an ownership interest in Alpha Manufacturing, which might theoretically be worth $10 million if liquid, would be valued at $7.5 million when accounting for the marketability discount.

Practical Applications

The marketability discount is a crucial adjustment in various financial contexts, particularly in business valuation and tax planning.

• Valuation of Private Companies: When valuing a private company for sale, acquisition, or internal purposes, analysts often start with valuation multiples derived from publicly traded companies or discounted cash flow models. A marketability discount is then applied to account for the lack of a public trading market.
  ¹⁰, ¹¹* Estate and Gift Tax Planning: For high-net-worth individuals, applying a marketability discount to privately held business interests or other illiquid asset classes can significantly reduce the taxable value of an estate or gift. This strategy is a common component of sophisticated estate planning.
  ⁹* Divorce Proceedings: In divorce cases involving the division of marital assets, a privately held business interest may be subject to a marketability discount to determine its fair value for equitable distribution.
  ⁸* Employee Stock Ownership Plans (ESOPs): Companies with ESOPs must have their shares valued periodically, and the marketability discount is a key consideration in determining the fair value for participants.
• Litigation and Expert Witness Testimony: In legal disputes where the value of a non-marketable asset is at issue, a marketability discount is often a point of contention and requires expert testimony.

The Internal Revenue Service (IRS) recognizes the concept of the marketability discount in its valuation guidelines, such as Revenue Ruling 77-287, which provides factors to consider when valuing securities restricted under federal securities laws. While the specific ruling deals with restricted securities, the principles extend to other non-marketable assets, influencing the overall valuation landscape. ⁷The IRS provides training guides for its valuation professionals that delve into the application and factors influencing the marketability discount IRS Valuation Training Guide.

Limitations and Criticisms

Despite its widespread application, the marketability discount is subject to limitations and criticisms, primarily concerning its quantification.

One major challenge is the lack of a universally accepted, precise formula for calculating the discount. While empirical studies (like restricted stock and pre-IPO studies) and option pricing models provide methodologies for estimation, the specific percentage can vary significantly depending on the data set, assumptions, and professional judgment. ⁵, ⁶Different studies have reported a wide range of average marketability discounts, from under 10% to over 50%, highlighting the variability and complexity.
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Critics also point to the "informational asymmetry" inherent in private company valuations. The lack of public disclosure requirements for private company interests means that buyers have less information, which itself can contribute to a lower price and be conflated with illiquidity. ²Some academic research suggests that the discount attributed solely to illiquidity might be smaller than commonly applied, with other factors such as control or informational effects playing a more significant role. ¹For instance, a paper published via Pepperdine Digital Commons argues that certain traditional methods might overstate the discount by not fully accounting for alternative strategies to monetize non-marketable assets. Similarly, a study from Tilburg University explores the driving factors of the private company discount, suggesting it encompasses more than just marketability.

The subjectivity involved in selecting the appropriate discount can lead to disputes, particularly in legal or tax contexts. Furthermore, applying a marketability discount might not fully capture all the unique attributes of a minority interest in a private entity.

Marketability Discount vs. Discount for Lack of Control

The marketability discount is often confused with the discount for lack of control (DLOC), but they address distinct aspects of value.

While a minority interest in a private company might be subject to both a marketability discount and a discount for lack of control, these are distinct adjustments. A controlling interest in a private company might still warrant a marketability discount because, even with control, converting the entire business to cash takes time and effort. However, it would not typically be subject to a DLOC, as the holder has the power to influence the entity's actions. The SEC also provides resources on factors influencing the marketability of securities, including those related to restricted securities and private capital raising methods, which often involve considerations distinct from control issues SEC Small Business Capital Raising Q&A.

FAQs

What assets typically receive a marketability discount?

The marketability discount is primarily applied to ownership interests in privately held businesses, real estate, limited partnership interests, certain collectibles, and restricted stock or illiquid securities in publicly traded companies. Any asset that cannot be readily sold on an active, organized market may be subject to this discount.

How is the marketability discount determined?

Determining the marketability discount involves various approaches, including analyzing empirical studies of restricted stock transactions and pre-Initial Public Offering prices, as well as using financial models like option pricing models. Valuation professionals consider factors such as the company's size, financial condition, dividend policy, anticipated holding period, and any contractual restrictions on transferability.

Does a marketability discount apply to publicly traded stock?

Generally, no, for freely traded shares. Shares of publicly traded companies are considered highly marketable due to the existence of liquid stock exchanges. However, a marketability discount can apply to "restricted stock" of publicly traded companies—shares that cannot be immediately resold on the open market due to legal or contractual limitations, such as those held by company insiders or acquired through private placements.

Is the marketability discount always applied in business valuations?

No, the application of a marketability discount depends on the purpose and context of the business valuation. If the valuation is for an active market transaction where a quick sale is expected or if the subject interest is already highly liquid (e.g., a controlling interest being sold to a strategic buyer who will absorb the entire entity), a marketability discount might be lower or not applied. However, for estate planning, gifts of minority interest in a private company, or other contexts where liquidity is a concern, it is often a critical adjustment.