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The
2001 Marketability Discount Study Copyright 2002 by Brian K. Pearson CPA/ABV/PFS, ASA Because the IPO market as a whole slowed significantly in 2001, our third annual study of the Discounts for Lack of Marketability in Initial Public Offerings (IPOs) was much smaller than in prior years. This is graphically illustrated in table 1, which lists the number of IPOs each year since 1996. Further, we excluded some of the 93 IPOs in 2001 from our study since they were foreign companies or non-corporate entities (for example, either ADR's or limited partnerships).
We used the same parameters as we used in our two previous studies, the results of which were published in the Spring 2000 and the Summer 2001 issues of CPA Expert. Our study separates marketability discounts into periods of three-month intervals for the 12 months immediately before an IPO, and a single period for the timeframe from one to two years before the IPO. Only 50 companies (with 117 transactions) met our criteria to be included in the 2001 study, down from 235 companies last year. This lower number of companies going public was largely a result of the downturn in capital markets and the economy. With stock prices falling, individual investors, venture capitalists, and investment bankers were less interested in funding riskier investments like IPO's. Also, few industry sectors showed strong financial performance or promise, thereby denying underwriters the needed investor enthusiasm for purchasing shares in companies in these industries. Although there were fewer IPO's in 2001, the companies going public last year were generally larger than in prior years. In 2001, the median revenues of the companies in our study were more than $72 Million, compared with only $10 Million in 2000. Median operating Income was also higher, averaging over $2 million, compared to negative operating income in 2000. Median assets were also up to $137 million in 2001 from $31 million in 2000. We used median figures because of our smaller sample size and a few very large deals in 2001 made the averages of these figures even larger. By these simple measures of company size, we can see that the 2001 IPO market shifted from small technology companies with a potential "big idea" to larger, more established companies with a longer history of financial performance and thereby lower perceived risk (for both investors and underwriters). This shift is logical following the drop in value of the technology sector specifically, and the stock market in general. New IPO Environment's Impact on Discounts What effect did this change in the IPO environment have on marketability discounts? In general, it lowered them. The overall discount for transactions within one year of going public, including convertible preferred stock (CPS), was 22.41%, down from 47.07% in 2000 as is shown in table 1.
Using only discounts in the narrowed 10%-90% range (in order to reduce the impact of "cheap stock or options" and "premiums" due to changing market conditions), we found the average discount was 40.84% (as seen in table 2), compared with 52.44% in 2000. This shows that in 2001, there were a high number of premiums paid on pre-IPO transactions. Eliminating the discounts of less than 10% (often these were actual premiums) or greater than 90% nearly doubled our average discount. Looking at the data, we see that 17 transactions (within one year of the IPO date) were not in the 10%-90% discount range. Of these transactions, 16 fell in the "below 10%" category, while only one transaction occurred at a 90% or greater discount. Additionally, 10 of the 16 "below 10%" transactions were premiums, or negative discounts. Those 10 premium transactions amounted to 14.7% of the total number of transactions (within one year of the IPO date) in this year's study. Last year only 5.22% of total transactions were premiums.
Lower Prices While the size of the companies going public increased, the prices investors were willing to pay decreased. A premium (or lower discount) can occur when a company is forced to offer its shares to the public at a price lower than expected (because of poor market conditions) or the company's valuation is declining (possibly because of poor industry conditions). Thus, certain prior transactions in the company's stock were done at higher valuations, or the anticipation of higher valuations. The same dynamics that cause average investors to be more risk averse make it easier for larger companies to go public, since they are perceived as having less risk. Investment bankers make money by taking companies public. So if investor risk tolerance shifts, investment bankers will shift the focus of their efforts to companies with lower perceived risk (that is, larger companies). Nonetheless, even larger companies had difficulty selling shares. The result was that even more established companies had to offer shares in their IPO at lower prices than originally expected. This factor combined with the smaller sample size resulted in the overall lower discount from prior years. Stock and Stock-Option-Only Transactions To review the stock and stock-option-only transactions, we removed the CPS transactions from tables 1 and 2. This gave us an average discount of 23.86%, and for the narrowed range, the average discount was 42.76%. Like last year's results, this year's results without the CPS discounts were in line with what we saw when they were combined with the stock and option discounts. This is shown in tables 3 and 4.
The lowered discounts seen across the board in this year's study reflect the fact that IPOs were not in demand by the investing public as in prior years, and thus investors were unwilling to pay higher stock prices for anticipated future growth. This year's results are helpful because over time fluctuations in the stock market will lead to better marketability discount results due to a larger number of studies occurring over different periods of time reflecting both ups and downs in financial market conditions, economic conditions, interest rates, and investor expectations. As we discussed in our 2000 study, during times of prosperity, companies (underwriters) raise their IPO price, in turn inflating the size of the marketability discount. In 2001, we saw the opposite situation: Companies were offering shares at reduced prices because of poor financial market and general economic conditions, resulting in lower discounts or even premiums on pre-IPO transactions. Over time, these fluctuating discounts balance out, and the results provide a better indicator of "average" marketability discounts. Since we are
valuing companies at a point in time, however, it is our job as
valuation experts to assess the effect of current market conditions
(underlying the discounts) on the value of companies. The lower
marketability discounts in 2001 reflects favorably on the quality
of the companies that went public (that is, riskier companies generally
couldn't do an IPO in 2001). This doesn't necessarily mean that
marketability discounts are now lower. In fact, some might suggest
this data means that the discounts are even higher for smaller companies,
since they may have an even more remote chance of going public.
Also, it's generally harder to sell companies in a recessionary
environment. Whatever your position on this issue, it is clear that
even "higher quality" companies' shares changed hands while still
privately owned with significant marketability discounts. Recruiting | Links | Home  |
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