Restricted stock is typically acquired from public companies or affiliates in transactions that are not registered with the SEC. For example, restricted securities may be issued through private placements, corporate mergers, the exercise of stock options or as compensation for services provided. They may later be resold into the public markets if:
- The issuer has filed an effective registration statement.
- The seller has complied with the requirements of Rule 144 under the Securities Act of 1933 (e.g., completed a one-year holding period).
In addition, a holder of restricted stock may resell the stock to a third party in a privately negotiated transaction pursuant to the Section 4(1-1/2) exemption. For more information on restricted stock and the rules governing resale of restricted securities, see the SecondMarket website.
Note that the restricted stock discussed here (also known as "SEC restricted" or "Rule 144 restricted") is not the same as employee restricted stock, which is subject to forfeiture and must be valued by a reporting entity for financial reporting purposes.
Restricted Stock Discounts
Investors value liquidity and would pay more, all else being equal, for an asset that is fully liquid than for an otherwise identical asset that is not fully liquid. Because of the requirements of Rule 144, in particular the six-month holding period before any public resale, restricted stock is valued at a discount from identical shares trading publicly.
Time Decay of the Discount
Because the six-month holding period under Rule 144 is the main driver of the discount, once the restricted stock is issued and sold, the discount should -- all else being equal -- begin to decline. But there are exceptions to this rule. For example:
- If the stock becomes much riskier, in the view of the market, the discount could increase.
- If the stock is sold by an affiliate of the issuer to a non-affiliate, the holding period sometimes restarts, causing the discount to increase.
Restricted Stock Studies
Many studies and databases are available that analyze restricted stock discounts and attempt to explain variations in the discount for lack of liquidity. One much-cited business valuation textbook quotes more than a dozen such studies.
All of these studies, though, are studies of private placements. Some cover only restricted-stock private placements and others cover private placements of both restricted stock and stock that is registered for resale. As such, the studies can be classified as either general private placement studies or restricted-stock private placement studies.
The LiquiStat™ Difference
Unlike all other available studies, the LiquiStat™ database is not limited to private placements. It also includes direct arm's-length resales -- from investor to investor -- of restricted stock and other illiquid securities.
This data provides a unique valuation advantage, as such sales are pure reflections of fair value (or fair market value). Conversely, private placement studies focus on transactions where discounts may also be based on factors other than fair market value. See the LiquiStat™ section for more information.
Restricted Stock Valuations For Hedge Funds
Hedge funds and other investment funds that hold significant restricted-stock positions have a unique challenge. Placing the illiquid stock in a "side pocket" or valuing it at cost causes inaccurate valuation of the portfolio, harming either redeeming or remaining investors. Applying a fixed discount causes the same problem, but typically harms redeeming investors more, because of the time-decay of the discount.
Restricted Stock Discounts in Tax Court
Any tax valuation of restricted stock, or of any security for which a discount for illiquidity is an important factor in the valuation, must consider Tax Court decisions.
Tax Court decisions are important because the ultimate arbiter of the value, if the tax return is audited, will usually be the Tax Court. For example, the Tax Court has raised objections to many private placement studies, because the discounts in those studies are driven by factors other than liquidity. In this sense, the Tax Court is catching up with academic research.
Valuing Restricted Stock
Any proper valuation of restricted stock should consider the main drivers of the discount, including:
- Prices paid for similar blocks in recent sales
- Size of the block held, compared with the trading volume for the stock
- Financial characteristics of the issuer, including size, balance-sheet risk, profitability, growth and dividend-payout ratio
- Volatility of the stock
- Ability of the holder to sell the stock short during the expected holding period
- Ability of the holder to hedge against stock-price volatility during the holding period
For more information on our restricted-stock valuations, contact Pluris today.