Page 36 - Bankruptcy and Reorganization Services

derived by applying the guideline public company method is indicative of the fair market value of mar-
ketable minority shares (or the value of minority shares if freely traded). If the interest or shares being
valued are nonmarketable minority shares, the valuation analyst would apply a lack of marketability dis-
count to reduce the value estimate derived using the guideline public company method. In general, ap-
plying a lack of marketability discount is necessary to adjust the fair market value estimate derived from
the guideline public company method (a level of value applicable to minority shares if freely traded) to
derive a value estimate applicable to nonmarketable minority shares.

A second type of empirical study used to estimate lack of marketability discounts is known as a pre-IPO
fn 4 study. Pre-IPO studies calculate lack of marketability discounts by comparing pre-IPO transactions
to the minority interest transactions involving the same company after the company has "gone public"
and has an established market for its shares. fn 5 The percentage difference between these two amounts
offers a frame of reference from which practitioners can estimate the discount the market demands, vis-
à-vis publicly traded stock, when acquiring closely held stock, or lack of marketability discounts. Due to
a number of technical issues, reliance on these studies has diminished in current valuation practice.

Another common method of estimating lack of marketability discounts is through the use of quantitative
approaches, such as the protective put method. Using the protective put method, the lack of marketabil-
ity is estimated by calculating the cost of a put option to hedge the fluctuation in value of the investment
between the valuation date and the anticipated liquidity date. There are a number of versions of the pro-
tective put method. The most common versions are the Longstaff Lookback Put Option model, fn 6 the
Finnerty Average Strike Put Option model, the Chaffee European Put Option model, and the Asian Pro-
tective Put model. The use of these quantitative models has become common in valuation practice. Fur-
ther discussion of these quantitative models, however, is beyond the scope of this practice aid.

Lack of marketability discounts may also be applicable to controlling interests, although some practi-
tioners are of the opinion that no such discounts should be applied to a controlling interest. Notwith-
standing the divisiveness among practitioners surrounding this issue, it is generally accepted that, if a
lack of marketability discount were to be applied to a controlling interest, it would be less than the dis-
count applicable to a minority interest.

necessary. Furthermore, it is assumed that the amount of earnings for the subject company employed in the calculation is reflective of
earnings available to a minority shareholder.

fn 4 IPO is the acronym for initial public offering.

fn 5 The pre-IPO transactions examined in the pre-IPO studies occurred at a time when the subject companies were anticipating an
IPO.

fn 6 Francis A. Longstaff, "How Much Can Marketability Affect Security Values?" The Journal of Finance 50, no. 5 (1995): 1767–
1774.

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