February 2005

Blockage Discounts in the Valuation of Public Stock

When a party owns a large block of shares in a public company, the real value of those shares may be significantly lower than the traded market price

When a business valuation engagement includes appraising a marketable security, such as a stock or a bond, the value is generally the average of the highest and lowest quoted selling prices on the valuation date. However, in some cases the reported price may not reflect a stock’s fair market value.

Although discounts for lack of marketability and lack of control are often well known and frequently utilized in the valuation of equity ownership interests, a lesser known discount is often applicable for holdings of publicly traded stock when the shares constitute a large block of the company’s total outstanding shares.

A blockage discount is a deduction from the actively traded price of a stock. The discount is warranted when the block of stock to be valued is so large (relative to the volume of actual sales on the existing market) that the block could not be quickly liquidated without depressing the market price.

Blockage discounts, which are considered in many business valuation assignments (especially for estate and gift tax purposes, marital dissolution and litigation), relate to the law of supply and demand. That is, at any point in time there is a known level of demand for shares in a particular stock at a certain price; an increase in the supply of that stock will decrease the price per share. As a result, a seller trying to convert a large block of stock into cash in a short period of time may realize less than the daily trading price quoted for regular trades because of the supply-demand imbalance.

Ironically, while the market may punish the hasty seller of a block of stock, it may punish the patient seller as well. A seller who dribbles-out shares over a reasonable period of time is also subject to market risk, since the share price of the company could drop during the period in which the shares are liquidated.

Section 20.2031-2(e) of the Estate Tax Regulations recognizes the applicability of the blockage discount:

In certain exceptional cases, the size of the block of stock to be valued in relation to the number of shares changing hands in sales may be relevant in determining whether selling prices reflect the fair market value of the block of stock to be valued. If the executor can show that the block of stock to be valued is so large in relation to the actual sales on the existing market that it could not be liquidated in a reasonable time without depressing the market, the price at which the block could be sold as such outside the usual market, as through an underwriter, may be a more accurate indication of value than market quotations. Complete data in support of any allowance claimed due to the size of the block of stock shall be submitted with the return (Form 706 Estate Tax Return or Form 709 Gift Tax Return). On the other hand, if the block of stock to be valued represents a controlling interest, either actual or effective, in a going business, the price at which other lots change hands may have little relation to its true value. (The Handbook of Advanced Business Valuation, by Robert F. Reilley and Robert P. Schweihs)

Sales of small blocks of stocks do not provide conclusive evidence regarding the discount for a large block of the same stock. The Estate Tax Regulations require the taxpayer to show (a) that the block of stock is so large that it could not be liquidated in a reasonable time without depressing the market; (b) that the number of shares ordinarily traded on the market must be so small, in comparison to the block, that even if the block is divided into smaller blocks, there would be a depressed sales price (this would have to be true even if the block was gradually sold through the market over a reasonably long period of time); and (c) whether the length of time needed to gradually dispose of the block is “reasonable” based on the facts and circumstances of each case.

Methods of disposition. Court decisions have demonstrated that all available methods of disposition of a large block of stock over a reasonable period of time should be considered. Individual exchanges have procedures for the sale of large blocks of stock including:

• the sale to an underwriting syndicate for resale to the public,

• a special offering by which a broker may buy the entire block and resell it or offer it into the market,

• exchange distributions, where one member acting as a principal or as an agent sells a block to other members of the exchange that have solicited purchases,

• private placement of the stock, which does not involve any public offerings, and

• sales made in smaller lots over a reasonable period of time.

If it is determined that one of the first four steps is the most reasonable, then the amount of the discount is based on the difference between the hypothetical sales price and the actual trading price on the date of the valuation.

If none of the first four procedures is feasible or fits the facts and circumstances, then the blockage discount is based on the technique of hypothetically selling the stock in smaller lots over a reasonable period of time.

Estimating the Discount

The good news is that when the appropriate tools are utilized, a competent business appraiser can successfully quantify and support blockage discounts and defend them before the IRS or the courts. This can be accomplished through discussions with market makers and utilization of one or more of three available techniques.

Method One. The first method of estimating the size of the blockage discount is the "estimation of the present value of cash flows" arising from the sale of small lots in the stock over a reasonable period of time. The estimation is based on (a) the number of shares the market could reasonably absorb and sustain and (b) a required rate of return to the shareholder over the “dribble-out” period to compensate for the risk of not receiving an amount equal to the current share price over the period. This dribble-out period should be the shortest amount of time necessary to liquidate the block without depressing the share price. In order to estimate the dribble-out period, market makers in the subject stock should be interviewed and historical trading activity should be analyzed to determine what the typical or average trading volume has been over a relevant historical period and what additional shares the market could absorb in scheduled periods without affecting the stock’s supply/demand price equilibrium.

Method Two. The "price pressure and market exposure" method consists of two separate and distinct cost components of blockage that should be measured:

• price pressure, the impact on stock price when a large block of stock depresses the market and lowers the price that can be obtained for the stock, and

• market exposure, the cost associated with bearing the risk of holding a position in the marketplace without the ability to close the position for a specified period of time.

The appropriate blockage discount is that combination of price pressure and market exposure that produces the least cost to the seller of the block.

Method Three. The "portfolio insurance" method involves a “protective put,” which is the combination of a share of stock with a put option on the same stock.

For years, portfolio managers have utilized protective puts to insure their portfolios against losses and thus reduce the risk to their portfolios. Protective puts make it possible to create a fully hedged position for the subject interest using a series of put options. Once the number of additional shares that the market can absorb above normal or average period volume has been determined, the holder theoretically needs only to purchase a series of put options with a strike price equal to that of the current stock price, with maturities equal to the subject periods required to liquidate the position in an orderly fashion without disrupting the stock’s supply/demand equilibrium.

Discount Ranges

Although blockage discounts typically range from 0% to 15% (according to Reilly and Schweihs), they can be much higher under certain circumstances. Estimation of a blockage discount requires that the analyst consider not only an analysis of applicable and readily observable historical statistics (price, volume, volatility, etc.), but also of information that could cause future statistics to differ significantly from the past. Specifically, an analysis of the subject company, its industry, and the overall economy are all required to adequately assess the potential for future changes in the supply/demand characteristics of the subject company’s shares.

It is the combination of the specific facts and circumstances of the subject block and those that exist for the subject company, industry and economy that determine the magnitude of the blockage discount at a point in time. ■