Understanding the Illiquidity Discount in Private Firm or Start Up Companies Valuation

Let’s analyze the Illiquidity discount or premium research paper published by Aswath Damodaran

When you buy shares in a public company like Apple or Google, you are paying for more than just a claim on future cash flows but also paying for the option to leave. If you need cash or want to change your strategy, you can sell that position instantly with minimal transaction costs.

However, this luxury does not exist for private businesses. When liquidating equity in a private entity, the costs can be substantial relative to the firm’s total value. This difference in value between a liquid asset and an illiquid one is known as the Illiquidity Discount (Premium which we can charge for investing in that particular comapny).

While “rules of thumb” often slap a flat 20–30% discount on private firms, the reality is far more complex. Let’s dive into what actually drives this discount and how to estimate it accurately.

One Size Does Not Fit All: Key Determinants

The illiquidity discount varies significantly across different firms and buyers. Before applying a discount, you must look at the specific characteristics of the business:

1. Liquidity of Assets: A private firm isn’t just a black box; it holds assets. If a firm holds significant cash and marketable securities, it should have a lower illiquidity discount than a firm burdened with hard-to-sell factories.
2. Financial Health: A profitable business is easier to sell than a struggling one. Firms with strong income and positive cash flows generally command a smaller illiquidity discount than those with negative income.
3. Size Matters: The discount usually shrinks as the size of the firm increases. For example, a massive private conglomerate like Koch Industries (worth billions) would have a much smaller discount percentage than a local business worth $15 million.
4. The IPO Option: If there is a high probability the firm will go public soon, the discount drops because the market prices in that future liquidity.

The Flaw in “Rules of Thumb”

Valuation practitioners often use a standard range (e.g., 25%) for all private firms based on averages derived from restricted stock studies.

1. The Data: Studies by researchers like Maher (1969-73) and Moroney (1973) analyzed restricted stocks, securities issued by public companies that cannot be resold for a specific period. They found average discounts ranging from 33% to 35%.
2. The Problem: Using these averages blindly is dangerous because it ignores the specific financial health and size of the firm in question.

Better Ways to Estimate the Discount

Rather than guessing, there are two rigorous methods to calculate a specific discount for a specific firm:

1. The Adjusted Discount (Regression Approach)

Silber (1991) improved upon the averages by running a regression to see what factors actually caused the discount to change. He found that discounts are smaller for firms with higher revenues and positive earnings.

The regression formula derived from his study is:

$$LN(RPRS) = 4.33 + 0.036 \cdot LN(REV) + 0.142 \cdot LN(RBRT) + 0.174 \cdot DERN + 0.332 \cdot DCUST$$

• REV: Revenues of the private firm.
• DERN: A dummy variable (1 if earnings are positive, 0 if negative).
• DCUST: A dummy variable reflecting if there is a customer relationship.

By using this approach, you can start with a benchmark discount (e.g., 25%) and adjust it upward or downward based on the specific revenue and profitability of the private firm.

Crux

The illiquidity discount is real, but it is not a fixed number. A profitable firm with $100 million in revenue should not be penalized with the same discount as an unprofitable firm with $10 million in revenue. To reach a fair valuation, we must move beyond averages and account for the specific financial reality of the business.