Determining Liquidity Discounts: the Taylor Devices and Tayco Development Merger

question 127

Essay

Determining Liquidity Discounts: The Taylor Devices and Tayco Development Merger

Privately held shares or shares for which there is not a readily available resale market often can only be sold at a discount from what is believed to be their intrinsic value.
However, estimating the magnitude of the discount often is highly problematic.
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This discussion is a highly summarized version of how a business valuation firm evaluated the liquidity risk associated with Taylor Devices’ unregistered common stock, registered common shares, and a minority investment in a business that it was planning to sell following its merger with Tayco Development. The estimated liquidity discounts were used in a joint proxy statement submitted to the SEC by the two firms to justify the value of the offer the boards of Taylor Devices and Tayco Development had negotiated.

Taylor Devices and Tayco Development agreed to merge in early 2008. Tayco would be merged into Taylor, with Taylor as the surviving entity. The merger would enable Tayco’s patents and intellectual property to be fully
Source: SEC Form S4 filing of a proxy statement for Taylor Devices and Tayco Development dated 1/15/08.
integrated into Taylor’s manufacturing operations, since intellectual property rights transfer with the Tayco stock. Each share of Tayco common stock would be converted into one share of Taylor common stock, according to the terms of the deal. Taylor’s common stock is traded on the NASDAQ Small Cap Market under the symbol TAYD, and on January 8, 2009 (the last trading day before the date of the filing of the joint proxy statement with the SEC), the stock closed at $6.29 per share. Tayco common stock is traded over the counter on “Pink Sheets” (i.e., an informal trading network) under the trading symbol TYCO.PK, and it closed on January 8, 2009, at $5.11 per share.

An appraisal firm was hired to value Taylor’s unregistered shares, which were treated as if they were restricted shares because there was no established market for trading in these shares. The appraiser believed that the risk of Taylor’s unregistered shares is greater than for letter stocks, which have a stipulated period during which the shares cannot be sold, because the Taylor shares lacked a date indicating when they could be sold. Using this line of reasoning, the appraisal firm estimated a liquidity discount of 20%, which it believed approximated the potential loss that holders of these shares might incur in attempting to sell their shares. The block of registered Taylor stock differs from the unregistered shares, in that they are not subject to Rule 144. Based on the trading volume of Taylor common stock over the preceding 12 months, the appraiser believed that it would likely take less than one year to convert the block of registered stock into cash and estimated the discount at 13%, consistent with the Aschwald (2000) studies.

The appraisal firm also was asked to estimate the liquidity discount for the sale of Taylor’s minority investment in a real estate development business. Due to the increase in liquidity of restricted stocks since 1990, the business appraiser argued that restricted-stock studies conducted before that date may provide a better proxy for liquidity discounts for this type of investment. Interests in closely held firms are more like letter-stock transactions occurring before the changes in SEC Rule 144 beginning in 1990, when the holding period was reduced from three years to two and later (after 1997) to one. Such firms have little ability to raise capital in public markets due to their small size, and they face high transaction costs. Based on the SEC and other prior 1990 studies, the liquidity discount for this investment was expected to be between 30% and 35%. Pre-IPO studies could push it higher to a range of 40–45%. The appraisal firm argued that the discount for most minority-interest investments tended to fall in the range of 25–45%. Because of the small size of the real estate development business, the liquidity discount is believed by the appraisal firm to be at the higher end of the range.
-In view of your answer to question 2, how might these factors have changed the appraiser's conclusions? Be specific.

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