VOLUME 24

|
NUMBER 1
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WI NTER 2012
APPLI ED CORPORATE FI NANCE
Journal of
A MORGAN S TANL E Y PUBL I CAT I ON
In This Issue: Liquidity and Value
Financial Markets and Economic Growth
8 Merton H. Miller, University of Chicago
A Look Back at Merton Millers Financial Markets and Economic Growth
14 Charles W. Calomiris, Columbia Business School
Liquidity, the Value of the Firm, and Corporate Finance
17 Yakov Amihud, New York University, and Haim Mendelson,
Stanford University
Getting the Right Mix of Capital and Cash Requirements
in Prudential Bank Regulation
33 Charles W. Calomiris, Columbia Business School
CARE/CEASA Roundtable on Liquidity and Capital Management
42 Panelists: Charles Calomiris, Columbia Business School;
Murillo Campello, Cornell University; Mark Lang, University
of North Carolina; and Florin Vasvari, London Business School.
Moderated by Scott Richardson, London Business School.
Statement of the Financial Economists Roundtable
How to Manage and Help to Avoid Systemic Liquidity Risk
60 Robert Eisenbeis, Cumberland Advisors
Clearing and Collateral Mandates: A New Liquidity Trap?
67 Craig Pirrong, University of Houston
Transparency in Bank Risk Modeling:
A Solution to the Conundrum of Bank Regulation
74 David P. Goldman, Macrostrategy LLC
Revisiting the Illiquidity Discount for Private Companies:
A New (and Skeptical) Restricted-Stock Study
80 Robert Comment
Are Investment Banks Special Too? Evidence on
Relationship-Specifc Capital in Investment Bank Services
92 Chitru S. Fernando and William L. Megginson,
University of Oklahoma, and Anthony D. May,
Wichita State University
80 Journal of Applied Corporate Finance Volume 24 Number 1 A Morgan Stanley Publication Winter 2012
Revisiting the Illiquidity Discount for Private Companies:
A New (and Skeptical) Restricted-Stock Study
1. Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993). 2. For additional discussion of the discount rates used in fairness opinions, see Robert
Comment, Business Valuation, DLOM and Daubert: The Issue of Redundancy, Busi-
ness Valuation Review, 29 (2010).
B D
by Robert Comment
ata from studies of restricted stock are routinely
used by business-valuation analysts and apprais-
ers when valuing private companies to estimate
liquidity discounts, often referred to as discounts
for lack of marketability, or DLOMs. Te standard rationale
for this use of DLOMs is that an asset that is hard to sell must
be worth less, all other things equal, than an asset that is
easier to sell. DLOMs as high as 20% to 40% are commonly
used in practice for valuing small private businesses. (Low
valuations are advantageous for some parties in gift-tax and
divorce matters.)
Te evidence supporting the use of such large DLOMs
comes from so-called restricted-stock studies that analyze
the average percentage price discount (market price less deal
price) seen in private placements of restricted stock (stock
not registered with the SEC for resale to the public). But
these studies, as I discuss in this paper, are badly awed. And
insofar as hard to sell is treated as a type of risk, any supple-
mental adjustment for illiquidity is potentially redundant; it
amounts to a discounting for risk that is already reected in
the core valuation to which a supplemental adjustment, such
as a DLOM, is applied. Te evidence from my own study,
which is summarized in the pages that follow, is consistent
with use of a DLOM no larger than 5-6%.
Large DLOMs have also been used by accountants when
determining the compensation expense associated with grants
of equity. In this case, the justication is largely theoretical.
Te large DLOM is calculated as the value of a put option
that protects its owner against all downside risk (with the
value of the put expressed as a percentage of total value).
Te intuition, if one can call it that, is that an elimination of
downside risk mitigates the inconvenience of illiquidity. Te
put estimate is based on the volatility of free-trading shares,
perhaps based on comparable public companies, along with
an estimate of the expected time before a liquidity event.
But this option-based approach is overkill at best, and adds
nothing to the purported empirical support for large DLOMs.
Accordingly, in public disclosures, corporate executives would
be well advised to characterize any double-digit DLOMs used
in fair-value estimates as assumptions based on managements
highly speculative judgment, and not on hard evidence.
Many business valuations are produced for the eyes of
a judge in a prospective future legal proceeding. Since the
Supreme Courts ruling in Daubert,
1
all federal judges (and by
now most state judges) are obliged to exclude expert opinion
that is not reliable. While judges have been slow to impose
Daubert standards on business-valuation methods, perhaps in
the belief that valuation is necessarily as much art as science,
such judicial forbearance is unlikely to last. One takeaway
from this paper is that a valuation that includes a large
DLOM based on evidence from studies of restricted stock
may not provide the anticipated degree of legal comfort.
Specically, judges have not yet addressed the likely
redundancy of large DLOMsa redundancy that results in
a double discounting for the risk reected in a core valua-
tion methodology like discounted cash ow (DCF) analysis.
In practice, discount rates depend strongly on the size of
the company being valued, with higher rates being used
for smaller companies. But it also happens to be true that
company size is highly correlated (across companies) with
liquidity or marketabilityan empirical regularity that has
been shown to hold using almost every measure of size and
liquidity. Because the eective size premium in discount rates
is large, there is a large discount for lack of size (DLOS)
embedded in core valuation methodologies. Because size and
marketability are highly correlated, a large DLOM is likely
to amount to just a second DLOS by another name, where
the rst DLOS is ample.
Just how ample eective size premiums tend to be can be
seen in the discount rates used in the fairness-opinion valua-
tions that investment bankers produce in support of their
M&A transactions.
2
Table 1 shows the average discount rates
used in a random sample of 700 DCF valuations produced
during 2007-2010 and publicly disclosed in an SEC ling,
most often in a proxy statement for a shareholder vote to
approve a merger. Tese 700 DCF valuations were produced
by a total of 162 investment banks and valuation rms, with
the four most active rms (Goldman Sachs, JP Morgan,
Merrill Lynch, and Morgan Stanley) producing one-quarter
of the total. Each valuation uses a range of discount rates, so
81 Journal of Applied Corporate Finance Volume 24 Number 1 A Morgan Stanley Publication Winter 2012
3. See Viral V. Acharia and Lasse Heje Pedersen, Asset Pricing with Liquidity Risk,
Journal of Financial Economics, 77 (2005).
4. See Table 4 in Mukesh Bajaj, David Denis, Stephen Ferris and Atulya Sarin, Firm
Value and Marketability Discounts, Journal of Corporation Law, Vol. 27 (2001).
5. An extreme example where buyer skepticism may have played a role is the private
placement by the development-stage pharmaceutical company HST Global, Inc., which
sold restricted stock without registration rights in August 2008. The new shares, which
amounted to 4% of shares outstanding, were sold to 22 buyers at a price of $1.25/
sharea discount of 86% off the (OTCBB) trading price on the day the deal closed. That
market benchmark had risen over the prior 30 calendar days from $3.59 per share to
$8.98 per share, or by 150%.
6. The known or potential rate of error is one indicia of reliability cited by the Su-
preme Court in its Daubert ruling governing the admissibility of expert testimony. See
Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993).
My study avoids four mistakes that are routinely made by
studies of the liquidity discounts seen in private placements
of restricted stock.
First and foremost, it is a mistake to assume that discounts
in private placements of restricted stock are attributable solely
to restricted marketability since discounts also occur in private
placements of free-trading shares. My data include free-trading
shares (28% of all deals) as well as restricted stock. Only the
dierential discount can be attributed to the restricted nature
of restricted stock, and then only after controlling for deter-
minants of discounts that are common to restricted stock and
free-trading shares. But, as discussed below, my own and other
studies have shown that actual discounts depend little on the
restricted nature of restricted stock.
Second, one long dominant feature of the private-place-
ment landscape has been the high participation by OTC
companies (those with Pink-Sheet or OTCBB-traded shares).
OTC companies account for 41% of the 1,103 private place-
ments of common stock during 2004-2010 (that are included
in my data). Tis is down from 82% of 88 deals during the
period 1990-1995.
4
Tis matters because almost all of the
largest discounts (those above 50%) in my data occur in deals
by OTC companies. Te prevalence of OTC deals means
that discounts are often calculated relative to market prices
that are set in trading venues that are not often thought of
as ecient markets. It is a mistake to overlook the eect of
OTC status, especially insofar as such data provide the juice
of the analysis.
Te third mistake is related to the second. It is a mistake
to overlook the change in the market price of the stock over
the several weeks before the deal. Te rationale is straight-
forward. Buyers may be skeptical about a market price, and
discount more heavily o that market price to compensate
for any recent increases.
5
Consistent with this possibility, the
percentage change in stock price over the 30 days before the
deal closes explains private-placement discounts as well as any
other explanatory variable that I consider.
Fourth, the dispersion in discounts from one deal to the
next is wide and it may be tempting to overlook this attribute
of private-placement discounts when reaching conclusions.
It is because the dispersion is wide, however, that it is impor-
tant to address this feature of the data.
6
Because t-statistics
increase with sample size, statistical signicance presents a
low bar in a sample as large as mine.
One nal mistake: it is wrong to assume that an average
discount reects blockage (a practical rather than regulatory
Table 1 reports the average high and average low. Te eective
size premium is simply the dierence in the discount rates
deemed appropriate for the smallest versus largest companies
(row D minus row A in Table 1), which comes to 7.6% based
on the low and 10.0% based on the high, or 8.8% overall.
While size and liquidity are correlated, a size premium this
large cannot be plausibly attributed to a dierence in liquidity
alone. In one model, illiquidity contributes 4.6% per year to
the dierence in annual risk premium between stocks with
low versus high liquidity.
3
Compared to this estimate, the
eective size premium of 8.8% seen in Table 1 should be
sucient to address liquidity risk.
Finally, the size premium in an annual discount rate can
be made comparable to a DLOM by converting it arithmeti-
cally into a one-time, up-front discount for lack of size, or
DLOS. Based on either the high or low rates in Table 1 and
using a Gordon growth model with an assumed growth rate
of 3%, the typical embedded DLOS approximates 53% of
total value (such as the result of a DCF valuation). Tat the
DLOS typically embedded in core valuation methods is this
large suggests that there is little remaining justication for a
DLOM of any signicance.
Ideally, the size premium in the discount rate used in a
DCF valuation should mimic a market-based size premium.
Similarly, because it uses market data, a restricted-stock
study holds the possibility of identifying an incremental,
non-redundant DLOM. Tis is because the market price
against which the price discount is measured already reects
a DLOS. Unfortunately, while a DLOM estimated in a
restricted-stock study is inherently incremental, this benet
easily can be oset by an otherwise awed methodology.
Size of Company Being Valued:
(based on deal terms)
Discount Rate
Number Average Low Average
High
A $1 Billion or more 224 9.7 11.8
B $200 to $999.9 Million 214 12.2 15.1
C $50 to $199.9 Million 141 15.8 19.4
D $0 to $49.9 Million 121 17.3 21.8
All Valuations 700 13.0 16.0
Table 1 Average Discount Rates Used in Fairness-
Opinion Valuations, Classifed by Size of
Company, 2007-2010
82 Journal of Applied Corporate Finance Volume 24 Number 1 A Morgan Stanley Publication Winter 2012
7. Karen Wruck, Equity Ownership Concentration and Firm Value, Journal of Finan-
cial Economics, Vol. 23 (1989); William Silber, Discounts on Restricted Stock: The
Impact of Illiquidity on Stock Prices, Financial Analysts Journal, Vol. 47 (1991); Mi-
chael Hertzel and Richard Smith, Market Discounts and Shareholder Gains For Placing
Equity Privately, Journal of Finance, Vol. 48 (1993); Mukesh Bajaj, David Denis, Ste-
phen Ferris and Atulya Sarin, Firm Value and Marketability Discounts, Journal of Cor-
poration Law, Vol. 27 (2001); and Michael Barclay, Clifford Holderness and Dennis
Sheehan, Private Placements and Managerial Entrenchment, Journal of Corporate Fi-
nance, Vol. 13 (2007).
8. See Table 5 of Mark Huson, Paul Malatesta and Robert Parrino, The Decline in the
Cost of Private Placements, working paper available at SSRN.com (June 2009).
9. Report of the Advisory Committee on the Capital Formation and Regulatory Pro-
cess, U.S. Securities and Exchange Commission, July 24, 1996. (I served as the staff
economist for the Wallman Committee.)
10. I understand that the change to six months applied retroactively to existing re-
stricted stock. Accordingly, absent an effective registration, restricted stock issued before
August 15, 2007 converted into free-trading shares no later than February 15, 2008,
while restricted stock issued between August 15, 2007 and February 15, 2008 con-
verted after six months.
11. See Mark Mitchell and Mary Norwalk, Assessing and Monitoring the Reliability
of Marketability Discount Studies and the 7.23% Solution, Business Valuation Review,
Vol. 27 (2008).
of common stock by seasoned public companies that are
current in their periodic lings.
9
Te Committees recom-
mendations coincided with the start of electronic ling, a
change that made periodic lings far more accessible. Tese
developments led the SEC to begin a gradual deregulation
to facilitate post-IPO issuances of common stock. One facet
was a modest lowering of the threshold to qualify for the use
of shelf registration, with the result that the current thresh-
olds mainly exclude OTC companies with a public oat
below $75 million. Earlier, during the period 1992-2007, all
companies with oat below $75 million had been excluded.
More importantly, the SEC shortened the minimum holding
period before restricted stock could be resold to the general
public without registration. Te regulatory holding period
was reduced from one year to six months as of February 15,
2008,
10
after being reduced from two years to one year in
early 1997.
The Mists of Time
One might imagine that the private placements most reveal-
ing about and representative of the DLOM were those before
1997, when the regulatory holding period was longest. Te
catch is that these deals mostly pre-date electronic ling,
which was phased in around 1995. Information about these
deals is limited to what issuers disclosed in press releases. If
better information was available at the time, it would have
been in disclosure documents stored on microche at SEC
headquarters. Te press releases are vague about the initial
and subsequent registration status of shares being sold.
11

Because of these data limitations, it appears to be dicult to
determine in these deals if a marketability restriction applied
for the full two-year term, or if one ever applied at all.
In any event, these older data are of dubious relevance
in the modern era. For one thing, the frequency of deals has
increased ten-fold, from 15 per year during 1990-1995 to 158
per year during 2004-2010. Buy-side competition, along with
the shift in composition away from OTC companies, may
have reduced discounts over time.
Even if a longer period confers a theoretical advantage
on pre-1997 data, these data are fuzzy, whereas a study using
modern data can use exact information, including the date
when restricted stock converts into free-trading shares. One of
my regression analyses nds that discounts in placements of
restricted stock vary little with the realized delay before free-
or contractual drag on marketability). Te most immediate
reason for this is that the shares sold in private placements are
not usually sold as a single block. Te buyers often number
in double digits. As a consequence, the size of the whole deal
(the macro block) is very dierent from the average size of
the blocks actually purchased (mini-blocks).
While my study is novel in several respects, it largely
follows a line of economic research on private-placement
discounts.
7
Te latest work in this line, a study by Mark
Huson, Paul Malatesta and Robert Parrino,
8
uses multiple
regression analysis and a large sample to estimate a dierential
discount for restricted stock after controlling for 15 other
explanatory variables. While the DLOM is not their focus,
they nd that the part of the discount directly attributable to
the regulatory restriction (which can be viewed as an estimate
of the DLOM) is 2.6% over their whole sample period, falling
from 4.8% during 1995-2001 to -0.5% during 2002-2007.
Tese estimates are somewhat lower than what I nd during
2004-2010.
SEC Deregulation
Te Securities Act of 1933 requires that companies sell stock
to the general public only after ling a registration state-
ment that discloses material information deemed necessary
to level the playing eld. Having said that, companies are
allowed to sell their securities without registration and the
investor protections associated with a prospectus, just not to
the general public. Common stock sold without registration
is known as restricted stock.
Te SEC has discouraged the sale of restricted stock
throughout its history, mainly by imposing a minimum
holding period before restricted stock can be resold to the
general public. Te social utility of this sand in the gears
deterrence was always dubious, however, given that most
purchases of shares of seasoned public companies occur in
the open market, supported by the companys periodic lings
(mainly on Forms 10-K, 10-Q and 8-K). If these disclosures
are sucient to level the playing eld, then why would (post-
IPO) buyers need registration, sta review, and a prospectus
when the seller happens to be the company rather than
another investor?
Applying this logic, a blue-ribbon advisory panel
convened by the SEC and known as the Wallman Committee
recommended in 1996 that the SEC deregulate the issuance
83 Journal of Applied Corporate Finance Volume 24 Number 1 A Morgan Stanley Publication Winter 2012
12. See Bernardo Bortolotti, William Megginson and Scott B. Smart, The Rise of
Accelerated Seasoned Equity Underwritings, Journal of Applied Corporate Finance, Vol.
20 (2008).
the buyers in private placements of free-trading shares. For
instance, the prospectus supplement led by Orthovita, Inc.
in July 2007 lists the buyers in its private placement of free-
trading shares, a group that includes one natural person, one
investment bank, and ve mutual funds or hedge funds. A
common clientele is not surprising since the same placement
agents handle either type of deal.
Table 2 reports the distribution of deals by the delay
before conversion, and does so separately for deals with and
without registration rights. It takes longer to accomplish free-
trading status without registration rights, as expected, but
registration rights do not eliminate delay. Te data in Table 2
show that quick registrations (in 90 days or less) rarely happen
without registration rights. If you do not have a shelf in place
but think a quick registration is feasible because your public
disclosures are complete and you face a level playing eld, you
might as well grant registration rights and reap the benet of
a (slightly) lower discount.
Blockage Discounts
Te fact that three-quarters of all the common stock of U.S.
public companies is held by institutional investors makes
the possibility of blockage discounts implausible as a general
matter. (A blockage discount at time of purchase anticipates
that exiting the investment through retail sales will drive
down the market price before the sale can be completed.)
But since institutional investors (even small-cap mutual
funds) avoid OTC stocks, blockage discounts are possible
for these smallest of small-cap stocks. In theory, then, since
OTC companies have been responsible for the lions share of
all private placements of common stock, part of the average
discount reported by past studies of restricted stock could
represent a blockage discount akin to a DLOM. But the
evidence for this discount, insofar as it assumes that there is
just one buyer per deal, is highly questionable.
trading status obtains. Te insensitivity of average discounts
to the length of the regulatory holding period suggests
that data originating in the distant past when the regula-
tory restriction was most severe oer no real advantage over
modern data, whereas modern data oer the considerable
advantage of timeliness.
Free-Trading Shares
Technically, it is the issuance and resale of shares that is regis-
tered. Because the shares themselves are not, I use the term
free-trading shares rather than registered shares. Private
placements of free-trading shares take place after a shelf registra-
tion, a type available since 1982. Although some underwritten
equity oerings resemble private placements,
12
my sample of
private placements of free-trading shares does not include any
underwritten oerings. A shelf-registration diers in that it
authorizes generic, future issuances rather than one specic,
immediate issuance. For example, IMAX Corp. stated in its
shelf ling in 2009 that: We may oer and sell, from time to
time in one or more oerings, any combination of debt and
equity securities that we describe in this prospectus having an
aggregate initial oering price of up to $250 million.
So, once the SEC has declared eective a shelf registra-
tion that includes boilerplate language describing the legal
attributes of the registrants common stock and sets a dollar
maximum, the registrant may sell free-trading shares in
subsequent private placements without further regulatory
permission or review. Being generic, a shelf-registration ling
does not include deal-specic information. Tat gets disclosed
in a prospectus supplement led later, at time of sale, which
can be several years later.
While the buyers of private placements of free-trading
shares need not be accredited investors, they mostly are. Te
same sort of institutions and wealthy individuals that are the
buyers in private placements of restricted stock appear to be
All Deals With Registration Rights Without Registration Rights
N % N % N %
Free Trading Immediately 307 28 0 0 0 0
Free Trading in 9 to 90 Days 198 18 194 42 4 1
Free Trading in 91 to 183 Days 352 32 149 32 203 61
Free Trading in 184 to 365 Days 246 22 118 26 128 38
All Deals 1,103 100 461 100 335 100
Table 2 Distribution of Delay Before Free-Trading Status Occurs,
Classifed by Whether the Buyers Receive Registration Rights

84 Journal of Applied Corporate Finance Volume 24 Number 1 A Morgan Stanley Publication Winter 2012
13. I was able to identify the exact number of buyers in 57% of all deals, either from
a count reported in the initial disclosure on Form 8-K or in a follow-on registration state-
ment where the buyers in the earlier placement are all named and thus countable. Also,
where no specifc count of buyers is provided, disclosure documents nevertheless refer to
the buyers using the singular or plural tense.
as a percentage of prior shares outstanding) as an explanatory
variable in my multiple regression, but not as a measure of
potential blockage. I see it instead as a measure of potential
dilution. Dilution will depend partly on how many shares
are sold and partly on the size of the discount. But since
one cannot use the discount itself to construct an explana-
tory variable, I settled for a measure of potential rather than
actual dilution.
While dilution is a better explanation for why discounts
might depend on deal size, it is not a simple explanation. One
would not expect discounts to depend on potential dilution
if (1) the size of the deal is disclosed before the time when
the discount is measured and (2) the market price quickly
and fully reects the mix of public information. Under these
conditions, the potential for dilution should be reected
equally in the market price and the deal price and net out
the calculated discount. I was unwilling to assume that these
two conditions hold routinely in my data. Also, there may be
other explanations besides blockage or dilution.
Why Regression Analysis?
When nancial economists study private-placement discounts,
it is standard practice to use multiple regression analysis to
estimate the eect of the regulatory restriction as a dieren-
tial discount. In contrast, when business-valuation analysts
produce restricted-stock studies, it has been standard practice
to limit the sample to restricted stock in order to sustain the
assumption that the regulatory restriction is the sole cause of
the average discount and the associated assumption that the
unconditional average discount constitutes a valid estimate
of the DLOM. Moreover, with this setup, one can further
maintain that every variable that correlates with discounts
necessarily tells a story about the DLOM. Tis is all problem-
Most private placements of common stock are sold to
groups of accredited investors who are assembled by private-
placement agents for nders fees. Te individual members of
the groups seem to be unrelated except in the sense that some
participating mutual or hedge funds have a common money
manager. It is unlikely that group members would eventually
sell in unison. Tey are unlikely to seek to exit their invest-
ments at the same time, and unlikely to conspire to ood the
market with coordinated sales if doing so will reduce their
sale proceeds.
Table 3 compares the average number of shares sold per
deal to the average number of shares sold per buyer.
13
Each
is expressed as a percentage of the number of pre-sale shares
outstanding and, alternatively, as a percentage of the trading
volume in the market during the last full calendar month
before the close of the sale.
Private placements were sold to a single buyer just 18%
of the time (201 of 1,103). Te size of the macro-block has
actually been an inverse proxy for the size of the typical mini-
block in that the smallest mini-blocks are associated with the
largest macro-blocks. In other words, as the number of shares
sold increases from one deal to the next, the number of buyers
tends to increase even more. In the extreme, in cases with 10
or more buyers, the total shares sold averaged 22.1% of prior
shares outstanding while the typical block sold averaged 0.9%
of prior shares outstanding. Similarly, when there were 10 or
more buyers, the total shares sold typically amounted to over
200% of one months volume while the typical mini-block
amounted to 9% of one months volume. A discrepancy this
great means that any correlation between discounts and the
overall size of the deal, the macro-block, cannot be indicative
of a blockage discount.
I nevertheless included the shares sold per deal (expressed
Buyers
Per Deal:
Number
of Deals
As a % of Shares Outstanding As a % of 1 Months Volume
Mean
Per Deal
Mean
Per Buyer
Median
Per Deal
Median
Per Buyer
1 201 7.9 7.9 104 104
2 9 183 13.2 3.6 214 55
10 or more 242 22.1 0.9 201 9
N/A, but >1 477 15.1 182
All Deals 1,103 14.9 176
Table 3 Shares Sold Per Deal versus Shares Sold Per Buyer

Classifed by number of buyers, alternatively expressed as a percentage of shares outstanding
and as a percentage of trading volume during the calendar month before the deal closed.
85 Journal of Applied Corporate Finance Volume 24 Number 1 A Morgan Stanley Publication Winter 2012
14. For a primer on multiple regression analysis, see Daniel Rubinfeld, Reference
Guide on Multiple Regression in Reference Manual on Scientifc Evidence, 2nd Edition,
2000, Federal Judicial Center. (A 3rd edition is forthcoming.)
15. Registration rights often oblige the issuer to use its best efforts or commer-
cially reasonable efforts to cause a registration statement to be declared effective by the
SEC. A registration-rights agreement can be diffcult to enforce insofar as issuers statu-
tory obligations regarding investor protection trump any obligation arising under a private
contract. The version of the registration-rights agreement with teeth specifes liquidating
damages that the issuer must pay at recurring intervals, regardless of effort or feasibility,
for as long as a timely registration is not accomplished.
lings. Sales of restricted stock in material amount are disclosed
on Form 8-K. While some smaller deals are disclosed only on
Forms 10-K or 10-Q (which I included when I happened
upon them), my sample came mostly from 8-K lings. Private
placements of free-trading shares are disclosed dierently in
prospectus supplements. Finally, conversions of restricted
stock into free-trading shares are disclosed in registration state-
ments led after the sale. Tese SEC lings generally disclose
whether any buyer is an aliate of the company and whether
buyers receive registration rights.
15
I excluded private placements of common stock for any
of the following reasons:
gross proceeds are below $100,000;
the deal price or the market price is below $0.10 per
share;
shares are sold for consideration other than immediate
cash;
shares are sold in a package with warrants or other
securities;
additional shares might ultimately be deliverable due
to a make-good provision;
the shares are issued upon exercise of an option to
buy;
the shares are issued pursuant to a standby equity line
atic to the extent that discounts are caused by factors other
than the regulatory restriction.
One reason that multiple regression analysis is so perva-
sive in economic research is that the estimated coecient
for any one explanatory variable is supposed to measure the
separate eect of that factor, after controlling for eects
that are statistically attributable to the other explanatory
variables included in the analysis.
14
Tis multivariate capabil-
ity addresses a problem with bivariate analyses, where variable
X proxies for variable Y and the separate eect of X on Z, if
any, is revealed only after controlling for the eect of Y on Z.
Multiple regression analysis is the recommended method in
this situation in part because it allows one to control for many
dierent Ys at once. Accordingly, the purpose of regression
analysis in the present study is to isolate the separate/direct
eect of the regulatory restriction on the average discount in
private placements after controlling for other determinants.
The Data for My Study
I analyzed 1,103 private placements of common stock that
closed over the seven-year period from January 1, 2004
through December 30, 2010. Tese deals were completed by
724 dierent companies. I found these private placements
using various keyword searches of Bloombergs archive of SEC
Restricted Stock Free-Trading Shares All Deals
Attribute: Mean Median Mean Median Mean Median
Market Capitalization 177.0 66.3 275.8 160.2 204.5 93.8
Total Assets 201.0 16.9 202.8 50.5 201.5 27.7
Cash & Short-Term Investments 13.2 2.2 28.4 16.8 17.5 4.1
Revenue (last 12 months) 141.4 5.2 281.5 9.4 180.4 6.4
Net Income (last 12 months) -7.0 -3.0 -21.0 -14.9 -10.9 -4.6
Shares Sold as a % of Prior Shares 16.0% 9.4% 12.4% 11.6% 15.0% 10.1%
Gross Proceeds of Sale 19.4 4.1 23.9 16.5 20.7 7.0
Deal Price Per Share 5.39 1.78 7.10 4.50 5.87 2.50
Change in Stock Price Over Prior 30 Days 13.8% 2.5% 2.8% -1.6% 10.7% 1.5%
Days Delay Before Free Trading 185 183 0 0
Fraction with Net Income < 0 79.8% 81.1% 80.1%
Fraction with Revenue = 0 21.2% 15.3% 19.6%
Fraction OTC 54.8% 3.9% 40.6%
Fraction with Deal Price <= $1/share 41.0% 14.7% 33.6%
Fraction with One Buyer 20.6% 12.1% 18.2%
Table 4 Attributes of 1,103 Private Placements of Common Stock, 2004-2010,
Per Deal, Classifed by Type of Deal, in $ Millions Except as Otherwise Indicated

86 Journal of Applied Corporate Finance Volume 24 Number 1 A Morgan Stanley Publication Winter 2012
16. In a few instances, insiders participated as buyers but were made to pay a higher
price than the other buyers (generally paying the market price without discount). In these
several instances, I include the deal but only insofar as it relates to the unaffliated buy-
ers.
17. Discounts Involved in Purchases of Common Stock (1996-1969), Institutional
Investor Study Report of the Securities and Exchange Commission, H.R. Doc. N.64, part
5, 92nd Cong., 1st Session, 1971, 2444-2456.
Te scarcity of large, well-known companies in this sample
is not surprising since such companies have operating cash ow,
ready access to debt nancing, and correspondingly less need
for external equity nancing. Consistent with this, the largest
companies in the sample tend to be master limited partnerships
and real estate investment trusts. Of the 20 companies with
the largest market capitalizations, half are MLPs or REITs.
For tax reasons, these entities pay out most of their earnings
as dividends or partnership distributions, and consequently
resemble smaller, growth companies in their reliance on exter-
nal nancing to fund new projects and expansions.
Te smallest companies are usually excluded from studies
of private-placement discounts, albeit indirectly by excluding
those with stock prices below $1 or $2 per share. Discounts
are correlated with OTC status, and only OTC companies
(and fallen angels) trade at stock prices this low. To have an
inuential explanatory variable like OTC status eectively
serve double duty as a sample-selection criterion introduces
an unneeded complication. My sample includes companies
with stock prices as low as $0.10 per share (but they must
trade on the day of the close, which excludes quite a few
OTC companies), and I then controlled for OTC status in
my regression analysis.
In sum, although my sample is large, it is unrepresentative
of the population of all companies. Most of the companies that
have done private placements of common stock are smaller,
cash-burning growth companies. Private-placement companies
are especially notable for the prevalence and size of their losses
in the year before the deal. Finally, the largest companies in
my sample (measured by market capitalization) are dispropor-
tionately MLPs or REITs. While MLPs and REITs comprise
just 46 (or 4%) of all the deals in this sample and thus have
little eect on the regression estimates reported below, these
companies comprise half of the largest 20 companies in the
sample. Accordingly, the very largest companies that do these
deals are not especially representative either.
Regression Model
The dependent variable in the regression analysis is the
private-placement discount, which compares the per-share
deal price to the prevailing market price. In calculating
the discount, I measured the prevailing market price as the
volume-weighted average price (VWAP) on the day the deal
closes. Te discount is the dierence between the deal and
market prices expressed as a percentage of the market price,
which has a positive value when the deal price is below the
market price.
In its Institutional Investor Study Report published in
1971,
17
the SEC found that restricted-stock discounts were
that gives the company the right to put shares to the purchaser
periodically at a formulaic price;
the sale constitutes a change-in-control transaction;
the buyer group includes an ofcer, director or afliate
of the selling company;
16
the buyer is a company that is a strategic partner of the
selling company;
the selling company is a bank; or
the selling companys stock does not trade on the day
the sale closes.
Te common stock sold in private placements is often
packaged with warrants (a right to buy more shares at a set
price over, typically, ve years). Warrant-sweetened deals are
more frequent than are stock-only deals. I followed standard
practice and excluded sweetened deals because there is not a
contemporaneous trading price for the warrants, and thus no
market price for the package (or unit) of shares and warrants
that a discount can be calculated against. In the alterna-
tive, one could venture to use an option-pricing formula to
value the warrant component of the package, but this would
produce a benchmark price that is based in part on a level-3
input and not solely on observed market values, meaning the
resulting estimate of the DLOM would seem to fall short of
the fair-market-value standard of value. In any event, stock-
only deals are plentiful.
Table 4 shows some of the attributes of the deals and the
companies in my sample. Te real eye-opener here is that
80% of the companies report negative net income over the
last four quarters before the deal closes, with the average
loss being $10.9 million. Losses are equally frequent for the
companies that sell free-trading shares and restricted stock,
but the average loss is three times greater among the compa-
nies that sell free-trading shares ($21.0 million) compared to
those that sell restricted stock ($7.0 million).
Te busiest of the seven years was 2007, with 21% of
all deals, while the slowest years were 2008 and 2009, each
with 11% of the total. Pharmaceutical companies accounted
for 19% of all deals, oil & gas companies 14%, manufactur-
ers 10%, medical technology 8%, non-medical technology
7%, and mining companies 5%. Smaller public companies
predominate. Of all deals, 5% were done by NYSE companies,
13% by Amex companies, 30% by NASDAQ Global Market
companies (regular Nasdaq companies), 11% by NASDAQ
Capital Market companies (the junior tier) and 41% by OTC
companies (all those not NYSE, Amex or NASDAQ). Compa-
nies that pay cash dividends comprise 6% of the sample. As
previously noted in the literature, the typical company that
sells common stock in a private placement has been a compar-
atively small, cash-burning growth company.
87 Journal of Applied Corporate Finance Volume 24 Number 1 A Morgan Stanley Publication Winter 2012
18. I calculate market capitalization as pre-deal shares outstanding times an average
of two market prices: the VWAP for the day 30 calendar days before the close and the
VWAP on the day of the close.
before the sale, expressed as a percentage of market capitaliza-
tion;
18
an indicator variable for negative net income;
sales revenue over the last four quarters before the sale,
expressed as a percentage of market capitalization;
an indicator variable for zero revenue;
holdings of cash, marketable securities and short-
term investments last reported before the sale, expressed as a
percentage of market capitalization.
Buyer Skepticism
Te sophisticated buyers in private placements may demand
a discount from the trading price because of skepticism about
that benchmark price. Tese variables include:
an indicator variable for OTC companies;
an indicator variable for NASDAQ Capital Market
companies (the junior tier of NASDAQ and the next closest
category to OTC status);
the percentage change in the market price over the
most dependent on (1) net income, (2) sales, (3) OTC status,
and (4) registration rights. My explanatory variables were
inspired by these four. Because my data are numerous,
however, I could employ a comparatively large number of
explanatory variables. I used 15 explanatory variables: ve as
indicators of solvency (more or less); three for buyer skepti-
cism about current prices; one for potential dilution; one for
deals done possibly not at arms length; and ve to cover
aspects of the regulatory restriction on marketability.
Ten of the 15 explanatory variables are simple indicator
variables (sometimes called dummy variables). An indicator
variable is a construct that equals one when a given condi-
tion prevails and zero otherwise. Te included explanatory
variables, and brief rationales, are as follows:
Solvency
Low solvency may weaken a companys bargaining position
when negotiating a sale price. Tese variables include:
net income (mostly losses) over the last four quarters
Regression 1 Regression 2 Regression 3
Explanatory Variable:
Coeffcient P-value Coeffcient P-value Coeffcient P-value
Intercept 6.281 0.000 4.075 0.017 3.938 0.021
Net Income as a % of Mkt. Cap. 0.045 0.000 0.045 0.000 0.044 0.000
Indicator for Net Income < 0 5.357 0.001 5.600 0.000 5.698 0.000
Revenue as a % of Mkt. Cap. -0.002 0.339 -0.002 0.271 -0.002 0.273
Indicator for Revenue = 0 4.915 0.001 4.991 0.001 5.186 0.001
Cash & STIs as a % of Mkt. Cap. -0.138 0.000 -0.130 0.000 -0.129 0.000
Indicator for OTC 13.961 0.000 11.575 0.000 11.842 0.000
Indicator for Junior Tier of Nasdaq 2.523 0.188 2.145 0.263 2.284 0.235
% Change in Market Price over 30 Days 0.107 0.000 0.105 0.000 0.105 0.000
Total Shares Sold as a % of Prior Shares 0.094 0.000 0.093 0.000 0.090 0.000
Indicator for One Buyer -8.834 0.000 -9.239 0.000 -9.147 0.000
Indicator for Restricted Stock
Sold without Registration Rights
5.238 0.006
Indicator for Restricted Stock
Sold with Registration Rights
3.464 0.021
Indicator for Free Trading in 990 Days 3.232 0.066
Indicator for Free Trading in 91183 Days 3.551 0.040
Indicator for Free Trading in 184365 Days 5.569 0.004
R-Square 0.270 0.276 0.276
Adjusted R-Square 0.264 0.268 0.268
Standard Error 18.96 18.90 18.91
Number of Observations 1,103 1,103 1,103
Table 5 Multiple Regression Analysis
Dependent Variable is Percentage Private-Placement Discount

88 Journal of Applied Corporate Finance Volume 24 Number 1 A Morgan Stanley Publication Winter 2012
this size. It is conventional to accept a coecient as being
signicantly dierent from zero if the P-value is at or below
0.05 or 0.10. Tese correspond to condence levels of 95%
and 90% (one minus the P-value, expressed as a percent).
Four of the ve explanatory variables that are more or less
related to company solvency (rows 2 through 6 of Table 5) are
inuential and statistically signicant. Percentage discounts
include a component of 5% to 6% if the company reports
negative net income over the four quarters before the deal,
and another 5% if the company is at a stage of development
where it has yet to generate any revenue. Tat the coecient
estimate for net income (as a continuous variable) is positive
may seem surprising at rst, but it may seem less of a surprise
when one considers (as reported in Table 4) that the losses
of companies that sell free-trading shares (at generally lower
discounts) are three times greater than the losses reported
by those that sell restricted stock. A private placement may
signal a faster-than-expected burn rate at the same time that
it reveals that funding is now in hand to keep the company
operating a while longer. But having said that, I dont claim to
understand the role that pervasive losses (the cash-burn rate)
play in determining private-placement discounts.
Te coecient for holdings of cash and short-term invest-
ments is negative, which is consistent with intuition: Te
more cash on hand, the lower the discount. More cash on
hand implies greater bargaining power, since the company is
less desperate for funding to continue its operations. Tus one
reward for better planning and more-deliberate fundraising
is a lower discount.
Two of the three explanatory variables related to buyer
skepticism about the validity or sustainability of the market
price (against which the discount is calculated) are economi-
cally and statistically significant. Statistically, the most
signicant explanatory variable (the one with the highest
t-statistic) is the percentage change in the market price during
the 30 calendar days before the closing date of the deal. Te
discount is approximately 1.1 percentage points greater for
every ten percentage points of recent run up in the market
price (and vice versa for a decline). Discounts are 11% to 14%
greater for OTC companies, depending on the regression.
Companies with stock listed in the junior tier of NASDAQ
are the closest thing to OTC companies, but are not so close
with respect to discounts and this variable explains little.
Discounts are 2% higher for companies in this category.
The explanatory variable that covers the effect of
potential dilution on discounts is the size of the deal (the
macro-block) expressed as a percentage of pre-sale shares
outstanding. Discounts are 0.9 percentage points greater
for every ten percentage points of increase in the number of
shares outstanding by virtue of the new shares that are sold.
For example, if a rm with 100 shares issues 10 new shares,
shares outstanding increase by ten percent and the discount
increases by 0.9 percentage points.
30-calendar-day period ended the day of the close, measuring
the market price by the VWAP for the day.
Potential for Dilution
As discussed in the earlier section on Blockage Discounts,
this variable is calculated as the total number of shares sold
expressed as a percentage of pre-sale shares outstanding.
Possibly Not at Arms Length
I excluded deals where the buyer is an aliate of the company,
insofar as that is disclosed, but disclosure of ulterior motives
is inherently incomplete. Beyond that, companies may reveal
positive inside information to select buyers, perhaps inappro-
priately, and want to limit the number of recipients of this
information. Tis variable is:
an indicator variable for deals sold to a single buyer.
Restricted Marketability
I measured every aspect of the marketability restriction I
could. Tese variables include:
an indicator variable for whether the shares initially
take the form of restricted stock without registration rights;
an indicator variable for whether the shares are
restricted stock with registration rights;
an indicator variable for restricted stock that ends up
converting into free-trading shares within three months (1
to 90 days);
an indicator variable for restricted stock that ends up
converting into free-trading shares in four to six months (91
to 183 days);
an indicator variable for restricted stock that ends up
converting into free-trading shares in seven to twelve months
(184 to 365 days).
For technical reasons (some of the indicator variables
just cited are a linear combination of the others), all ve of
these cannot be included as explanatory variables in the same
regression. I express certain accounting values as percentages
of market capitalization because, so scaled, their explanatory
power in the regression is much enhanced. Te rationales for
these explanatory variables are not all strong, as I err on the
side of inclusion. What matters is that none of the included
variables (and no omitted variable) be directly related to, or
a signicant proxy for, the regulatory restriction other than
the ve intended for that purpose.
Regression Results
Table 5 summarizes the results of three formulations of multi-
ple regression analysis. Te estimated coecients for most
of the control variables are statistically signicant, as would
be expected in a sample as large as this. Statistical signi-
cance is reported in Table 5 as a P-value (there is one for each
coecient estimate), which tells you whether the estimated
coecient is signicantly dierent from zero in a sample of
89 Journal of Applied Corporate Finance Volume 24 Number 1 A Morgan Stanley Publication Winter 2012
19. R-square is the fraction (ranging from zero to one) of the total variance in the
dependent variable that is explained in a given regression. The adjusted R-square statis-
tic differs from the raw R-square statistic in that the adjusted R-square increases only if
the added explanatory variables improve the model more than would be expected by
chance. The validity of this fnal test does not depend on the accuracy of the estimated
coeffcients of the individual explanatory variables.
Te coecient estimate reported in Table 5 that is most
relevant for the DLOM is the one (5.238) that appears in the
column labeled coecient under the heading Regression
2. After controlling for determinants of discounts unrelated
to the regulatory restriction, the portion of the typical
discount that can be tied directly to the regulatory restriction
in its most severe form is thus 5.2%, which is signicantly
dierent from zero but much smaller than conventional
DLOMs of 20% to 40%. As for the companion indicator
variable, when the regulatory restriction is mitigated through
a grant of registration rights that could serve to accelerate the
conversion of the restricted stock into free-trading shares,
discounts are 3.5% higher instead of 5.2% higher.
In Regression 3, the regulatory restriction is represented
by the realized delay before free-trading status obtains. Tis
information is not available to participants at the time of
the deal, but these data may proxy for the expectations of
the participants at the time of the deal. Discounts are 3.2%
higher when conversion occurs within 90 days, 3.6% higher
when conversion occurs within 91 to 183 days, and 5.6%
higher in the remaining cases where restricted stock ends up
converting into free-trading shares 184 to 365 days follow-
ing the close. Te last two of these estimates of the DLOM
is signicantly dierent from zero. Accordingly, discounts
depend some, though not much, on the realized delay before
the regulatory restriction is lifted.
As I explain below, data on the CD-Treasury yield spread
imply a DLOM of 2.5%. Because the DLOM on the riskless
asset can be calculated most directly, without need for multi-
ple regression analysis, the interesting statistical test is not
whether an estimate of the DLOM from a multiple regression
diers from zero, but whether it diers from 2.5%. In other
words, one concedes a DLOM of 2.5% and then asks of any
additional data whether the concession is merited.
Of the two coecient estimates in Regression 2 that
relate to the regulatory restriction, even the higher of the
two estimates, 5.2%, is not statistically signicantly dierent
from 2.5% (t-statistic of 1.44, P-value of 0.150). Likewise,
the highest of the three estimates in Regression 3 is 5.6%, an
estimate that is not statistically signicantly dierent from
2.5% (t-statistic of 1.61, P-value of 0.110).
Finally, and most importantly for my conclusions, one
can ask if the inclusion of the several explanatory variables
related to the regulatory restriction on marketability adds
to the overall explanatory power of the multiple regression
analysis. Te relevance of additional explanatory variables
is established by comparing the adjusted R-square statistics
(reported near the bottom of Table 5) of two alternative
models.
19

Discounts are around 9% lower when there is a single
buyer. Some of this may be due to sweetheart deals (oddly,
ones that favor existing shareholders, in contrast to friends
and family allocations of underpriced IPOs). While I
exclude deals known to be made with affiliated buyers,
informal relationships are commonplace among the small
companies that do private placements of common stock and
informal relationships and ulterior motives are not necessarily
disclosed. Also, as I noted earlier, lower discounts in single-
buyer deals are consistent with a desire by companies that
improperly leak positive inside information as part of a sales
pitch to limit the number of recipients of such information
to a single investor.
Regression 1 in Table 5 is the base regression, meaning
that it excludes all of the explanatory variables related to the
regulatory restriction. Tis formulation yields information
about how much of the overall variance in discounts can be
explained without any help from the explanatory variables
related to the regulatory restriction.
Regression 2 includes the indicator variable for restricted
stock sold without registration rights, along with the compan-
ion indicator variable for restricted stock sold with registration
rights. Because registration rights serve to mitigate the eects
of the regulatory restriction, the estimated coecient on the
rst of these two indicator variables (without registration
rights) should reect the eect of the regulatory restriction on
discounts more fully than will the second indicator variable
(with registration rights).
Chart 1 CD-Treasury Yield Spreads,
Monthly from June 1998 through June 2011
1%
2%
3%
4%
5%
6%
7%
1% 2% 3% 4% 5% 6% 7%
Y
i
e
l
d

o
n

5
-
Y
e
a
r

C
D
s

Yield on 5-Year Treasuries
90 Journal of Applied Corporate Finance Volume 24 Number 1 A Morgan Stanley Publication Winter 2012
20. Historical data on CD yields are available from mid-1998 for several different
maturities, including the fve-year CD. My source for Treasury yields is also Bloomberg,
which offers a screen for a yield curve based on U.S. Treasury Actives from which the
yield on a hypothetical security of exactly fve years maturity can be obtained, as of any
given date, via interpolation from the actual yields on that date on Treasury notes and
bonds with remaining lives closest to fve years. Because the time of day of the CD
measure is ambiguous, I compare the CD yield on a given day to the average of the (close
of day) Treasury yields for that day and the preceding day.
21. See Susan Chaplinsky and Latha Ramchand, The Impact of SEC Rule 144A on
Corporate Debt Issuance by International Firms, The Journal of Business, Vol. 77
(2004).
22. See Yakov Amihud and Hiam Mendelson, Liquidity, the Value of the Firm, and
Corporate Finance, Journal of Applied Corporate Finance, Vol. 20 (2008).
buildup method of nding a discount rate for use in a DCF
valuation.
Equivalently, one can convert the CD-Treasury yield
spread into a DLOM to be applied supplementally to the
results of a core valuation methodology. An initial invest-
ment of $97,500 in the average ve-year CD would result in
approximately the same ending balance (including reinvested
interest) after ve years as would an initial investment of
$100,000 in a ve-year Treasury security. So, a CD-Treasury
yield spread of 0.5% implies a supplemental, non-redundant
illiquidity discount, or DLOM, of 2.5% (since $97,500 is
2.5% lower than $100,000).
That the DLOM on the riskless asset approximates
2.5% leads to the conclusion that any discounting for lack
of marketability beyond 2.5% constitutes a second round
of discounting for risk (where the rst round occurs in a
DCF or similar valuation). While illiquidity and the risk of
future cash ows are separate factors in valuation,
22
redun-
dant discounting represents a potential problem with any
business valuation that includes a large DLOM. As discussed
earlier, liquidity is highly correlated with company size, where
size is already an important determinant of discount rates.
So, while liquidity matters to valuation, the close association
between liquidity and company size, along with the ample
size premiums used in business valuations, mean that any
supplemental DLOM in excess of 2.5% is likely to constitute
redundant discounting.
Tat any DLOM in excess of 2.5% represents a second
round of discounting for the risk of owning a private business
frames the reliability issue. How condent can one be that a
second round of discounting for risk is not redundant to the
rst? Te evidence furnished by past restricted-stock studies
provide a questionable basis for this practice.
Conclusion
Te purpose of this study has been to determine if data on
discounts in private placements of restricted stock imply a
DLOM that is dierent from the DLOM on the riskless asset.
Tis analysis is skeptical in the sense that it is not cong-
ured, as many past studies have been, to document what is
being hypothesized and, perhaps to some degree, desired by
some interested parties. Specically, this study allocates to the
DLOM only that portion of the restricted-stock discount that
can be tied directly to restricted marketability. No portion is
allocated to the DLOM by default or presumption.
Tis approach yields estimates of the DLOM that are
no larger than 5.2% or 5.6%, which is consistent with some
Te adjusted R-square statistics for Regression 2 and
Regression 3 are both 0.268, which is remarkably close to
the adjusted R-square of 0.264 for Regression 1, the base
model with no explanatory variables related to the regula-
tory restriction on marketability. Tat only one-quarter of the
dispersion in discounts is explained by the regression analysis
reects the wide dispersion in private-placement discounts.
Tat these adjusted R-square statistics are so close (0.268
versus 0.264) means that the several explanatory variables
related to the regulatory restriction on marketability, consid-
ered as a group, add almost nothing to the explanatory power
of the base model.
DLOM on the Riskless Asset
Te DLOM on the riskless asset can be calculated from the
dierence in yields between a ve-year bank certicate of
deposit (illiquid due to penalties for early withdrawal) versus
a ve-year U.S. treasury security (highly liquid). Here, the
requisite calculations go beyond mere arithmetic only in that
one must use an average of the yields on CDs oered by some
sample of banks. Data on yields oered on CDs by various
banks are compiled by bankrate.com, which reports averages
that are available on the Bloomberg service.
20

Chart 1 is a scatterplot that compares the yields on ve-
year bank CDs versus ve-year U.S. Treasuries. It shows a
CD-Treasury yield spread as of the last day of each month
from June 1998 through June 2011. Te CD-Treasury yield
spread equals the CD yield minus the Treasury yield. It
appears in the scatterplot as the distance from a given months
dot to the diagonal line. A normal, positive yield spreadone
that compensates for restricted marketabilitywill plot above
the diagonal. Te plot shows that yields on bank CDs tend
to track Treasury yields less closely when ve-year Treasury
yields are high, and shows that the CD-Treasury spread is
nearly always positive when the Treasury yield is below 5%.
Mainly, the CD-Treasury spread is just small. It averages
an implausible -0.053% per year in the 26 months when the
yield on 5-year Treasuries exceeded 5.0%, but still averages
only 0.49% in the other 131 months. My conclusion from
these data is that a typical CD-Treasury spread is no greater
than 0.5%. A CD-Treasury yield spread of 0.5% is almost
identical to the estimated yield spread of 0.49% between
Rule 144A bonds (the xed-income counterpart to restricted
stock) and otherwise-comparable free-trading corporate
bonds.
21
Restricted bonds are typically issued with registra-
tion rights. A yield spread of 0.5% could be included as an
illiquidity premium in an implementation of the Ibbotson
91 Journal of Applied Corporate Finance Volume 24 Number 1 A Morgan Stanley Publication Winter 2012
tory restriction is the sole cause of discounting. Considerable
research, some of it my own, suggests that regulatory restric-
tion is not even the primary cause of discounting. And
without this false assumption and its consequences, little of
the average discount can be tied to the restricted nature of
restricted stock.
Private-company status may merit a discount below
what core valuation methods (such as DCF analysis) would
indicate; indeed, it may even merit a double-digit discount.
But any merited large discount is not primarily a discount for
lack of marketability. Based on evidence from modern private
placements of common stock, the DLOM is not reliably
dierent from the DLOM on the riskless asset, or 2.5%.

robert comment is an Accredited Valuation Analyst who has taught
fnance at Johns Hopkins University, New York University, and the Univer-
sity of Rochester. He served as the SECs Deputy Chief Economist under
Chairman Arthur Levitt and has appeared as an expert witness in over 50
litigations. Dr. Comment can be reached at bobcomment@msn.com.
previous ndings. Moreover, my estimates based on private-
placement data are not statistically signicantly dierent from
the DLOM on the riskless asset of approximately 2.5%.
Valuations are a kind of expert opinion and, in the
Supreme Courts Daubert decision governing the admissi-
bility of expert opinion in court,
23
there is no grandfather
clause that permits continued reliance on methods that are
seasoned but unreliable. In Daubert, the Supreme Court
demoted general acceptance from being the sole requirement
for the admissibility of expert opinion, as it had been for
70 years (under the Frye rule),
24
to one of several items in a
non-exclusive list of indicia of the ultimate goal of reliability.
Moreover, the acceptability contemplated by the Supreme
Court is that within the relevant scientic community.
Daubert requires reliability and fealty to the scien-
tic method. In a follow-on decision in Kuhmo Tire,
25
the
Supreme Court told the many clinician critics of its Daubert
ruling, in eect, to get with the program. Yet, proponents
of double-digit DLOMs have overlooked scientic studies
of private-placement discounts and continued to rely on
evidence that depends on a false assumption: that the regula-
23. Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993).
24. Frye v. United States, 293 F. 1013 (D.C. Cir. 1923).
25. Kumho Tire Co. v. Carmichael, 526 U.S. 137 (1999).
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