A paper published a dozen years ago by Michael Hertzel and Richard L. Smith, finance professors at the W. P. Carey School of Business, is still causing a stir among valuation practitioners and tax officials. "Market Discounts and Shareholder Gains for Placing Equity Privately" published in the Journal of Finance in 1993, challenged the notion that private placement discounts can uniformly be applied as marketability discounts in valuing closely-held firms. In a finding somewhat tangential to the thesis of the paper, Hertzel and Smith discovered that the private placement discounts vary widely, depending on circumstances. Their tables are often used in cases where disagreements develop over the value of privately held firms. Hertzel has recently completed another study on private placements that is likely to add more fuel to the fire.
Knowledge@W. P. Carey: A continuing debate in the valuation industry concerns how to value privately held companies. What are the issues?
Hertzel: Determining the value of a privately held firm can be critical for tax purposes, for example at the time of an estate, or when dissenting minority shareholders in a merger are looking for an appraisal remedy. In addition to disputes with the Internal Revenue Service, the issue of valuation is central to many litigation controversies. The complications arise from the difficulty in assigning value to privately held firms. For publicly traded companies, determining value is relatively easy … simply look at the stock price. Valuing privately held firms is not so straightforward –- there is no ready market with posted prices to rely on.
Knowledge@W. P. Carey: Without a stock price as a reference, what technique is used for valuing a privately held firm?
Hertzel: You could come up with a value by considering sale prices of similar privately held companies. An analogy would be the homeowner who wants to know what his house is worth. He will look for a similar house that has recently been sold to get to an idea of the market value of his house. Because of the number of houses that are sold each year, there is an abundance of data about houses. The trouble with using this technique to value privately held businesses is that there are so few sales of similar companies and the transaction data is hard to get. As a result, for comparables, appraisers look for similar publicly held firms.
Knowledge@W. P. Carey: Does that mean that when you find a comparable publicly held firm you know what your business is worth?
Hertzel: Almost. There is one more step, and that's the tricky part. That comparable public company differs from our private company in one important way: it is readily marketable. For example, you can easily and quickly sell your shares of IBM, but there is no ready market for the privately held firm. Investors value marketability, and everything else the same, they will pay more for an asset that is marketable than for one that is not. The next step is to apply a "marketability discount" to the public firm value.
Knowledge@W. P. Carey: How do you calculate the marketability discount?
Hertzel: One widely used approach relies on evidence from studies of the restricted stock of public companies. When a public firm issues stock in a private placement, rather than to the public at large, it can avoid costly SEC registration. As a result, however, the private investors are restricted from reselling the privately placed shares in the public market for a specified period of time. Currently the restricted trading period is one year; prior to 1997 the restricted trading period was two years.
Because of the lack of marketability, the restricted shares are not as valuable as the company's freely traded shares and so are offered at a discount to the market price of the firm's publicly traded shares. In a sense, it is akin to our public versus private firm comparison: everything is identical except for the degree of marketability. The restricted stock discounts are a natural a way to identify the appropriate discount for marketability that the valuation industry is after.
Knowledge@W. P. Carey: Seems logical. Where does your study with Richard Smith come in?
Hertzel: We were initially interested in private placements for a different reason. Earlier evidence had shown that there were positive stock price reactions to private placements of equity by public firms. This evidence stood in sharp contrast to the negative market reaction to public equity issues by public firms. The most widely accepted explanation for the market's negative reaction to public issues is that the issue conveys managers' private information that the firm is overvalued. The idea here is that managers would be reluctant to issue stock to new investors when it was undervalued -- a stock issue conveys the message that managers believe their firm is fairly valued or overvalued. Hence, the negative price reaction –- the stock price drops.
Knowledge@W. P. Carey: Conversely, managers would issue private placements when they felt the firm was undervalued?
Hertzel: Yes, in part because they are in a better position to try to make this case when negotiating directly with a small group of private investors. In our story, where there is no SEC oversight and thus no filing with its wealth of information, the private placement discount reflects compensation to the private investors for the extra due diligence they must undertake.
Knowledge@W. P. Carey: So how does this tie back into the debate about the size of the marketability discount?
Hertzel: If our model is right, private placements discounts should be larger when the costs of due diligence are higher -- for example, when the firm's assets are intangible and therefore harder to value. Similarly the discounts should be smaller when it is easier to value the firm, say, when there are more assets in place. So we tested our model by seeing whether discounts varied along these lines and found supportive evidence.
Additionally, our study found that discounts reflect other factors besides marketability, and that the discounts vary in predictable ways. I suspect that this is what the IRS takes notice of when it challenges the practice of applying the average private placement discount in all cases, and the assumption that this figure only reflects marketability concerns. This challenge arises because taxpayers would like to use a higher marketability discount to obtain a lower taxable value for their privately held firm. The tables from our study are widely cited in tax litigation cases.
Knowledge@W. P. Carey: So the attention your paper received from the valuation industry was a surprise?
Hertzel: Yes, although this is often how the results of academic research show up in practice. You know, we are often asked about the practical implications of our research and quite often it is difficult to say precisely what an individual study brings to the table. I think basic research in finance is similar to research efforts going towards, say, the cure for cancer … individually the multitude of laboratory experiments may not have direct applications, but collectively finding a cure for cancer would be huge. Finance may not seem as sexy as cancer research, but let's face it, even when the cure for cancer is found people are still going to die. But, as I tell my colleagues, they will live longer, which highlights why it's so important for us to figure out savings and investment. So you see, I'm only partly kidding when I compare cancer research to finance...
Knowledge@W. P. Carey: Are there any new developments on the horizon?
Hertzel: My recent paper, "Long-run Performance following Private Placements of Equity," which ran in the Journal of Finance (co-authored with former ASU scholars Michael Lemmon, James Linck and Lynn Rees), looked at the post-issue performance of firms that did private issues. We found that stock price does poorly over the three years following the private issue –- the opposite of the conventional wisdom that the market looks favorably on these offerings. That means there is yet another possible reason for private investors to require discounts -- anticipation of this poor performance. This provides a further argument against the practice of attributing the full extent of the private placement discount to lack of marketability. I have not seen this argument used in practice yet, but our study is relatively new.