Making Sense of Blockage Discounts – What, When, and Why?
The subject of blockage discounts is not a topic that is widely discussed or used among those who should closely consider it, such as individuals with large blocks of publicly traded stocks, or insiders of publicly traded companies who hold blocks of stock that can not immediately be liquidated. Blockage discounts are appropriate in a number certain circumstances. Below, we navigate through what a blockage discount is, when it should be used, and why the application of the discount is difficult.
The fair market value of small holdings of publicly traded stock is known. The fair market value of publicly traded stocks for estate or gift tax, or divorce may require a discount if the size of the subject interest cannot be readily liquidated without materially creating downward pressure on the stock price, or, if the ownership interest of the common stock is restricted, or held by an insider, and must be sold in conformance with the Securities and Exchange Commission’s regulations. In these circumstances, a discount to the quoted stock price may be warranted. This discount is referred to as a blockage discount.
What is a Blockage Discount?
The International Glossary of Business Valuation Terms defines blockage discount as,
“an amount or percentage deducted from the current market price of a publicly traded stock to reflect the decrease in the per share value of a block of stock that is of a size that could not be sold in a reasonable period of time given normal trading volume.”
Additionally, fair market value is defined in the International Glossary of Business Valuation Terms as, “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” The fair market value definition affects how valuation professionals estimate the blockage discount.
The law of supply and demand dictates that when the demand for a stock of a public company exceeds the available supply, the price of that stock rises in order to stimulate additional supply. Inversely, when the available supply of stock of a public company increases, the price of that stock will decline in order to stimulate additional demand. When a block of stock is too large for the market to absorb without depressing the price, the “hypothetical buyer” would demand a lower price since the buyer is taking on the risk that the stock price may decline while they try to liquidate their position.
Case law gives guidance on the relevant factors to consider when estimating the blockage discount. Some of these factors include:
- The number of shares in the block relative to the total company shares outstanding and daily trading volume.
- The average trading volume in the periods preceding the valuation date.
- Any restrictions on the transferability of stock.
- Whether the size of the block constitutes control of the entity.
- The volatility of the company’s stock.
- The company’s ability to pay dividends.
- The company’s current economic outlook.
- The required holding period for the stock.
- Other relevant factors specific to the circumstances.
Not all of these factors should be weighted equally and the weighting depends on the facts and circumstances of the situation.
Once the sale restrictions of the subject block of publicly traded stock is determined, a valuation analyst can then determine which method is the appropriate method to use in calculation of the blockage discount. There are many different options an owner of large blocks of restricted stock and unrestricted stock can use to sell their shares, such as a secondary offering, company redemption, private placement or dribble-out. However, due to the different methodologies, many court cases have found some methodologies for determining blockage discounts to be more appropriate than other methods or have used a weighted average of multiple approaches in their rulings.
Difficulty in Applying the Blockage Discount
On the surface, estimating a blockage discount should seem easy. Valuation analysts regularly use discounts, such as the discount for lack of control or marketability. However, a major obstacle when estimating the blockage discount is determining the amount of time it would take to sell off the stock without negatively affecting its price. This time is often referred to as a dribble-out period. The dribble-out period also depends on if the subject stock is restricted or if the subject stock’s owner is an insider (affiliate) of the subject company.
One of the first considerations a valuation analyst should make in determining the blockage discount is whether the subject block is restricted, held by an insider, or held freely-traded securities. Restricted stock is generally acquired in private sales. An insider, or affiliate, is someone who has the power to directly affect the management or policies of the company. Even if these controlled securities were not restricted in the hands of the affiliate, they are deemed restricted to any potential buyer. Subject blocks of insider stock may take longer to sell than restricted or freely-traded stock because insider stock is subject to regulations on the amount of shares that can be sold each quarter. The dribble-out periods for blocks of insider or restricted stock may be measured in years for thinly-traded companies, whereas the dribble-out period of blocks of unrestricted stock may occur in a shorter period of time.
Blockage discounts are a very useful tool for valuation professionals in determining the fair market value of a sizeable interest in a public company. Whether you are a high net worth individual with large blocks of publicly traded stocks, or an attorney / tax professional representing these individuals for estate planning or gift tax purposes, it is important to know there are many factors to consider when determining a blockage discount. Every situation is different and should be treated as such.
Charles A. Wilhoite, CPA, and Aaron M. Rotkowski. “Fair Market Value and Blockage Discounts: When the Market Doesn’t Give You the Answer.” Insights, Autumn 2014, pp. 76-85.
George B. Hawkins, ASA, CFA. “Blockage Discounts for Publicly Traded Stock.” Business Value, Banister Financial, Inc., Fall 2001.
William H. Frazier and Ronak P. Shah. ”Determining the Cost of Blockage by the Market-Derived Blockage Discount Model.” Business Valuation Review, American Society of Appraisers, Summer 2018, Vol. 37, No. 2, pp. 64-74.