The Liquidity Discount

August 5, 2016

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Further to last week’s blog on minority discounts, this week we will focus on another common valuation discount known as the liquidity discount. In general, valuation discounts refer to a reduction from the rateable en bloc value of an ownership interest to recognize certain disadvantages in such an ownership.

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An investment in a closely held corporation may be somewhat illiquid because a sale to a private purchaser would take time and involve costs. In some cases, there may be restrictions placed on the transfer of shares that would increase the time, cost and risks of marketing the ownership interest. This inherent lack of liquidity may justify a further discount applied to the value of an ownership interest (“liquidity discount”)

The background behind the liquidity discount is that a shareholder in a privately held company does not enjoy many of the same benefits as a shareholder does in a publicly traded company, perhaps the most important of which is liquidity. For example, if an investor in a publicly traded company needs cash, becomes dissatisfied with the performance of the company or its management team, or otherwise wishes to dispose of their investment, the public markets provide virtually instant liquidity so that the value of the investment can be realized. Generally, investors in privately held companies are not able to do so.

Without access to a ready market an investor’s ability to control the timing of potential gains, to avoid losses and to minimize the opportunity costs is severely impaired. Therefore, an interest in the shares of a private company comes with inherent liquidity risks which are in excess of those associated with alternative market investments. As a result, the fair market value of investments in privately held companies ought to consider a liquidity discount, as compared to investments in publicly held companies.

Valuation textbooks often refer to the concept of a liquidity discount as follows:

“an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.[1]

 “the amount by which the en bloc value of a business or rateable value of an interest therein is reduced in recognition of the expectation that a ready market for the disposition of said interest does not exist.”[2]

Liquidity discounts are often considered in business valuations in conjunction with the minority discount. However, it is important to note that such discounts may not always apply and are often determined in a case-by-case scenario. A valuator’s professional judgement is called upon in because many factors come into play when performing a valuation engagement.

[1]  ASA Business Valuation Standards, 2009 American Society of Appraisers pg. 26

[2] The Valuation of Business Interests, Ian R. Campbell, Howard E. Johnson, 2001 pg. xviii

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