Selling out to a Public Company Buyer Blockage, Restricted Shares, and Value the Stated Price Versus Reality
1338 HARDING PLACE • SUITE 200 BANISTER FINANCIAL, INC. CHARLOTTE, NORTH CAROLINA 28204 Business Valuation Specialists PHONE: 704-334-4932 FAX: 704-334-5770 www.businessvalue.com Contact: George B. Hawkins, ASA, CFA, President FAIR VALUETM
Reprinted from Volume VI, Number 1 Spring/Summer 1997
SELLING OUT TO A PUBLIC COMPANY BUYER BLOCKAGE, RESTRICTED SHARES, AND VALUE THE STATED PRICE VERSUS REALITY
By: George B. Hawkins, ASA, CFA 1. Restrictions on Sale- Shares received are often restricted from public sale for some period of Introduction. Sometimes a fortunate private time (up to two years). business owner will hit the financial home run most entrepreneurs salivate over- a rich purchase price paid 2. Not Registered For Public Sale- Once for his or her company in an acquisition by a public restrictions on sale lapse, the shares cannot then company. While the price may sometimes be paid all in be sold publicly unless they have undergone the cash, it is more common to receive part expensive process of registration with the of the purchase price in cash and a Securities and Exchange Commission. The portion in the shares of the acquiring smart business owner will typically require as a public company. With public shares part of the transaction that the acquiring prices at an all-time high, public company agree to immediately undertake the companies are eager to use their high efforts and costs to accomplish registration. priced share currency wherever possible to pay for some or all of the 3. Blockage- The seller may now own a large George Hawkins purchase. In such a transaction the block of the public company’s shares. If they company owner and his attorneys need were to be immediately sold this could cause a to know the following: demand/supply imbalance in the public stock (i.e., more shares being offered for sale than the � What is the actual value of the public company daily trading activity could normally absorb). shares the seller receives, such as in computing To induce buyers to acquire such a large block, a the amount of the taxable gain? substantial “blockage discount” from the traded daily price may be required. � What is the value of the shares for estate tax purposes if the seller dies? This article will deal primarily with the valuation impacts of a delay until the shares can be It seems simple. Just look up the trading price of registered and sold in the public marketplace, although it public company’s shares in the paper. In reality, will briefly address blockage. It will summarize how however, the public company shares might be worth information on trading activity and the use of options significantly less than the actual trading value for the pricing techniques might be used to estimate the actual following reasons: fair market value of the public company shares received on the day of the transaction.
© Copyright 2003, Banister Financial, Inc. All Rights Reserved. 1 of 4 SELLING OUT (continued) Blockage Discount-The First Step. The previous twelve months, the block received by Seller valuation process begins by addressing the impact of would constitute approximately three times the total blockage on the value of the shares received on the date average of all trades in a given day, a major block of of the acquisition. In other words, what price per share shares. Therefore, in addition to the average trades could be realized by a sale of the shares on that date, already occurring daily, the Seller’s block of stock, if taking into account daily trading activity in the stock and sold on the valuation date, would materially exceed market forces? A business valuator is usually not the typical trading volume causing a demand/supply best source to estimate this discount. Instead, the market imbalance which needs to be reflected in the price that maker in the shares of the public company is normally could be received for the shares. The specialist firm that the best place to start. Market makers are specialists makes a market in the shares of Pubco was asked to who actually serve as the intermediaries who match estimate the discount that would required, if any, from purchase and sell orders for the stock, maintaining an the bid price for the shares to sell them, based on the inventory on hand of the shares to match the needs of size of the block. It was the specialist’s indication that buyers and sellers and create an orderly market. Since the discount for the block of shares would total they are in daily contact with the liquidity and supply approximately $5.00 per share below the traded bid and demand forces of the stock, they are normally the price of the stock on the day of the transaction ($29.75 best equipped to estimate the price impacts of dumping a per share). Based on a price of the openly traded shares larger block of the shares on the market. of $29.75, this indicates that the block would be worth Impacts of Awaiting Registration. Next, the $24.75 per share ($29.75 less $5.00 blockage discount), value of shares (adjusted for blockage) are adjusted for assuming marketability. illiquidity by the business valuator, taking into account Restrictions on The Liquidity of the Shares. the impact of the time required until registration, and During the 90 day period the Seller’s shares in Pubco are hence, marketability can be achieved. In a recent case held until being registered with the SEC they are where the acquirer agreed to undertake immediate illiquid, and thus exposed to potential market changes in efforts to register the shares and bear the costs involved, the share price until they can in fact be sold. Thus, until the minimum estimated time frame required was they can be sold it cannot be known what the Seller will approximately 90 days. Thus, the entrepreneur cannot actually receive for the shares, particularly since the convert the shares to cash for at least 90 days and is shares of Pubco are highly volatile. Therefore, options exposed until that time to potential changes in the share pricing methodology is used to estimate the cost of a put price. While the shares might be worth more 90 days option for this time period which will hedge the Seller later, they might also be worth less. To guarantee that against a potential decline in the value of the shares the owner will receive their stated value (net of blockage arising from their volatility. discount), insurance can be purchased in the form of a Other methods are available to identify the costs 90 day “put” option which effectively guarantees that associated with restricted stock and involve the use of the owner can “put” the shares to the holder of the put so-called restricted stock studies which have been option (i.e., require them to buy the shares) at the stated undertaken to estimate associated discounts. These price during the period of the option, here 90 days. The studies, such as the SEC Institutional Investor Study, as cost of purchasing a put option can be modeled using well as those by Maher and Moroney, have typically standard stock option pricing models, thus estimating found discounts for restricted stocks to be approximately the cost of the illiquidity during this 90 day time frame. 32% to 35% as compared to their unrestricted The subtraction of the blockage discount and the counterparts. This methodology was not employed for cost of purchasing a put option from the traded price per several reasons. First, the studies generally deal with share (at the time of the transaction) results in the final Rule 144B stock which is restricted for up to two years cash equivalent fair market value of shares received at from public sale, whereas Seller’s shares are not covered the time of transaction by the seller. by such restrictions. Second, since Seller’s shares are to An Example of Blockage. As an example, be registered, the likely time frame required to achieve assume the selling company owner (“Seller”) receives a registration is substantially less than the two years in substantial minority share block (about 3%) in the traded restricted stocks, therefore limiting the time frame to shares of the acquiring public company (“Pubco”). which Seller would be exposed to share price Based on average daily trading volume during the fluctuations. Finally, the publicly traded shares of Pubco
2 of 4 SELLING OUT (continued) are highly volatile. Options pricing techniques can This article is too short to go into the reliably quantify the direct impact of this volatility and mathematics of the calculations using the above how it affects the cost of insuring against a change in variables. As an overview, the Black-Scholes method is value, in effect a cost associated with the illiquidity. The based on options deriving their value from two sources- greater the volatility of the underlying stock, the more time value and intrinsic value. Intrinsic value is the expensive it is to hedge against changes in the share profit to be realized if the holder of the option were to price. exercise the option today. In the case of a call option, Option Valuation Methodology- an Overview. suppose the holder has the right to buy shares of IBM A widely used tool for pricing the value of put and call for $100.00 per share and the current traded price of options on a stock is the so-called Black-Scholes options IBM shares is $110.00 per share. Thus, the holder could pricing model.1 This model has been shown in call the stock for $100.00 and simultaneously sell the academic studies to reasonably predict the value of shares for $110.00, realizing a $10 per share profit. shorter term put and call options of publicly traded $10.00 per share is the intrinsic value of the option. stocks. A “put” option gives the holder the right to “put” In addition, options also have time value. Time the underlying shares to the counter-party at a value arises because the option gives the holder the right predetermined price (the ‘exercise price”) at any time to purchase the stock in the future at a fixed price. Since during the term of the option (up to its “expiration date”) stocks fluctuate in value over time this volatility gives despite what changes have occurred in the underlying the potential to realize additional profits in the future. price of the traded stock. Thus, the holder of a put can This time value of an option can be valued by two well insure against downside changes in the stock price known valuation methods, the Black-Scholes and Thorp- through the ability to put those shares to the buyer at the Kassouf models. Options traded on an exchange are predetermined price. The cost of using a put option is typically of short duration to expiration (typically 180 the “option premium” paid by the buyer. A call option is days or less) and are readily and reliably valued by the just the opposite of a put, giving the holder the right to Black-Scholes method. “call” (buy) the stock during the option period at a Calculating the Cost of a Put Option in predetermined price. Thus, if the price of the traded Pubco. Data on the trading activity and price of Pubco stock price rises, the holder can acquire the shares at the shares was obtained for the twelve months prior to the lower exercise price per share. transaction date. Next, the standard deviation of the Black-Scholes Option Pricing Model. The share prices was computed as a measure of volatility. Black-Scholes options pricing model is based on the The conclusion is that the shares of Pubco are highly assessment that an option derives it value from the volatile. As noted earlier, the greater the volatility of the following variables2 : underlying stock, the greater the cost of the option to insure against a change in the value of the underlying 1. The current traded price of the underlying stock. stock. 2. The exercise price of the shares in the option Conclusion of Option Value. Use of the input agreement. variables in the Black-Scholes options pricing model 3. The alternative risk-free interest rate that can be results in an estimated cost of a put option for each share earned on investments during the duration of the of Pubco as shown at the bottom of the following table: option period (continuously compounded rate). 4. Time to option maturity in years (or fractions Calculation of Cost of Put Option To Hedge Pubco Share Price thereof). Until Shares Can Be Sold (Assumed To Be 90 Days To 5. Natural logarithm. Registration) 6. Standard deviation of the annualized, VARIABLES: continuously compounded rate of return on the Stock Price $24.750 stock. Exercise Price $24.750 7. Value of the call option. Term (90 days) (Expressed As Fraction Of A Year) 0.246 Volatility 93.33% Annual Rate of Quarterly Dividends 0.00% 1 Fisher Black, and Myron Scholes, “The Pricing of Options and Annual Risk Free Interest Rate 5.020% Corporate Liabilities,” Journal of Political Economy 81 (May/June 1973). Put Option Value $4.35 2 Investments, 2nd Edition, by Zvi Bodie, Alex Kane, Alan J. Marcus, Irwin Publishing.
3 of 4 SELLING OUT (continued) Bringing the Pieces Together To A Final cash value of what is being received, whether for Value. Therefore, the final fair market value of Seller’s taxation or estate purchases, or simply to make a better shares in Pubco is estimated by subtracting the blockage and more informed decision in deciding what type of discount and the cost of purchasing a put option from the offer to take from the acquiring public company. It is traded price per share. As shown below, the actual final important to note, however, that the case law involving cash equivalent value is $20.40 per share, or a discount blockage and restricted stock discounts is complex, so of 31.43% from the traded share price at the time of the the aforementioned techniques may not be warranted in transaction: specific situations. ♦
Final Calculation of Fair Market Value Per Share George B. Hawkins is co-author of the CCH Transaction Price Per Share $29.75 Business Valuation Guide and a Managing Director of Less: Blockage Discount Estimated By Market Maker ($5.00) Banister Financial, Inc., a business valuation firm in Equals: Adjusted Value Per Share After Blockage $24.75 Less: Cost of Put Option ($4.35) Charlotte, North Carolina. He can be reached at [email protected] or 704-334-4932. Equals: Final Fair Market Value Per Share For Pubco Shares Received $20.40 This article is an abbreviated discussion of a complex topic and does not constitute advice to be Conclusion. Blockage and restrictions on applied to any specific situation. No valuation, tax or shares received from a public company in a purchase legal advice is provided herein. Readers of this might cause the shares to be worth substantially less article should seek the services of a skilled and than what they appear to be at face value. The trained professional. techniques described can be used to quantify the true
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