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2000 MARKETABILITY DISCOUNTS AS REFLECTED IN INITIAL
PUBLIC OFFERINGS
Copyright 2001 by Brian K. Pearson CPA/ABV/PFS, ASA We recently completed our second study on the Discounts for Lack of Marketability. Our study was of Initial Public Offerings (IPOs) in 2000. The study used the same parameters as our 1999 study (1), which was also published in CPA Expert. Our study separates Marketability Discounts into periods of 3-month intervals for the 12 months immediately before the IPO, and into a single period for the timeframe from 1- 2 years before the IPO. A sample of our study results is listed below. In addition, this year we added a few new features to the study. First, we tracked the discounts on transactions of convertible preferred stock ("CPS"). We used the same 3-month measuring periods as those used for common stock and options. Not surprisingly, the CPS discounts were similar to those of common stock. Second, we tracked those transactions that fall outside our "range" of discounts for inclusion in the study (our so called "narrowed discount range"). Our narrowed discount range is for those discounts from 10% to 90% of the IPO price during the 2-year period prior to the IPO. We exclude transactions outside this range because they may be either "cheap stock or options" or may be at a premium due to changing market conditions. This aspect of the study will be discussed in greater detail later in this article. Table 1 shows the overall results of our entire study (both common and preferred stock, and all discounts and premiums) for 2000. The overall discount for the entire 1-year period averaged 47.07%. When we simply include those transactions in the middle-range (Table 2), the average 1-year discount increased to 52.40%. When we exclude the CPS transactions, the narrowed discount range for common stock or options only (Table 3), falls to 49.76%. This is down from the 1999 figure of 52.44%. This would likely indicate that there were more premiums paid than large discounts on pre-IPO transactions in 2000.
Table 4 shows the results for the CPS only discounts. With the exception of the first three months, every other CPS period, compared to the common stock only transactions, shows a reasonably larger discount. This may be partially explained by the fact that these transactions are typically at larger dollar amounts than the majority of the common stock and option transactions, thereby allowing the venture capital firms engaging in such transactions to negotiate better deal terms. Also, to the extent that common stock based transaction use CPS transactions as a benchmark, the common transactions are usually priced higher thereafter, even though they may fall in the same three-month period.
Table 5 shows the number of premium transactions by quarter. A review of these transactions showed that the majority of these transactions Occurred during the third quarter. What causes premiums to occur? For those companies that were not "hot" offerings (i.e. those whose shares are oversubscribed in the offering), the only way to complete an IPO as the year progressed was to lower the IPO price(2) and sometimes more than once. (3) As the IPO price was lowered to generate additional interest necessary to complete the offering, the lowered price often ended up being lower than prior prices for options, and common and preferred stock already issued or sold. Primarily, more difficult capital markets for an IPO. Generally, as the stock markets fell as the year progressed, investors became more selective in investing in IPOs(4). Thus, many companies lowered their offering prices to complete an offering in the third quarter while the IPO window was still open. By November, half the 2000 IPOs were trading below their IPO price.(5) Essentially, as investors became more selective, they were less willing to pay higher valuation multiples for all companies.
This raises an interesting issue. Some valuation professionals have argued that the IPO studies calculating Marketability Discounts overstate discounts since IPOs overstate the true "Fair Market Value" price of a company’s shares. In general, I would argue this is simply not true. First, in both 2000 and early 2001, a number of companies had to lower their offering prices to go public. Over time, this tends to offset raised offering prices in better markets. Second, in 2000 a number of companies cancelled their offerings because the IPO market simply dried up. Table 6, which is reproduced from IPOMonitor.com, shows a chart by quarter in 2000 of IPOs and those companies that withdrew their offerings. There were 422 IPOs in 2000, and 232 offerings that were withdrawn. Thus 35% of all companies filing offerings never made it public. None of prior lack of marketability studies (including ours) captures the presumed increase in lack of marketability in those companies whose offerings were cancelled or withdrawn. Third, once an IPO is cancelled, the company may be viewed differently by other potential investors, who know one avenue for liquidity is closed, maybe permanently. According to a study by finance professor Craig Dunbar, only 10% of failed IPOs ever manage to go public at a later date.(6) Fourth, to the extent a failed IPO means the Company does not have funding to complete its business strategies, its "attractiveness" to investors as a competitor in its industry is lessened. "Withdrawing an IPO is usually a crippling event, even if the company doesn’t realize it at the time."(7) Ironically, these drawbacks must be weighed against the likelihood that the Company may now seek a buyer for itself as a strategy to continue growth, thereby creating liquidity for investors.
Based on the large number of companies that file and don’t go public, and those that simply will never be able to go public, one can argue the discount for a private company could be higher than the averages in this study. For example, in poor markets, any IPO takes longer. According to alert-IPO.com(8) , "Companies that priced IPOs in March this year had spent an average of about 73 days in registration, but in October the average number of days surged to 161." If we assume the average IPO process (from filing to successful offering) takes approximately six months, a way to calculate this additional lack of marketability is to look at the difference between six month intervals of our study. The discount difference between the 181 - 270 day period and the 1-2 year period was approximately 15.14% in 2000 and 11.35% in 1999. Since in both years, the discount for the 181-270 day period is considerably greater than the average discount for all time periods, this may be a good base period to use in looking at the discount for an additional theoretical 6 month period. Clearly, the companies in our study are more liquid to an investor than the average privately held company valued. Thus, for an "average" privately held business, this may be one approach to capturing the potential additional lack of marketability that we need to consider further. Similar to last year, we have also classified all our transactions in the study by NAICS code. At Table 7, we present the companies included in the NAICS categories "Chemical Manufacturing" and "Computer and Electronic Product Manufacturing." The discounts by NAICS category varies with the number of transactions in that category, as well as the timing of the transaction (i.e. first vs. fourth quarters). We presented these two categories because both had sufficient transactions for each time period.
Another interesting fact that can be gleaned from the study is the nature of the "hot" market for IPOs in the first quarter. This can be seen at Table 8 which separates the transactions by calendar quarter. In the 3 months just prior to the IPO, the first quarter discount was 41%, whereas the next two quarters were in the low 20% range, and the final quarter was 16.36%. This shows how IPO prices were typically raised by underwriters in the first quarter, mostly maintained in the second and third quarters, and often lowered in the fourth quarter. On balance, this also points out the need to consider external market conditions. Clearly, the market conditions at a valuation date do impact IPO valuations, and thus should be considered for private companies, even in the context of discounts.
I think it’s important to once again stress that each valuation case should be viewed differently, and there is no "one discount fits all" answer. Our study this year, and in prior years, clearly indicate that over many industries, and multiple time periods, investors have paid less for an investment the further away from the IPO liquidity event. Since this is intuitively what a logical investor would also do, I believe our study results are a useful guide in gauging the lack of liquidity for closely held stock. 1. 1999 Marketability Discounts
as Reflected in Initial Public Offerings, Brian K. Pearson, CPA
Expert, Spring 2000. Recruiting | Links | Home  |
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