Adjusting Valuations for Illiquidity and Control

Private company valuations often need adjustments for two key factors: illiquidity and control. Illiquidity discounts reflect the difficulty of selling private shares quickly, often reducing valuations by 20-40%. Control premiums, on the other hand, represent the added value of decision-making authority, typically increasing valuations by 25-30%.

For example, SpaceX - valued at over $350 billion - faces steep illiquidity discounts due to limited trading options and strict ownership restrictions. Additionally, Elon Musk's majority control means pre-IPO investors can't influence decisions, reducing the relevance of control premiums for minority stakeholders.

Key Takeaways:

• Illiquidity Discounts: Private shares are harder to sell, lowering their value.
• Control Premiums: Buyers may pay more for decision-making authority.
• SpaceX Example: Limited liquidity and Musk's ownership impact valuation adjustments.

Understanding these factors ensures accurate valuations and smarter investment decisions in private markets.

Private Company Valuation (2025 Level II CFA® Exam – Equity – Module 6)

How Illiquidity Discounts Work in Private Equity Valuations

Investing in private companies comes with a challenge that public stock investors don’t face: private shares can’t be sold quickly. This limitation creates what's known as liquidity risk - the potential loss in value from being unable to sell an asset promptly. To account for this, private equity valuations apply an illiquidity discount, which adjusts a company’s theoretical value to reflect its reduced marketability.

Here’s how it works: Analysts start by estimating what the company would be worth as a publicly traded entity. Then, they apply a discount to compensate investors for the added risks and costs tied to limited liquidity. Research shows that restricted stocks often trade 25% to 35% lower than their freely tradable counterparts. This discount reflects factors like longer holding periods, higher exit risks, and increased transaction costs. Let’s dive into what influences these discounts and how they’re calculated.

Factors That Affect Illiquidity Discounts

The size of an illiquidity discount depends on several factors, ranging from the company’s characteristics to broader market conditions.

• Company Size: Larger firms usually face smaller discounts because they attract more buyers and enjoy greater visibility.
• Financial Health: Companies with strong cash flows and stable earnings generally secure lower discounts, while those with volatile or negative earnings may see discounts closer to 40%.
• Asset Liquidity: Firms with significant cash reserves or marketable securities tend to have smaller discounts compared to those with illiquid assets.
• Industry Dynamics: Companies in niche sectors with limited buyers often face higher discounts, whereas industries with active mergers and acquisitions (M&A) markets experience smaller adjustments.
• Holding Periods: Longer expected holding periods justify higher discounts, as investors bear liquidity constraints for extended durations.
• Exit Options: Firms with clear paths to public offerings, established secondary markets, or multiple potential buyers typically command lower discounts. Conversely, tight credit conditions or economic uncertainty can push discounts higher .
• Minority vs. Controlling Stakes: Minority interests usually carry larger discounts since investors lack control and must rely on the decisions of majority stakeholders.

"The illiquidity discount is likely to vary across both firms and buyers, which renders rules of thumb useless."
– Aswath Damodaran

Methods for Calculating Illiquidity Discounts

Accurately estimating illiquidity discounts is crucial for valuing private companies, particularly in pre-IPO markets. Several methods are commonly used, each with its strengths and limitations:

• Restricted Stock Studies: These studies compare the prices of publicly traded shares with restricted shares under lock-up periods. Historical data often shows discounts averaging around 35%.
• Pre-IPO Studies: By analyzing valuations before and after a company goes public, these studies estimate liquidity premiums. Discounts in this category typically range from 40% to 60%, though adjustments for factors like growth expectations and market sentiment are necessary.
• Regression Models: These models predict discounts based on measurable company traits like size, profitability, and industry sector. For example, Silber’s model incorporates variables such as revenues and the size of restricted stock blocks to calculate a tailored discount.
• Option Pricing Models: These models treat the illiquidity discount as the cost of a theoretical put option that provides liquidity. Researchers like Chaffe, Longstaff, and Finnerty link the discount to factors like time until sale and stock price volatility .
• Bid-Ask Spread Approach: This method uses public market data, relating bid-ask spreads of traded stocks to private company metrics like revenues and cash holdings.

Other techniques, such as comparable company analysis and discounted cash flow (DCF) adjustments, can further refine these estimates.

"Ultimately, mastering the art and science of illiquidity discount estimation can improve valuation accuracy, support better investment decisions, and contribute to fairer outcomes for all stakeholders involved in private company transactions."
– Financial Advisory Department, Andersen in Egypt

While rules of thumb suggesting 20–30% discounts may serve as a starting point, actual discounts can range widely - from as little as 2–5% to as much as 50% - depending on the unique circumstances of the company . Professional judgment remains an essential part of the equation, ensuring that each valuation reflects the specific risks and opportunities tied to the investment.

Control Premiums: How They Add Value to Valuations

Control premiums represent the extra amount a buyer is willing to pay for majority ownership, offering the ability to steer a company's strategy and operations. Essentially, this premium reflects the perceived value of having direct decision-making authority. For investors in private markets, understanding control premiums is key - it complements adjustments for illiquidity and helps guide smarter investment choices.

Control premiums generally range from 25% to 30%, but in cases where buyers anticipate substantial operational improvements, they can climb to as high as 50% to 70%. The driving factor behind these premiums is the buyer's belief in their ability to boost cash flows through management control. Paying this extra amount often signals confidence in achieving a turnaround or aligning the acquisition with broader value-creation goals.

"The control premium is relevant only if the buyer is able to generate higher cash flows by virtue of controlling the management decisions." - GraduateTutor.com

Take this example: ABC Company, with an EBITDA of $1,000,000 and a 5× EV/EBITDA multiple, is valued at $5,000,000. A buyer who believes they can increase EBITDA to $1,500,000 through operational changes would see the valuation rise to $7,500,000. The $2,500,000 difference showcases the added value that justifies a control premium.

When and Why Control Premiums Are Used

Control premiums are typically applied when buyers aim for majority ownership, granting them the authority to make key decisions. In mergers and acquisitions, these premiums act as an incentive for shareholders to sell, compensating them for relinquishing control. Private equity deals, especially leveraged buyouts, frequently involve control premiums since these firms often take an active role in managing operations to unlock greater value.

Strategic buyers tend to pay higher premiums compared to financial buyers. This is because strategic buyers can realize additional benefits, or synergies, from integrating the acquisition into their existing operations. Market conditions also play a role in determining premium levels. For instance, during the economic recovery from 2010 to 2012, median control premiums ranged from 32.7% to 37.6%. As markets strengthened post-2012, premiums dropped to 26.2%–29.4%, reflecting a more cautious approach as stock prices rose.

Methods for Calculating Control Premiums

Several methods are used to calculate control premiums, each offering unique insights:

• Comparable Transactions Approach: This method looks at premiums paid in similar M&A deals to establish market-based benchmarks. However, it requires careful selection of comparable transactions and adjustments for differences in factors like size, performance, and market timing.
• Income Approach Adjustments: By modifying discounted cash flow (DCF) analysis, this approach accounts for the benefits of control, such as improved revenue or reduced costs. The difference between the adjusted DCF value and the minority share value provides an estimate of the premium.
• Market Approach Considerations: This method compares public company valuation multiples with acquisition multiples to infer control premiums. In some cases, option pricing models are used to estimate the value of control.

The formula for calculating a control premium is straightforward:
Control Premium = (Offer Price Per Share ÷ Unaffected Price Per Share) – 1.
For example, if a company's shares trade at $80 and a buyer offers $100 per share, the resulting control premium is 25%.

Accurately estimating the unaffected price is critical. A notable example is Peloton in early 2022. After disappointing earnings, its stock surged over 20% in one day due to takeover rumors involving major companies like Amazon, Nike, Apple, and Disney. This highlights how speculation can temporarily inflate prices, making it essential to use pre-rumor prices when calculating control premiums.

In industries with high asset intensity, control premiums often trend higher, as buyers anticipate stronger future cash flows. To justify these premiums, buyers must present clear plans for operational improvements and synergies. This ensures the premium reflects actual economic value rather than speculative optimism. Paired with illiquidity discounts, control premiums provide a balanced perspective on how operational control can enhance a company's valuation.

How to Combine Illiquidity and Control Adjustments

This section outlines how to properly integrate illiquidity discounts and control premiums into valuations. These adjustments, when combined, must be applied carefully to avoid errors like double-counting risks or benefits. The process hinges on using the correct baseline values and systematically capturing the economic effects of both factors.

Start by defining the "status quo value", which represents the company's current worth under its existing management. Control premiums are then applied to this baseline, not to an "optimal value" that assumes perfect management. This distinction is critical because applying premiums to idealized valuations can inflate results beyond what’s realistic.

The process should follow a logical sequence: first, establish the base valuation, then add the control premium for majority ownership, and finally apply the illiquidity discount to reflect investment-specific risks. This order ensures each adjustment builds on the last without introducing artificial value inflation.

Best Practices for Accurate Valuation Adjustments

To ensure accuracy, adjustments should be tailored to the specific characteristics of the company, rather than relying on generic percentages. For example:

• Control premiums should reflect the actual potential for improvement. Companies with poor management may warrant higher premiums, while well-managed firms might justify lower ones.
• Illiquidity discounts should consider factors like asset volatility, corporate governance, and realistic timelines for exiting the investment, rather than applying fixed rates across all scenarios.

Transparency is key. Document every assumption, calculation, and source of data. As valuation experts advise, your analysis should include enough detail for another professional to replicate your work. This means explaining why you chose specific discount rates, how you determined premium sizes, and what market data supported your conclusions.

"No matter how 'correct' your conclusion of value is, the court may not accept it if you do not provide sufficient details and explanations about how you arrived at that conclusion." – Mercer Capital

Consistency across valuation methods is equally important. If you're using multiple approaches - like discounted cash flow (DCF), comparable company analysis, or precedent transactions - ensure that assumptions about growth rates, risks, and market conditions align across all methods. Contradictory assumptions can undermine the credibility of your analysis.

Another best practice is using comprehensive market data. Avoid cherry-picking data that supports your hypothesis. Include all relevant guideline companies and transactions, even if they challenge your initial assumptions. This approach strengthens your analysis and helps uncover potential blind spots.

Finally, for complex cases, consult independent specialists. When dealing with high-stakes investments or unusual circumstances, experienced valuation experts can provide an unbiased perspective and help you avoid costly errors.

Common Mistakes to Avoid

While following best practices is essential, steering clear of common mistakes is just as important.

One of the biggest pitfalls is double-counting. This can happen when illiquidity discounts are applied even though lack of marketability has already been factored into higher discount rates, or when control benefits are included in both the base valuation and as a separate premium.

"The first is that these risks can be easily double counted, if analysts bring their concerns about the risk into the estimation of discount rates and cash flows." – Capital Ideas Online

Another mistake is over-relying on generic studies or fixed percentages. For example, applying standard illiquidity discounts of 25–35% from restricted stock studies or using generic control premiums of 20–30% without considering the company’s specific situation can lead to inaccuracies. Many of these studies have limitations, such as small sample sizes or selection bias, and may reflect overpayment in acquisitions rather than true economic value.

Post-valuation adjustments can also introduce bias. When analysts tweak values using premiums or discounts to align with a desired outcome, they compromise the integrity of the valuation process.

"The third problem is that adjusting an estimated value with premiums and discounts opens the door for analysts to bring their biases into the number." – Capital Ideas Online

Ignoring market-specific factors is another common error. Factors like management quality, corporate governance, asset volatility, and industry-specific liquidity characteristics must be considered to ensure accurate adjustments.

Inconsistent application of methodologies across reports or within the same analysis can also damage credibility. If your approach to adjustments varies without clear justification, it can suggest result-driven analysis rather than objective valuation.

To avoid these pitfalls, establish a clear and transparent valuation process. Document all assumptions, regularly review your methods, and critically assess your conclusions. Valuing illiquid assets with control considerations requires sound judgment - your goal should be to apply that judgment in an objective and well-documented manner.

Applying These Adjustments to SpaceX Pre-IPO Investing

SpaceX offers a fascinating example of how valuation adjustments for illiquidity and control come into play. As one of the most valuable private companies globally, with an estimated valuation exceeding $350 billion, SpaceX highlights why these concepts matter for pre-IPO investors. The principles discussed earlier are especially relevant in this context.

Illiquidity and Control in SpaceX Valuations

Being a private company, SpaceX faces significant illiquidity challenges, which directly influence how investors should approach its valuation. Unlike publicly traded companies on the NYSE or NASDAQ, SpaceX shares cannot be freely bought or sold, leading to notable valuation discounts.

To address this, SpaceX conducts company-sponsored tender offers about twice a year. During these events, the company sets a share price and allows limited participation from employees and existing shareholders. This approach restricts external access to SpaceX shares and comes with strict conditions.

"Most of the company's lifecycle has been cashflow positive", - Christian Garrett, Partner at 137 Ventures

Illiquidity discounts on private companies like SpaceX can be steep. Research suggests these discounts often range between 20% and 40%, or even higher, depending on specific circumstances. For SpaceX, several factors amplify this discount:

• Liquidity Restrictions: Limited tender offers and the company’s prolonged private status significantly lower share value. SpaceX enforces a Right of First Refusal (ROFR) on private share sales, which can delay deals and limit external transactions. While private companies now remain private for an average of over 12 years, SpaceX has stayed private for 23 years, raising around $10 billion during this time.
• Market Conditions: Broader market trends also play a role. In 2024, U.S. venture exit activity dropped by 82.2% compared to 2021, with Limited Partner distributions hitting a low of just 11% of NAV. These trends further influence how private holdings like SpaceX are valued.

The control premium is another critical factor, though it operates differently in SpaceX’s case. The Elon Musk Trust owns 54% equity in the company, granting Elon Musk majority control. This ownership structure means pre-IPO investors cannot gain any meaningful control, regardless of their investment size.

"SpaceX itself is owned mostly by the Elon Musk Trust, which has 54% equity." - FOREX.com US

Starlink, a subsidiary of SpaceX, adds another layer of complexity. As part of SpaceX’s ownership structure, Starlink’s value is indirectly tied to SpaceX shares. Investors cannot directly purchase pre-IPO shares of Starlink through secondary platforms, meaning any investment in SpaceX only provides indirect exposure to Starlink’s potential.

"Starlink wasn't a publicly traded company as of early 2025. The satellite internet provider was part of SpaceX, a privately held company controlled by Musk." - The Motley Fool

These liquidity and control challenges highlight the importance of tailored investment strategies for those considering SpaceX shares.

How SpaceX Stock Investment Guide Can Help

Navigating these unique challenges requires specialized insights, and the SpaceX Stock Investment Guide is designed to provide exactly that. It offers targeted resources to help investors understand the nuances of pre-IPO investing in both SpaceX and Starlink.

The guide dives into SpaceX’s valuation dynamics, explaining how illiquidity discounts and control considerations can shape potential returns. Instead of relying on generic methods, it delivers SpaceX-specific analysis, factoring in the company’s liquidity mechanisms, ownership structure, and market position.

To further support investors, the guide includes:

• Private Equity Market Education: It explains how tender offers work, what to expect in secondary market transactions, and how to evaluate investment opportunities. This knowledge is crucial for navigating private markets, which operate under different rules than public ones.
• Investor Community: An investor club allows participants to share insights and stay informed about SpaceX developments. With shares being scarce and timing critical in secondary markets, access to a knowledgeable network can be a significant advantage.
• Stock Price Trend Analysis: The guide examines how SpaceX’s valuation has evolved over time and identifies factors driving changes in private market pricing. This helps investors set realistic expectations based on the illiquidity challenges tied to SpaceX shares.

For anyone considering an investment in SpaceX, understanding these factors is essential to making informed decisions. The SpaceX Stock Investment Guide provides the tools needed to navigate this complex landscape effectively.

Key Takeaways for Investors

Illiquidity discounts and control premiums play a significant role in shaping returns in private markets. While these factors can reduce asset values by large percentages, they also open doors to potentially higher long-term gains. These adjustments are essential for crafting effective investment strategies.

Why Adjusted Valuations Matter

Valuation adjustments are critical for safeguarding returns in private markets. They account for the added risks that come with investing in illiquid assets. Essentially, when you choose illiquid investments, you’re trading the convenience of quick exits for the possibility of greater returns. Studies indicate that illiquidity discounts can be as high as 50%, depending on the circumstances.

"The illiquidity discount stems from liquidity risk, which is the incurred loss in asset value from the inability to easily liquidate the position."

These adjustments ensure you don’t overpay for private investments. Without factoring in illiquidity, you might end up paying public market prices for assets that come with higher risks and restrictions. This is especially relevant given the rapid growth in private market assets under management - up $4 trillion in the last decade, a 170% surge.

Interestingly, illiquidity can also encourage better investor behavior. It reduces the likelihood of panic selling during market downturns, fostering a more disciplined, long-term mindset. Historical data supports the idea that adjusted valuations can promote this approach.

However, these advantages come with notable risks. Capital in private markets is often locked up for five to ten years or more. There’s also the danger of a "fire sale", where companies facing liquidity pressures may sell assets at steep discounts to raise cash quickly.

"What if investors are simply smart enough to know that they can take on a lot more risk (true long-term risk) if it's simply not shoved in their face every day (or multi-year period!)?"

Next Steps for SpaceX Investors

For those considering SpaceX investments, accurate valuations are especially critical. Start by reassessing your liquidity needs. Run cash-flow scenarios and stress test different market conditions. To manage risk, maintain a liquidity buffer by holding part of your private market allocation in cash or other liquid assets.

Ensure the potential returns justify the illiquidity and control limitations of pre-IPO investments. The SpaceX Stock Investment Guide can be a valuable resource, offering tailored analysis, private equity education, community insights, and stock trend analysis. These tools are essential for understanding how valuation adjustments could affect your returns.

Stay up-to-date on developments like the recent Starlink-EchoStar deal, which could influence SpaceX’s IPO plans and overall valuation. It’s worth noting that individual investors control about 50% of global assets under management but represent only 16% of alternative asset fund investments. This highlights both the opportunities and the importance of being well-prepared before venturing into private markets.

Finally, align your investments with your broader financial goals, tax considerations, and risk tolerance. Plan for liquidity needs by balancing private market investments with accessible assets, and mitigate concentration risk by ensuring these investments fit seamlessly into your overall portfolio strategy.

FAQs

How do illiquidity discounts and control premiums affect the valuation of private companies like SpaceX?

Illiquidity discounts often reduce the valuation of private companies by 20% to 30%. This happens because selling shares in these companies can be challenging due to the lack of a liquid market. For example, private companies like SpaceX, where shares aren't publicly traded, are particularly affected by this limitation.

In contrast, control premiums can push valuations higher when someone acquires a majority stake. This is because holding a controlling interest offers significant advantages, such as the ability to make key decisions and influence the company's strategic direction.

What factors impact illiquidity discounts, and how can investors estimate them accurately?

Illiquidity discounts stem from various factors like market liquidity, transaction costs, and the difficulty of selling an asset without causing a noticeable price impact. Assets that are tougher to sell, come with steeper transaction costs, or require more time to liquidate often carry larger discounts. On top of that, adjustments related to control - such as premiums for ownership control or discounts for limited control - can also influence valuation.

To estimate these discounts effectively, investors should review the asset's trading volume, current market conditions, and comparable transactions in similar markets. Tools like spread analysis or discounted cash flow adjustments can offer helpful insights. By blending market data with professional judgment and considering the asset's unique context - such as its industry, size, and regulatory factors - investors can fine-tune these estimates for a more accurate valuation.

When are control premiums most relevant, and how do they impact a private company's valuation?

When a buyer acquires a controlling interest in a private company - whether through mergers, acquisitions, or buyouts - control premiums often come into play. These premiums reflect the extra value tied to gaining authority over key elements of the business, such as its assets, operations, and strategic decisions.

With control in hand, buyers have the power to make changes that could boost efficiency, refine management practices, or tap into hidden potential that isn't captured in the current valuation. This ability to drive better decision-making and create additional value makes control premiums an essential consideration when evaluating a company's overall worth.

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