Introduction
Restricted stock studies are an important tool for valuation analysts in estimating discounts for lack of marketability and are almost always among the empirical data used in the valuation of minority interests in closely held companies. A number of restricted stock studies have been performed aimed at measuring the diminution of value associated with an investment that lacks a ready market. The body of empirical data most commonly cited covers transactions occurring over a 30-year period from the late 1960s to the late 1990s. The regulations governing restricted stock have eased significantly since 1990 and only a few studies capture the impact on the magnitude of discounts. Effective in 2008, the regulations were relaxed further, reducing the minimum holding period. SRR is performing ongoing research and analysis to study the impact of this change on indicated discounts. Other motivations for performing this study include:
- Responding to IRS criticism of reliance on “old” data
- Tax Court’s desire for more quantitative evidence in estimating lack of marketability discounts
- The quality of recently published studies appears lacking given improperly screened data
In addition, a discount study involving short holding periods may prove useful in the presence of improving market conditions. To the extent the merger and acquisition market rebounds, a greater number of instances may arise involving the need to estimate discounts applicable to a minority interest in a private company whereby a transaction is imminent.
Overview of Restricted Stock
Restricted stock of a public company is identical to freely traded stock except for temporary restrictions that preclude it from trading on the open market for a certain period of time. Such restrictions are contained in SEC Rule 144 (“Rule 144”), which governs the purchase and resale of restricted securities. A public company may issue restricted stock to accredited investors, as opposed to the general public, to avoid the costs of registering the shares with the SEC or to mitigate the increase in the company’s float that would occur with the issuance of a large block of stock at one time. These issuances may occur when a company is raising capital for an acquisition, for example.
Restricted stock studies compare the prices that investors are willing to pay, at the exact same point in time, for two otherwise identical securities, with one being fully liquid and the other having liquidity-related restrictions. The underlying transactions involve private placements whereby investors understand that because the stock is unregistered, it cannot be sold for a certain period of time. These investors also understand that market conditions could change, the stock price could decline, alternate investment opportunities may arise, or their investment profile may change. Consequently, investors seek a discount on their restricted stock investment relative to the freely traded stock price to compensate them for this holding period risk. The discount can be influenced by numerous factors, including time horizon for liquidity and investment risk, and the magnitude can vary based on the specifics of each individual transaction. The results of these studies serve as a useful starting point in assessing the discount for lack of marketability. Because an investor in a privately held company also faces liquidity restrictions, implied discounts in restricted stock transactions can be used to estimate the discount for lack of marketability applicable to a minority interest in closely held stock. This process typically involves:
- Identifying relevant restricted stock studies and observing trends in the level of discounts
- Analyzing the factors that influence the magnitude of restricted stock discounts
- Applying these factors to the specific characteristics of the subject interest
Expected Holding Period
There is abundant empirical evidence that an investor’s expected holding period is the primary determinant of the
magnitude of the marketability discount in restricted stock transactions. The impact of expected holding period on restricted stock discounts can be measured in two ways: (1) by analyzing trends in restricted stock discounts over time; and (2) by analyzing the expected holding periods of individual securities included in the restricted stock studies.
Trends in Restricted Stock Discounts
The decline in average discounts reflected in more recent restricted stock studies may be largely attributable to changes in securities laws that had the effect of enhancing the liquidity of restricted stock. Prior to 1990, institutional investors that purchased restricted stock and did not register the stock had a minimum holding period of two years before the stock could be sold in the public market. Average restricted stock discounts reflected in pre-1990 studies generally ranged from 30.0% to 35.0%. In 1990, the SEC adopted Rule 144A. Rule 144A enhanced the liquidity of restricted stock by permitting qualified institutional investors to trade unregistered securities among themselves. The increased liquidity resulted in lower negotiated restricted stock discounts. Average restricted stock discounts following Rule 144A generally ranged from 20.0% to 27.0%. In 1997, the SEC reduced the required holding period imposed by Rule 144 from two years to one year. Although there are few post-1997 empirical studies of restricted stock, the limited data available suggests that average restricted stock discounts were lower relative to previous studies.
2008 Amendment to Rule 144
Most recently, the SEC further reduced the required holding period for the resale of restricted securities for both affiliates and non-affiliates of a reporting issuer from one year to six months, effective February 15, 2008. This amendment was enacted with the stated objectives of increasing the liquidity of privately sold securities of public issuers and decreasing the cost of capital for all issuers without compromising investor protection.
A common criticism from the Internal Revenue Service is that the older studies are “outdated” and that greater weight should be accorded to the more recent studies. While these changes in securities laws and other market efficiencies have enhanced the liquidity of restricted stock, there has not been a similar change in the liquidity of privately held stock. Thus, as restricted stock has become more marketable, the marketability of privately held stock has remained largely unchanged. As such, the less liquid securities included in pre-1990 restricted stock studies may more closely resemble an investment in privately held stock relative to the more recent studies with shorter holding periods and lower discounts. In any event, the attributes of the subject interest being valued should be compared and contrasted with the subjects of the empirical studies to perform a meaningful analysis.
The SRR Restricted Stock Study
While numerous restricted stock studies have been completed in the past, there are a number of reasons why we are performing a restricted stock study. First, our study incorporates transactions from September 2005 through February 2010. This time period incorporates transactions in the few years before and after the most recent changes to Rule 144. Because there are a limited number of studies that have analyzed data following this most recent change, our study provides updated data and analysis to measure the impact of a shorter holding period.
Second, the time period we are analyzing includes the financial crisis of 2008 and 2009. Analysis of transactions during this time period may help quantify how restricted stock discounts change during different market environments and in periods of heightened volatility.
Third, previous studies have attempted to determine the correlation of different factors contributing to the size of restricted stock discounts, with varying degrees of success. Our goal is to provide a more robust and comprehensive study by including numerous ways to analyze factors such as size, growth, profitability, risk, and financial market conditions to determine which attributes are most highly correlated with the magnitude of restricted stock discounts.
Finally, in reviewing the underlying data of a few recently published studies involving transactions subsequent to the 2008 amendment, we have found that the data set did not appear to be screened carefully. For example, transactions involving start-up companies or companies in severe financial distress were included. To the extent the freely traded prices of these stocks are based on speculation, comparison to the prices observed in a private placement may produce unreliable results. Consequently, SRR is motivated to produce a high quality study with carefully screened transactions to ensure meaningful results. The criteria we used in our search are discussed in more detail below.
Procedures
The process of performing a restricted stock study is a substantial undertaking. The general process starts with screening for transactions of private placements of restricted stock. Our basic search criteria included the following:
- The transaction is a private placement of common shares
- The subject company is domiciled in the U.S. and trades on a U.S. exchange
- The transaction has been closed or rendered effective
We selected transactions that were announced between September 2005 and February 2010. This includes data before and after the latest change to Rule 144. Next, we refined the data by reviewing public filings for each offering to confirm the details, ensure accuracy, and verify that sufficient data is available to properly analyze each transaction. In addition, any transactions involving attached warrants, convertible debt, preferred equity, etc. were excluded so as to capture “pure play” transactions of common equity.
Finally, we carefully analyzed each transaction to determine if there are material reasons why the implied restricted stock discount could be attributable to factors other than lack of marketability. Certain studies have shown that private placements are often undertaken by companies with limited tangible assets, those engaged in speculative development of new products, and those in financial distress. The indicated discounts tended to be higher for these types of companies and some speculate these higher discounts are required on the stock of companies with these attributes to serve as compensation for the higher information and monitoring costs associated with the investments. This argument has been the source of a common attack on the use of restricted stock studies in estimating lack of marketability discounts. In order to diminish being susceptible to this line of attack, other criteria in our screening process included:
- Determining that the company is not a development-stage company
- To ensure that the company is not traded based on speculation, a minimum threshold stock price greater than $1.00 was established
- Financially distressed companies were excluded (e.g., companies with negative 5 year average operating income or EBITDA)
- To ensure we captured actively traded companies, we established a minimum 6 month average trading volume greater than 10,000 shares
Preliminary Results
So far, the outcome of our screening process has resulted in a data set of 127 private placement transactions. For each transaction, we calculated the implied discount by comparing the transaction price per share derived from the private placement to the stock price immediately prior to the announcement of the transaction. Based on the preliminary results of our study, the median and average discounts for the entire data set were 9.1% and 10.6%, respectively. The median and average discounts for 44 transactions occurring subsequent to the most recent amendment to the Rule 144 holding period were 11.0% and 11.7%, respectively. For 83 transactions occurring prior to the amendment, the median and average discounts were 8.8% and 10.0%, respectively.
Intuitively, we expect a decline in the discount to the extent the minimum holding period declined from one year to six months, but the following factors may have contributed to the results. First, increased market risk during the economic crisis of 2008 and 2009 may have led investors to demand greater discounts during this period of uncertainty and volatility. Second, we acknowledge that we reviewed fewer transactions subsequent to the change to Rule 144, which could have impacted the results. Finally, during our screening process, it became apparent that most of the private placement transactions were subject to registration rights agreements. Registration rights entitle the investors holding restricted stock to force the issuing company to register the shares, or a portion of the shares, with the SEC within some specified timeframe. The presence of these rights allows the investor to sell the shares to outside investors prior to the expiration of the minimum holding period established by Rule 144. However, we note that even though an issuer of a private placement may be obligated to file registration statements within a certain period of time, it is not certain how long it will take for the registration statements, once filed, to be declared effective by the SEC. We were able to determine the registration effective date for 94 transactions in our study. Of these transactions, the time between the filing of the registration statement and the registration statement being declared effective ranged from 0 days (effective immediately) to 166 days, with an average of 36 days. Accordingly, the impact of registration rights present in most of the transactions, while difficult to quantify, may indicate that the “effective” holding period did not change substantially despite the sixth month holding period reduction.
To further investigate the potential effects of registration on restricted stock discounts, we plotted the restricted stock discounts for the transactions in our study against the number of days from the close of the transaction to the registration being declared effective (i.e., this includes the number of days for the company to file a registration statement and for it to become effective). As shown in the graph above, there is no clear trend between the restricted stock discount and the number of days it took for the registration to be declared effective. We hypothesize two potential reasons for this. First, the effective days for registration are based on ex-post data (i.e., the number of days until the registration is declared effective is not known in advance). If an investor’s expectations for when a registration will become effective are significantly different from what actually occurs, or if investors do not believe they are reasonably able to forecast when a registration will become effective, we would not expect a significant trend in the restricted stock discounts.
Second, restricted stock discounts may be more heavily influenced by other factors specific to the private placement issuer related to investment risk. The next phases of our study will include statistical analysis performed on the underlying data to determine significance of various independent variables. We continue to review the underlying data to analyze the correlation of the magnitude of the implied discount to attributes such as size, risk, growth, profitability, industry, block size, and other blockage factors.
The following tables demonstrate examples of analysis of variables segmented by quartile including size (by market capitalization) and risk (by volatility). Generally, smaller and more volatile companies are perceived as having greater investment risk, which would warrant greater discounts. Note that we are still in the initial phases of our study and that certain outliers may be impacting the results. Further, we are analyzing a large number of data points since not all financial metrics will be meaningful for every transaction. In addition, we continue to explore the impact of registration rights and other contractual rights, since we believe that the presence of these rights decreases the effective holding periods and allows for other positive liquidity attributes.
Next Steps
SRR is performing ongoing research and analysis to study the impact on discounts related to the 2008 amendment to the Rule 144 holding period on restricted stock. We are focused on developing this empirical data to support discounts applicable to situations involving relatively short holding periods. Other motivations for performing this study include responding to IRS criticism of reliance on “old” data and satisfying the Tax Court’s desire for more quantitative evidence in estimating lack of marketability discounts. The final phases will consist of collecting a greater number of transactions, in-depth statistical analysis, and a peer review of our work. We are excited about this effort and look forward to publishing the full study by the end of the year.
