A Giant LEAP for Mankind? Maybe Not, but Some Helpful Data for Valutions

This month we're going to do some finance stuff - be warned, there may even be a formula...


As valuation analysts, we are always trying to find empirical data sources to support the valuation approaches we use. One of the areas that cries out for this type of support is the derivation of the discount for lack of marketability for a non-controlling interest in a closely held company.


One approach to this is to use data relating to the pricing of a specific type of publicly traded option - the Long Term Equity AnticiPation Security (which has the convenient acronym (LEAPS). If you buy a"put" LEAP, you are purchasing the right to sell stock in a public company to another person at a specified price at a specified time in the future. The main difference between a LEAP and a normal option is that a LEAP will expire in one to three years in the future whereas normal options have much shorter maturities.


The price paid for the LEAP represents the cost of the price protection. You can think of it as the cost of an insurance policy that allows the owner of the stock to sell that stock for the current price at a future date, in effect removing the risk of a drop in the price of the underlying stock.


Some smart valuation analysts figured out that this risk is analogous to the situation faced by the owner of shares in a private company who cannot sell the shares quickly. Since LEAPS reflect holding periods in excess of a year, they better reflect the holding period that the private shareholder is facing than normal options. Therefore, the theory goes, dividing the cost of the LEAP by the price of the stock gives a discount for lack of marketability.


Robert Seaman of DLOM, Inc. recently released a study in which he showed that the cost of buying a LEAP with 14 months to expiration represented around 17% of the price of the underlying stock and that this increased to around 24% of the price for LEAPS with 26 months to expiration. This would seem to suggest that discounts for lack of marketability should be of at least these magnitudes and maybe higher since the LEAP companies are much larger than most privately held companies and there are other factors that can affect the prospects for the private company shareholder being able to sell the interest.


Hopefully that wasn't too painful and it looks like we got away without using a formula!