In Brief

Many privately held companies treat their stock as if they were public companies, but such stock is less liquid than if it were traded publicly. This lack of liquidity can create complications when valuing shares in the entity. The author demonstrates his newly developed method for calculating this discount, which takes both call and put options into account when making its calculations.

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The valuation of a privately held business seems simple at first glance; the value should be equal to the per share value of the stock multiplied by the number of shares. Private companies, however, muddy the issue, as their stock is considered less liquid—that is, less readily able to be converted into cash—because it is not publicly traded. To account for this, valuation professionals apply a discount for lack of marketability (DLOM). There are several methods of calculating such discounts; this article introduces and explains a new method created by the author: the Predictive Illiquidity Process (PIP).

Basics of the PIP

The PIP is a new model developed out of a desire for an easy-to-use, reliable, and defendable approach to calculating a DLOM for privately held entities. The PIP is a two-step process; the first step uses a discount determined from both calls and puts on publicly traded stock options known as long-term equity anticipation securities (LEAP), while the second step involves assigning additional discounts from a list of key value-creating factors that are likely lacking in the privately held entity being valued. For example, the typical privately held entity will never have the brand name recognition of Starbucks or Nike.

Prior LEAP valuation discount models have used puts only, whereas the PIP uses both calls and puts. Calls are included because this author believes they are more representative of the creation of liquidity in the theoretical sale of a business. Puts generally only lock in the current price or something less, but do not provide their holder a higher price; this only protects the current value of the investment.

Calls, on the other hand, allow call buyers the right to “call” away shares at a higher price in the future. This is equivalent to a business owner indicating he is willing to sell his shares (i.e., his business) at a higher known price in the future. If the business value (i.e., stock price) increases to that level, the call buyer can call away the shares; if that were to happen, the business owner essentially would have received the asking price for his business. An example will demonstrate the difference between a call and a put.

Calls versus Puts

Suppose the stock market value of a large home goods company, National Home Goods (NHG), is approximately $6 billion. For comparison, a regional home goods chain called Suzi’s Home Goods (SHG) has a total stock value of $6 million. SHG has 150,000 shares outstanding, and thus has a per share value of $40. The company founder, Suzi Abrams, owns 100% of the company’s common stock. For simplicity, assume that SHG’s stock’s beta is the same as NHG’s, or approximately .82 (a beta less than 1.0 means less volatility than the overall stock market, and therefore likely lower discounts). Similar to NHG, SHG pays an annual dividend of 50 cents, or 1.25%.

Using NHG’s two-year LEAP call and put prices and applying them to SHG, a simple outcome-based model can be developed to decide whether Suzi should consider buying a put or selling a call. Suzi can protect her current $40 per share value by buying puts, or potentially sell her shares (i.e., the entire company) at a higher value by selling calls. Exhibit 1 uses the $40 per share strike price on two-year LEAP calls and puts for NHG as a proxy for Suzi’s decision.

Exhibit 1

Example Call/Put Comparison

Suzi's Home Goods Price per Share: $40.00 Shares Outstanding: 150,000 Annual Dividend Paid: $0.50 per share or 1.25% Current Fair Market Value: $6,000,000 Put Price for a 2-year LEAP: $6.25 Call Price for a 2-year LEAP: $6.25 Possible Outcomes Stock Price in 2 years; $30; $35; $40; $45; $50 Put cost; ($937,500); ($937,500); ($937,500); ($937,500); ($937,500) Business sold; No; No; No; No; No Business value; $6,000,000; $6,000,000; $6,000,000; $6,750,000; $7,500,000 Proceeds to Suzi—Put; $5,062,500; $5,062,500; $5,062,500; $5,812,500; $6,562,500 Call proceeds; $937,500; $937,500; $937,500; $937,500; $937,500 Business sold; No; No; No; Yes; Yes Business value; $4,500,000; $5,250,000; $6,000,000; $6,000,000; $6,000,000 Proceeds to Suzi—Call; $5,437,500; $6,187,500; $6,937,500; $6,937,500; $6,937,500 Call proceeds in excess of put proceeds; $375,000; $1,125,000; $1,875,000; $1,125,000; $375,000

The cost of buying the two-year LEAP puts for SHG is $937,500 (150,000 shares at $6.25), and likewise, the proceeds from the sale of the two-year calls are $937,500. The LEAP call and put prices are identical at the $40 per share strike price, as NHG’s stock price is very close to the $40 option strike price at the date of the example.

Exhibit 1 shows the outcomes to Suzi are better over the next two years by selling calls, not buying puts, as long as the per share value of SHG’s stock price does not go either up or down by more than $12.50 per share, or a 31.25% change in company value in either direction. It also demonstrates why, under typical market conditions (i.e., normal levels of market volatility), calls will provide a better financial outcome to business owners: they provide a premium over current stock price (i.e., company value), which is typically desired by an owner selling a business. Compared to the put, the call provides a (possible) higher future stock value.

Although the above example clearly shows why calls are likely a better representation of obtaining liquidity in the context of the sale of a business than puts, if the stock price is equal to the LEAP option strike price, and the options have the same time duration, the call and put prices should be the same. Any difference in the option price is the markets’ expectation of the likely future direction of either the company’s prospects or the stock market in general.

Measuring LEAP Discounts

For the past four years, the author has tracked the LEAP option call and put prices for a proprietary sample group of 30 large, well known, publicly traded companies. The sample group represents a broad cross-section of actively traded companies in industries including retail, banking, technology, energy, infrastructure, entertainment, healthcare, defense, consumer products, and insurance. The discounts have been counted over three separate time periods: six months, one year, and two years. The size and diversity of the large company group provides a good market-based indicator of such discounts. In addition, to track market-neutral discounts over the same time periods, the author also calculated the discounts for LEAP calls and puts from select companies on three market-based indexes: the Dow Jones, the S&P 500, and the Russell 2000.

As shown in Exhibit 2, the large company group had discounts well in excess of the market-neutral indices for the same time periods, even though the median stock market equity capitalization of the large company group is slightly over $50 billion. The large company discounts exceeded the market-neutral index discounts by approximately 77%, 65%, and 50% for the six-month, one-year, and two-year time periods; thus, their implied illiquidity risk was significantly higher than the index-based group. It is also interesting that the large company group’s combined average beta over the past two years has averaged 1.09, versus a presumed market beta of 1.0 for the market-neutral index group. This would seem to indicate that only a small percentage of the large company discount is being accounted for by these companies’ implied volatility, as compared to the market-neutral index group. The remaining discount presumably reflects the business risks of the underlying stocks of the large company group.

Exhibit 2

LEAP Call and Put Monthly Discounts

6 Month; 12 Month; 24 Month Large Company Public Group Low; 7.76%; 10.63%; 19.90% High; 12.23%; 22.20%; 36.84% Median; 8.96%; 13.66%; 22.94% Market Neutral Index Group Low; 3.97%; 6.15%; 8.99% High; 6.37%; 10.50%; 19.08% Median; 5.04%; 8.27%; 15.35% Median Increment; 3.92%; 5.39%; 7.59%

The usefulness of the LEAP call and put discounts is that they are market-based measures of liquidity—what multiple buyers and sellers have agreed upon as a price whereby they would relinquish or acquire shares in the future.

Value Creation Factors

Similar to using the risk-free rate as a starting point in determining a discount rate, the LEAP option discounts provide a good market-based foundation for the first step in determining a DLOM. The LEAP discount selected in step one of the PIP should be based on the expected timetable to liquidity for the entity or ownership interest be valued. If the expected liquidity timetable is beyond 24 months, the 24-month discount should nonetheless be a good starting point.

The second step in the PIP is to consider discount factors specific to the entity being valued compared to the publicly traded sample group. The list of value creation factors in Exhibit 3 was developed to allow determination of a specific company illiquidity discount; it is designed to clearly distinguish the weaknesses of a privately held entity compared to a world-class publicly traded company, such as Microsoft, Disney, or Starbucks (each of which is in the sample group). These weaknesses lessen the private entity’s investment attractiveness, thereby increasing its lack of marketability. The benefit of the factors is that they force users to account for what would make it more difficult to sell a privately held entity beyond market-based risks, which have already been considered using the LEAP discounts in step one.

Exhibit 3

Value Creation Factors

Multiple products or services with recurring sales and not subject to cycles A company organizational structure with capacity to grow Products or services resilient to technological change or obsolescence Deep and talented operating and financial management Durable competitive advantages Predictable cash flows with low capital intensity Brand recognition or other attractive intellectual property A high return on assets and invested capital A strong balance sheet and access to capital Favorable industry conditions Research and Development work and the ability to make acquisitions A lack of legal restrictions and ownership impediments

The value creation list is derived from the author’s valuation and investing experience and the work of numerous other professionals on what creates a desirable investing moat and unique competitive advantages. A competitive advantage is a feature that allows a company to enjoy higher profit margins and earn higher returns than its competitors, and an investing moat represents a sustainable competitive advantage over time. Such attributes make a company a much more attractive investment, increasing its marketability. The lack of these attributes would conversely make a company a less attractive investment, and therefore more illiquid. Clearly, most privately held entities will have some level of discount in each category. This author’s firm assigns discounts of up to 3% in each of the 12 categories on the list. The value creating factors can be modified to reflect the user’s professional experience on what separates a world-class company from a typical privately held entity.

Two items are worth noting here. First, the final factor (“a lack of legal restrictions and ownership impediments”) is often ownership-level specific, while the others are more company specific. Second, valuation analysts must be careful not to double-count any similar factors already considered in the income method discount or capitalization rate.

As an example of how to use the value creation factors list, think of a local pizza chain, Hometown Pizza, compared against Domino’s Pizza, as analyzed in Exhibit 4. This example presumes a 5% interest is being valued, but the minority aspect is not considered. This is not a pizza quality comparison, as many local chains make great pizzas. But Domino’s has over 13,000 locations internationally with over $10 billion in system-wide revenues, serves over 1 million pizzas a day, has 50% of total revenues coming from digital ordering channels, has a 15% U.S. pizza market share, and owns over 100,000 pizza delivery vehicles. In other words, it is a world-class pizza preparation and food delivery company.

Exhibit 4

Example Value Creation Factor Analysis

Hometown Pizza versus Domino's Discount 1%; Multiple products or services; More than likely a local pizzeria will have a good following, offer good quality, and therefore generate recurring sales. Besides pizza, it will likely offer chicken wings/fingers, possibly submarines/heroes, and a few desserts. It may have a liquor license and offer some craft brews. The wider the selection here, the better, to the extent the quality is good. It may lack some innovative product offerings compared to a national chain (e.g., stuffed crust). 3%; Organizational structure with capacity to grow; Usually the local chain will have an owner, operating manager, and store managers. It may also have a CFO. It rarely has a product or store development person that affords further growth outlook beyond its market territory. 2% Resilient to technological change; Most would think pizza is not affected by technological change, but that is changing. Examples include ordering via text, Facebook Messenger, mobile apps, Apple Watch, or Twitter; social media marketing; the latest in oven technologies and pizza making to make better, faster pizzas; delivery tracking; build-your-own-pizza; mobile pizza-making vehicles; and third-party delivery services. 3%; Deep and talented management; While the owner/managers may indeed be talented, they rarely have a “deep bench” of management talent. Domino's has a technology team of over 400 people working on ordering and delivery. 3%; Durable competitive advantages; While a local pizzeria may have a good reputation, that alone is not a durable competitive advantage. 1%; Predictable cash flows; A pizzeria with a good reputation provides predictable cash flows and is usually not very capital intensive, especially if periodic improvements are made. 2%; Brand recognition; It will have significant brand recognition in its local market, but very little to zero recognition in other markets. 1%; A high return on assets; This metric will increase over time for a local chain as leverage decreases and initial capital intensity wanes. There is no incremental margin leverage, however, without unit expansion, as food costs cap such amounts. 2%; A strong balance sheet; Most closely held chains operate as pass-through entities and rarely maintain significantly more capital than is necessary beyond normal working capital needs. The businesses typically operate as a lifestyle provider to the owner. 3%; Favorable industry conditions; Industry conditions are not usually favorable given the low barriers to entry, price competition, constant couponing, and national competitors for both pizza and all other fast foods. 2%; R&D and ability to make acquisitions; It is rare for a local pizzeria to introduce a novel product; usually they simply mimic larger national chains. Likewise, national chains can mimic local products that do become successful (e.g., buffalo wings, gluten-free crusts, non-GMO ingredients). Local acquisitions are very rare for growth, as de novo expansion is easier. 2%; A lack of legal restrictions and ownership impediments; Other than possible zoning restrictions and periodic food inspections, government regulations are usually light for pizzerias. Recent healthcare legislation may make growth more costly. This is usually addressed via ownership classes (voting and nonvoting), buy-sell agreements (restrictive or nonrestrictive), or multiple layered entity ownership. Typically, a closely held company has one of these restrictions. This example presumes only a restrictive buy-sell agreement. 25% Total Discount

CPAs should never simply use a model or formula for calculating a DLOM in place of professional judgment.

Using a presumed timetable of 18 months to liquidity for Hometown Pizza, the midpoint of the one- and two-year LEAP stock option discounts, or approximately 18%, is used as a starting point. Next, as shown in Exhibit 4, the specific company illiquidity discount is 25%. Combining this value creation factor discount with the 18% LEAP stock option model discount arrives at a DLOM of 43% for a small equity interest in Hometown Pizza.

Illiquidity outside of financial market crises is typically company specific. The less attractive a company’s future prospects, the more difficult it will be to retain and attract investors. In publicly traded companies, this process plays out when sellers exceed buyers and the company’s stock price declines until market equilibrium occurs. Step two of the PIP is designed to accomplish the same result for a privately held entity by highlighting certain entity deficiencies that would likely raise investor concerns. Such concerns assist in determining the discount necessary to establish a value that represents the shares fair market value on a presumed liquid basis (i.e., after the DLOM).

Showing the Math

As professionals, CPAs should never simply use a model or formula for calculating a DLOM in place of professional judgment. There is no one “right answer,” but instead only the answer that is most intellectually defendable. In Berkshire Hathaway’s 2016 annual report to shareholders, Warren Buffett stated, “Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover—and this would apply even to Charlie [Munger, Berkshire Hathaway’s vice chairman] and me—will almost inevitably come up with at least slightly different intrinsic value figures.”

Likewise, valuation professionals, even with the same set of facts, will likely calculate somewhat different DLOMs. If, however, professionals start with a reliable market-based discount from the LEAP discounts, and then consider the key factors that make businesses attractive investments, professional judgement can be demonstrated in arriving at a DLOM by differentiating such attractive factors from the privately held entity being valued. This author hopes that the PIP provides readers with a reliable tool for the determination of a DLOM.

Brian K. Pearson, CPA/ABV/CFF/PFS, ASA is managing member of Valuation Advisors LLC, Williamsville, N.Y.