"Even if We're Just Dancing in the Dark" Or on the head of a pin?

Oh yes, just squeezing in a Springsteen reference again - it's been a while. So how do I justify this random reference this time? Read on...


When we value interests in a privately held company, we generally apply a discount for "lack of marketability". In some cases, this is also referred to as a discount for illiquidity. This month, I wanted to explore why two different terms are used and whether there is actually a difference in what they are designed to measure.


The Inernational Glossary of Business Valuation Terms (a succinct read for those interested) defines both marketability and liquidity in essentially the same terms: "the ability to quickly convert property to cash".  (You can find the International Glossary of Business Valuation Terms at http://www.bvresources.com/FreeDownloads/IntGlossaryBVTerms2001.pdf)


However, two business valuation gurus, Shannon Pratt and Roger Grabowski recently wrote that they consider the concepts to be distinct: marketability relating to the ability to sell an interest and liquidity relating to the ease (or difficulty) of receiving the proceeds of the sale.

Marketability is really a question of degree with unrestricted stock in a publically traded company at one end of the spectrum and minority interests in closely held businesses at the other. Although the term "non-marketable" is often used to describe an interest in a closely held business, that interest can be sold in the long run and there are very few interests that are truly "non-marketable". The term really refers to situations where there are obstacles to sale - for example, there may be restrictions on the sale of the shares for a period of time or a requirement to give other shareholders an option to buy the shares before offering the interest to a third party. In general, the greater the number and severity of these obstacles, the less marketable the interest.


While an interest is marketable, it may not necessarily be liquid. If you own 100% of a private company, you have a marketable asset -i.e. there is generally nothing to stop you from putting the stock up for sale. However, that 100% interest is nowhere near as liquid as your stock in Dell. You can convert your Dell stock to cash in three days, while it may take you upwards of three months to sell your company (with the additional risk that you may never be able to find a buyer).


What does all this dancing on the head of a pin do for us as we value companies? At the very least it explains why discounts are higher for interests that are less than 100% in a company than for the entire company. In the first case we are often seeking to measure a discount to reflect both a a lack of marketability and liquidity, whereas in the second case liquidity is the main consideration.