The quoted unit price of a publicly traded security is sometimes not definitive of fair market value for a specific block of the shares or bonds. Such a condition typically arises when the subject holding has impaired marketability. In such a circumstance the exchange quoted price of the security overstates the fair market value of the subject block. That is, the value of a block of stock or bonds may be less than the product of the number of units and the price per share or per bond in the public market. In other words, a discount (that is, a marketability discount) from the market price is indicated for the shares or bonds in the subject block.

Impairments to the marketability of the securities of public companies commonly result from the following factors:

  • The absence of registration under Securities and Exchange Commission Rule 144
  • The presence of a contractual restriction on resale, such as a lockup agreement
  • Thin trading volume of the public security relative to the number of shares or bonds in the subject block

SEC Rule 144 imposes restrictions on the resale of securities of public companies that are issued without the benefit of a registration statement. The unregistered shares of a public company must typically be held by an investor for a minimum of one year before they can be sold into the public market. After the one year holding period is satisfied, public sales of the unregistered shares are subject to volume limitations for an additional year. Sales in private placement transactions of unregistered securities to entities qualifying as sophisticated investors under SEC regulations are permitted, but the minimum holding period and volume limitations regarding resale in the public markets start anew each time the securities change hands.

Lockup agreements frequently apply to shares received by sellers in mergers and acquisitions. Such agreements specify conditions under which the subject shares may be resold and may impose outright prohibitions on any resale for some specified period.

Volume blockage issues arise when the number of shares or bonds in the subject block is large relative to the daily trading volume in the public market. Such a circumstance often implies that liquidation of the block would likely have to occur over a protracted period in order to avoid creating an oversupply which would depress the market price of the security. Liquidity may be impaired due to block size even if the subject shares are registered and no contractual restrictions on resale apply.

One, two or all three of the preceding impairments to liquidity may apply to any given block of securities. For example, the marketability of a block of registered shares may be impaired by the presence of a lockup agreement or other contractual restriction as well as large size relative to recent trading volume. By the same token, a block of stock for which volume blockage or contractual restrictions are not present may not be freely tradable in the public market due to lack of registration under Rule 144.

Guidance on valuing unregistered or restricted securities of public companies for Federal tax purposes is provided in Revenue Ruling 77-287. A valuation under this pronouncement (essentially the determination of the appropriate discount from the quoted market price) requires consideration of the various limitations and enhanced rights attaching to the subject block and the financial condition of the issuer. The marketability discount is quantified by reference to the discounts documented in various published restricted stock studies which analyze the pricing of sales of restricted stock relative to the market prices of otherwise identical freely tradable shares in historical, publicly reported transactions.

An alternative methodology for quantifying the discount relative to the market price of the subject security is the use of an option pricing model to estimate the cost of hedging the price of the security during the period of illiquidity implied by Rule 144, or by any contract or during the period required to conduct an orderly liquidation in the case of volume blockage.

In addition to impaired marketability, a subject holding of securities issued by a public company may carry with it features which further distinguish it from the issuer’s registered securities. Common and preferred shares may lack voting rights. Debt securities and preferred stock may lack the protective covenants or priority of claims attaching to their registered counterparts. Conversion rights and redemption provisions may differ. When valuing nonregistered securities, it is important to consider all characteristics of the subject security which may differ from the issuer’s publicly traded stocks and bonds and reflect those differences in the valuation of the subject security. In these cases it may be necessary to go beyond merely applying a marketability discount to the quoted exchange price of a stock. For example, if the issuer’s public debt is better secured or has better call protection, pricing a minority issued note to yield a rate representative of an incremental return for lack of marketability plus the market yield on the issuer’s publicly traded debt securities of similar maturity may overstate the note’s fair market value.

Clarity regarding the fair market value of privately issued securities of public companies is essential in the following situations:

Estates and Gifts

The presence of a block of such securities in an estate and a transfer of same may entail an overpayment of taxes if the quoted market price is applied without consideration of impaired marketability or of other differences relative to the issuer’s public securities.

Mergers and Acquisitions

If the securities issued by the purchaser to the seller do not qualify for a capital gains rollover and a capital gains tax liability is realized at the closing of the transaction, an excessive capital gains tax liability may be calculated if the quoted market price is applied without consideration of impaired marketability or of other differences relative to the issuer’s public securities.

In addition, comparisons of offers by competing bidders or comparisons with the pricing of other transactions may be misleading if quoted market prices are applied to securities offered as purchase consideration without considering impaired marketability or other differences relative to the issuer’s public securities. Similar valuation issues may also arise in a variety of other situations, including corporate reorganization transactions, marital dissolutions, bankruptcies and transactions involving trusts.

Simply applying the market price of an issuer’s publicly traded securities to the shares or bonds in a given block may provide a deceptive indication of value leading to faulty tax and investment decisions. Mercer Capital has substantial experience in valuing the unregistered shares, restricted stock and other privately issued securities of public companies and in determining block size discounts. Please call us if you have a question in this area.

Reprinted from Mercer Capital’s Value AddedTM – Vol. 10, No. 3, 1998.