5.3 Discount for lack of liquidity (marketability discounts)
It is common knowledge that the shares of publicly traded companies have a ready and usually liquid market. This liquidity allows such shares to find their value in the public market on the usual economic basis of supply and demand. The challenge for a business valuator valuing the shares of a private company, which are seldom liquid, is that fair market value, by definition, requires (notionally) an “open and unrestricted market.”
The lack of liquidity of private company shares is dealt with by CBV’s in various ways. One way is to value the company, if it is sufficiently large, as if it were public and then apply a liquidity discount. Alternatively, especially for smaller companies, allowance is made in the build up of the capitalization rate for the fact that the company is small and illiquid. In cases where the company is both small and has a very limited market for its shares it may be necessary:
- to incorporate a small company premium in the cap rate, and
- to apply a discount for lack of liquidity to the final value.
Many private companies, if put up for sale, could take many months, if not years, to sell. The lack of immediate access to the sale proceeds needs to be reflected in the conclusion of fair market value.
The fair market value of unlisted shares is impacted by their lack of liquidity.
The concluded fair market value of any share needs to reflect the full risk of an investment therein. The CBV therefore needs to ensure that the effective yield on the investment recognizes both:
- the intrinsic risk in the business itself, and
- the risk that the shares themselves may not trade readily.
The expected time to liquidity will be different for every private company and will depend on the existence of likely purchasers. The liquidity discount is therefore case specific.
Contact MVI to discuss the liquidity issues that may impact the FMV of your private company shares.