Paper Millionaires Only?
Researcher shows how much restrictions on selling stock hurt owners
By Alan Breznick

wning large chunks of restricted company stock may not be all that it’s cracked up to be — for both the stockholder and the company.

Victims of the dot-com crash have certainly known the downside of owning restricted stock for years. Numbers of entrepreneurs, corporate executives, venture capitalists and private equity holders watched their paper shares turn worthless earlier this decade because they couldn’t sell their stock before the Internet bubble burst.

But the problem may be much bigger than previously suspected. So says Matthias Kahl, assistant professor of finance at UNC Kenan-Flagler. In a provocative study published last year in the Journal of Financial Economics, Kahl and two co-authors found that stock sale or liquidity restrictions can impose “surprisingly large” costs on stockholders, affecting their lifestyle, distorting their investment strategy and even changing the way they run their companies.

In fact, Kahl and his two colleagues — Jun Liu and Francis Longstaff from UCLA’s Anderson School — discovered that selling restrictions can make an owner’s stock worth as little as 10 percent or 20 percent of its value on paper, in the most extreme examples. Even in more moderate cases, they found, the stock can be worth less than 50 percent of its market value.  

“We were not expecting that,” says Kahl, who joined UNC Kenan-Flagler’s faculty in July 2003 after teaching at UCLA for six years. “We knew there would be a discount … (but) we were actually surprised at the magnitude.”

 The researchers’ theoretical model shows that the magnitude depends greatly upon how long the lockup or vesting periods last. A five-year limit on stock sales, for instance, is likely to have more severe effects than a one-year restriction.

Kahl and his fellow researchers also found that a lot depends on how much of the shareholder’s wealth is tied up in the illiquid stock holdings. If the percentage is higher, the costs may be higher as well, because this makes the restriction more severe.

Faced with such costs, the researchers say, owners of restricted stock may cut back significantly on their personal spending, tightening their belts to compensate for the potential lost income. “Clearly, this has an impact on the lifestyle of entrepreneurs,” Kahl says. “Their consumption rate goes down a lot.”

Sale restrictions may also prompt restricted stock owners to invest the rest of their wealth quite differently than before, according to the study. Seeking to balance their investment portfolio, they may put far more or far less money in the stock market than they would otherwise. 

“They invest quite differently,” Kahl says. “They try to hedge the risk.”

The study suggests that companies handing out the restricted stock as financial incentives may feel an adverse impact, too. For one thing, a company officer holding a lot of such stock might try to “make diversifying

acquisitions” for his firm, even if such purchases are not in the other shareholders’ interests, because it would spread out his own investments.

“The more he can diversify his firm’s business, the more he can diversify his portfolio,” Kahl says. “Managers may have an incentive to diversify or go public early.”

Even more notably, the study concludes, stock restrictions may prove to be costlier to companies than expected. If executives value the stock less, firms also do not get as big a bang for their buck.

 “What we suggest is that restricted securities are less efficient forms of compensation,” Kahl says. “If you give a CEO $10 million worth of restricted shares, he may value them at $2 million ... They will certainly know that this stock is worth less to them than to others.”

Contact Kahl at (919) 962-9574, .