Liquidity refers to the ability to readily convert an asset, business, business ownership interest, security, or intangible asset into cash without significant loss of principal.[1] Illiquidity, therefore, is the inability to readily convert an asset, business, business ownership interest, security, or intangible asset into cash without significant loss of principal.
Marketability refers to the capability and ease of transfer, or salability, of an asset, business, business ownership interest, security, or intangible asset.[2] Illiquidity factors reduce the marketability of an investment. The difference in value between a liquid investment and an illiquid investment is commonly referred to as the discount for lack of marketability (“DLOM”).
When selecting a DLOM, appraisers will often reference restricted stock studies (such as those conducted by Management Planning, Inc., FMV Opinions, Inc. (now Stout), Bruce Johnson, etc.) as a source of quantitative data to develop their concluded DLOM. However, these studies are based on, and relate to, estimating a DLOM for non-controlling ownership interests. When valuing an ownership interest in a privately held company (even a controlling interest), there are still illiquidity factors that must be considered. Selling a company or the controlling interest in a company takes time, can be costly, and the results are uncertain.
According to Shannon P. Pratt’s Valuing a Business,[3] there are five transactional factors that affect the illiquidity of a controlling ownership interest:
- Time to close
- The amount of time it takes to sell the company or the controlling ownership interest is uncertain
- Professional/administrative costs associated with the sale of controlling ownership interest
- Auditing and accounting fees to provide the purchaser with sufficient and reliable financial information
- Legal costs to negotiate the transaction and create necessary transaction documents and agreements
- Investment banking or other brokerage fees to market and sell the controlling ownership interest of the company
- Uncertainty regarding the eventual sale price of controlling ownership interest
- Risk regarding the actual price realized from the sale of the controlling ownership interest (the purchase price paid in a transaction is often different than the value of an ownership interest determined in a business valuation because a business valuation is an estimate)
- Form of transaction consideration
- Transaction consideration may be in a form other than cash such as: contingent consideration, a seller note, or the purchaser’s stock. These alternative forms of consideration may have a cash equivalency value below the stated value
- Inability to hypothecate controlling ownership interest
- Banks rarely allow the owners of a business to use the company’s stock as collateral for a loan, even if the value of the company’s stock is derived from an expected transaction sale price
Restricted stock studies are often referenced as a quantitative source of data for selecting a DLOM when valuing a non-controlling ownership interest. However, when valuing a controlling ownership interest, other illiquidity factors associated with a hypothetical transaction should be considered.
[1] Definition from the American Society of Appraisers, ASA Business Valuation Standards
[2] Ibid.
[3] 5th Edition.
