2000 Marketability Discounts as Reflected in Initial ... - BVMarketData

September 20012000 marketability discounts as reflected in initial public offeringsby Pearson, Brian *This interview by Alina Niculita is based on the Valuation Advisors Study of pre-IPO transactions for the year 2000. The complete article describing the study isavailable on BVLibrary.com along with the results from their 1999 study. --SPAlina Niculita: How many Valuation Advisors pre-IPO studies are there and whatare the time horizons covered in them?Brian Pearson: Valuation Advisors recently completed its second study on thediscounts for lack of marketability (DLOM) topic and it looks at the Initial Public Offerings(IPOs) completed in 2000. The first was published in early 2000 and was based on IPOscompleted in 1999.1 The study distinguishes among the pre-IPO transactions that took place in each ofthe quarters of the year immediately preceding the IPO and the transactions that took place in the entireyear before the immediately preceding year. As a result, the study reports five different marketabilitydiscounts for five different time horizons:• Four marketability discounts for the four three-month periods immediately preceding the IPO and• One marketability discount for the timeframe from one to two years before the IPOA sample of the 2000 study results is listed in Table 9 on page 6 and the results are summarized in Table1 on page 4.AN: Are the discounts reported for common stock, convertible stock, or option transactions?BP: The 2000 study has new features that help the analyst deal with these necessary distinctions. Onesuch feature is that the study tracks the discounts on transactions of convertible preferred stock (CPS)separately from discounts on transactions of common stock and options on common stock. The samethree-month measuring periods were used for both types of transactions. The observed CPS discountswere similar to those of common stock.AN: How does the study deal with outliers, e.g., observations of discounts that are very far fromany measure of central tendency?BP: The 2000 study uses what is called a "narrowed discount range." The study includes in the narroweddiscount range only those companies with discounts from 10% to 90% of the IPO price during the two-yearperiod prior to the IPO. The study tracks those transactions that fall outside the narrowed discount rangeand excludes them because they may be either "cheap stock or options" or at a premium due to changingmarket conditions.AN: What are the summary results of the 2000 study?BP: Table 1 shows the overall discounts and premiums for year 2000 for the entire study, including bothcommon and preferred stock. The overall discount for the entire one-year period averaged 47.07%. Whenonly the transactions from the narrowed discount range are included the average one-year discountincreased to 52.40%, as shown in Table 2.AN: How does the inclusion or exclusion of the discounts on CPS transactions affect the averagediscounts?

BP: When the CPS transactions are excluded, the narrowed discount range for common stock or optionsonly falls to 49.76%, as shown in Table 2.1, down from the 1999 figure of 52.44%. This likely indicates thatmore premiums were paid than large discounts on pre-IPO transactions in 2000.Table3 shows the discounts for the CPS-only pre-IPO transactions. With the exception of the first threemonths, all the other CPS periods, compared to the common-stock-only transactions, show reasonablylarger discounts. This may be explained partially by the fact that these transactions typically are at largerdollar amounts than are the majority of the common stock and option transactions, thereby allowing theventure capital firms engaging in such transactions to negotiate better deal terms. Also, to the extent thatcommon-stock-based transactions use CPS transactions as a benchmark, the common stock transactionsusually are priced higher thereafter, even though they may fall in the same three-month period.Table 1: Complete StudyResultsTime of Transaction Before IPO1-90 Days 91 - 180 Days 181 - 270 Days 271 - 365 DaysNumber of Transactions 123 165 105 86 134Average Discount 31.50% 43.58% 56.47% 64.39% 71.61%Average One-year discount 47.07%1-2Yrs.Table 2: Narrowed Discount RangeTime of Transaction Before IPO1-90 Days 91 - 180 Days 181 - 270 Days 271 - 365 DaysNumber of Transactions 99 146 94 73 106Average Discount 40.60% 49.29% 59.16% 65.95% 66.85%Average One-year discount 52.40%1-2Yrs.Table 2.1: Narrowed Discount Range - Excluding CPStransactionsTime of Transaction Before IPO1-90 Days 91 - 180 Days 181 - 270 Days 271 - 365 DaysNumber of Transactions 82 95 53 49 50Average Discount 39.56% 47.64% 56.98% 63.17% 63.54%Average One-year discount 49.76%1-2Yrs.Table 3: CPSTransactions OnlyTime of Transaction Before IPO1-90 Days 91 - 180 Days 181 - 270 Days 271 - 365 DaysNumber of Transactions 24 56 43 30 73Average Discount 31.83% 47.78% 57.51% 73.00% 75.45%Average One-year discount 52.96%1-2Yrs.AN: Sometimes, when trying to measure discounts from IPO prices, premiums result instead. Whydo pre-IPO premiums occur and was 2000 a year of mostly pre-IPO premiums or discounts?

BP: Table 4 shows the number of premium transactions by quarter. A review of these transactions showsthat the majority of these transactions occurred during the third quarter of 2000. For those companies thatwere not "hot" offerings, the only way to complete an IPO as the year progressed was to lower the IPOprice,2 sometimes more than once.3 As the IPO price was lowered to generate additional interestnecessary to complete the offering, the lowered price often ended up being lower than prior prices foroptions and common and preferred stock already issued or sold.Generally, as the stock markets fell as the year progressed, investors became more selective in investingin IPOs.4 Thus, many companies lowered their offering prices to complete an offering in the third quarterwhile the IPO was still possible. By November, half the 2000 IPOs were trading below their IPO price.5Essentially, as investors became more selective, they were less willing to pay higher valuation multiplesfor all companies.AN: Are the discounts resulting from pre-IPO studies a good indication of DLOM for interests inprivate companies that will never have the possibility or the opportunity to go public?BP: Some valuation professionals have argued that the IPO studies calculating marketability discountsoverstate discounts, since IPOs overstate the true "fair market value" price of a company’s shares.Generally, this is simply not true:• First, in both 2000 and early 2001, a number of companies had to lower their offering prices to gopublic. Over time, this tends to offset raised offering prices in better markets.• Second, in 2000, a number of companies canceled their offerings because the IPO market simplydried up. Table 5, which is reproduced from IPOMonitor.com, shows a chart of companies thatwithdrew their offerings in each quarter of 2000. There were 422 IPOs in 2000 and 232 of them—or53%—were withdrawn. None of the prior lack of marketability studies (including this) captures thepresumed increase in lack of marketability in those companies whose offerings were canceled orwithdrawn.• Third, once an IPO is canceled, the company may be viewed differently by other potential investors,who recognize that one avenue for liquidity is closed, maybe permanently. According to a study byfinance 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 itsbusiness 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 thetime."7 Ironically, these drawbacks must be weighed against the likelihood that the company maynow 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 beable to go public, one can argue that the discount for a private company could be higher than theaverages in this study.Table 4: Premiums ByQuarterQuarter Premiums Transactions % of Total1st 2 217 0.92%2nd 4 64 6.25%3rd 21 216 9.72%4th 5 116 4.31%TOTAL 32 613 5.22%Table 5: IPO's and Withdrawls in2000Quarter IPO's Withdrawls1 Q 2000 136 202 Q 2000 95 78

3 Q 2000 137 474 Q 2000 54 87TOTAL 422 232Note: Reproduced from IPOMonitor.comAN: How could one go about estimating a DLOM for a private company starting from the discountsreported in this study?BP: According to alert-IPO.com,8 "companies that priced IPOs in March this year had spent an average ofabout 73 days in registration, but in October the average number of days surged to 161."Table 6: Study Results - NAICS Code 325 and334NAICS325Time of Transaction Before IPO1-90 Days 91 - 180 Days 181 - 270 Days 271 - 365 Days 1-2 Yrs.Number of Transactions 8 13 7 6 15Average Discount 32.17% 49.66% 56.66% 64.81% 70.88%Average One-year discount 49.66%NAICS334Time of Transaction Before IPO1-90 Days 91 - 180 Days 181 - 270 Days 271 - 365 Days 1-2 Yrs.Number of Transactions 18 23 16 10 24Average Discount 30.46% 46.94% 58.79% 60.10% 69.07%Average One-year discount 47.31%If we assume that the average IPO process (from filing to successful offering) takes approximately sixmonths, a way to calculate this additional lack of marketability is to look at the difference between sixmonthintervals of our study. The discount difference between the 181-270 day period and the 1-2 yearperiod was approximately 11.26% in 2000 and 11.35% in 1999. Since in both years, the discount for the181-270 day period is considerably greater than the average discount for all time periods, this may be agood base period to use in looking at the discount for an additional theoretical six-month period.Clearly, the companies in our study are more liquid to an investor than the average privately held companyvalued. Thus, for an "average" privately held business, this may be one approach to capturing thepotential additional lack of marketability that we need to consider further.AN: How are the pre-IPO transactions classified in the Valuation Advisors study?BP: Similarly to last year, all the transactions in this study are classified by NAICS code. Table 6 presentsthe companies included in the NAICS codes 325 "Chemical Manufacturing" and 334 "Computer andElectronic Product Manufacturing." The discounts vary by NAICS code, number of transactions, and timingof the transaction (i.e., first vs. fourth quarters).Table 7 presents NAICS code 3391 or "Medical Equipment and Supplies Manufacturing." The 21companies presented here went public from 1996 to 2001. There were 57 transactions, out of which 42took place less than one year before the IPO. The resulting discounts comport to the prior entire studyresults.AN: Does the study give any insights into the market activity level in the year 2000?BP: An 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 thethree months just prior to the IPO, the first quarter discount was 41%, whereas the next two quarters werein the low 20% range, and the final quarter was 16.36%. This shows how IPO prices typically were raisedby underwriters in the first quarter, mostly maintained in the second and third quarters, and often loweredin the fourth quarter.On balance, this also points out the need to consider external market conditions. Clearly, the marketconditions at a valuation date do impact IPO valuations, and thus should be considered for privatecompanies, even in the context of discounts.Table 7: Study Results - NAICSCode 3391NAICS 3391Time of Transaction Before IPO1-90 Days 91 - 180 Days 181 - 270 Days 271 - 365 DaysNumber of Transactions 9 18 11 4 15Average Discount 43.93% 49.59% 56.88% 72.64% 80.26%Average One-year discount 52.48%Table 8: Study Results - 1-90 dayTransactions by QuarterQuarter1 Q20002 Q20003 Q20004 Q2000Number OfTransactionsAverage Discount57 41.00%14 20.43%28 21.97%16 16.63%1-2Yrs.Click here (BVU0901-Figure9.xls/30kb) to download Table 9: Sample from 2000 IPO ValuationDiscount Study, Valuation Advisors, LLCClosing remarksIt’s important to once again stress that each valuation case should be viewed differently, and that there isno "one discount fits all" answer. The Valuation Advisors 2000 and prior years’ studies clearly indicate thatover many industries and multiple time periods, investors have paid less for an investment the furtheraway the transaction is from the IPO liquidity event. Since this is what a rational investor also would do,the Valuation Advisors Study results are a useful guide in gauging the lack of liquidity for closely heldstock.AN Comment: Readers can get a copy of the original published study from AICPA by calling (800) 862-4272.1Brian K. Pearson, "1999 Marketability Discounts as Reflected in Initial Public Offerings," CPA Expert(Spring 2000): 1-6.2 Raymond Hennessey, "Firms Lower Prices, Withdraw Offerings As IPO Market Slows," Wall StreetJournal (Thursday, November 16, 2000): C20.3 Raymond Hennessey, "New Year Won’t Ring in Bells in IPO Market," Wall Street Journal (Tuesday,January 2, 2001): C15.

4 Jed Graham, "IPO Window Shuts As Crop of Newly Public Firms Withers," Investors Business Daily(Friday, December 22, 2000): A6.5 Matt Krantz, "With Fewer Filers, Lower Prices, IPO Market ‘Pretty Ugly Out There,’" USA Today(Monday, November 13, 2000): 16B.6 Jon Birger, "Public Skeptical—A Company’s IPO Withdrawal Could Either Be Fatal, or a Windfall," RedHerring (August 2000): 354-356.7 Ibid.8 Denise Duclaux, "IPO View—New Stock Offerings Wait Out Rollercoaster," Reuters Limited, via AmericaOnline.* Brian K. Pearson is president of Valuation Advisors, LLC, Amherst, New York, which specializes in business valuations and valuationconsulting. He can be reached at (716) 839-5290 or bp@valuationspros.com .Copyright © 2002 Business Valuation Resources. All rights reserved.