Value is not price

Although the concepts of value and price are often confused, they are far from being similar. The main difference is that price represents the consideration that must be paid for having a certain value. Thus, price has its own dynamic that can move it away from intrinsic value. This difference between value and price leads to a premium if it is positive or a discount if it is negative.

Price represents the consideration that must be paid for having a certain value.

In recent years, the start-up environment has seen the emergence of a new category of company: unicorns. This term, coined by Aileen Lee in 2013, initially refers to those private technology start-ups valued at more than a billion dollars. Today, there are more than 450 unicorns in the world, according to the database of the CB Insights platform. When a unicorn goes public, investors’ enthusiasm may give rise to premiums, sometimes sharp ones. For example, during Snap’s IPO in 2017, the closing price at the end of the first trading day showed an increase of 44% compared to the IPO price.

However, selling an asset at a premium is, similarly to unicorns, quite rare. In fact, it is more common to see assets sold at a discount. But what is the economic rationale behind the discount? Several factors may be considered, among which the share’s illiquidity plays a key role. During the valuation process of a private company, it is frequent to apply a discount.

The illiquidity discount varies according to the size of the company but also according to the size of the block of shares. If a buyer acquires a majority stake, giving them control over the company, a premium will normally be observed. However, if the acquired ownership does not give them control, a discount will generally be applied. Furthermore, the imbalance between the buyer’s and the seller’s bargaining power may also explain the discount. Finally, there is an additional risk when investing in start-ups which may lead to a discount. Investors actually invest in companies at the dawn of their development. Most of the time, they have no guarantee on the company’s ability to generate recurring cash flows or on the quality of the underlying asset.

In practice, two approaches can be used to account for the illiquidity of a stake in an unlisted company.

In practice, two approaches can be used to account for the illiquidity of a stake in an unlisted company. Under the transactional approach, the discount is a parameter that is deducted from the final valuation. The company is thus valued as if it were listed and then the discount is applied. Following the economic approach to illiquidity, it should be incorporated into the cost of capital as a risk factor, just like the other typical risks faced by a company (sector, leverage, specific risk). Buyers investing in start-ups tend to favour this approach as it allows them to translate illiquidity into an additional rate of return.

Our experience shows that, in a non-listed company, the discount offered by a majority shareholder is generally between 10% and 50%. A discount of more than 25% is often psychologically difficult for a shareholder to accept. dups interventions are very often focused on the best strategy to adopt in order to propose an objective valuation but also to reduce the discount to a reasonable and fair level, considering the economic elements and the particular context.