A Simple Method for Estimating the Marketability Discount of Large Blocks of Shares
The value of a controlling block of shares depends largely on its marketability. The lack of marketability results in a marketability discount, which is inherently difficult to value due to its raison d'être: the illiquidity of the market for controlling stakes. This illiquidity is the result of three different forces: the difficulty of finding a buyer that could increase shareholder value after taking over; the occurrence of unexpected events that may force a blockholder to sell immediately; and, in the possibility of having to sell the block at a fire sale price following such events. Theoretically, illiquidity affects the block value in a complex, possibly nonlinear way. Empirically, illiquidity reduces the number of observations available to the econometrician and constrains the empirical strategy of estimating the block value.
To date, there are no estimates of the marketability discount that consider these illiquidity costs. This glaring lack of estimates is surprising for two reasons. First, the need to price these dimensions of illiquidity is not new. In the famous case of Mandelbaum et al. v. Commissioner of Internal Revenue (1995), the court points to the lack of evidence on the proper size of the discount on the value of large blocks relative to the value of exchange traded shares. Second, the predominance of high ownership concentration as a form of corporate governance is by now well established. High ownership concentration is a pervasive phenomenon in public corporations in many countries, including the United States. It is also, by definition, an integral part of privately held corporations.
In this paper, we review the model and estimation of the value of large blocks of shares in public corporations developed in Albuquerque and Schroth, which accounts for the market illiquidity costs listed above. From its results, we develop a simple method to estimate the marketability discount for both firms that are publicly traded and for privately held corporations. We illustrate the application of our method for privately held corporations to the case of Mandelbaum et al. v. Commissioner of Internal Revenue.
The precise valuation of controlling blocks of shares, or of completely privately held companies, must recognise the complex effects of the illiquidity of the market for corporate control. While it is possible and necessary to solve and estimate a model that spells out this complexity, it is also necessary to devise a way to use the model's results in a straightforward way. We describe a method to value large, controlling blocks of shares by simply applying a discount on the exchange-traded share price, when publicly available, or on the value obtained from a standard valuation exercise that assumes full liquidity, when the company is only privately traded. Besides its simplicity, two other important strengths of this method are that (i) it allows for firm, industry and macroeconomic determinants of liquidity to affect the marketability discount, and (ii) it can be quite accurate relative to the more exact approach in AS with remarkably little data.
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