What does illiquidity discount mean for warrants?

When you set the price of a warrant you sometimes come across the concept of ”illiquidity discount”, which is used to lower the price of the warrant. Whether it is legitimate to use it or not is a hotly debated issue, and in this blog post we will try to explain the pros and cons.

The background to the concept of illiquidity discount is the fact that a warrant issued to employees in practise will only be traded very rarely, if at all. This is despite the fact that you could, theoretically, trade it like any other equity. This means that the liquidity of the warrant is very low. This is independent of liquidity of the share to which the warrant will give the right to subscribe to (and of course also has nothing to do with the liquidity of the company).

Listed examples

There are examples of listed companies that sometimes issue warrants to employees and then lists these warrants on a public exchange. This creates a perfect environment to see whether the assumption that the Black-Scholes formula provides an accurate valuation of the warrant is correct or not. This is possible since the underlying share is also listed. This means that you get all the required ingoing parameters: The price per share and the volatility. This means that you can calculate the theoretical value of warrant, as per the Black-Scholes formula, at the same time as you can see what the actual price paid for such warrants is. In a perfect world, the price calculated by Black-Scholes and the actual market price would be the same. But in most cases, one can observe that the actual price paid is significantly lower than what the Black-Scholes formula would suggest, at least at the beginning of the duration of the warrant (which is what is of interest, since we are interested in the price of the warrant when it is issued). This can be explained by the fact very few warrants are actually being traded. In other words the liquidity of the warrant is very low. Since warrants in a private company will not even have the underlying shares listed, one can argue that the liquidity is likely to be even lower, and therefore, that the price of the warrant should be lower than what the Black-Scholes formula would suggest. This discount is called ”illiquidity discount” and is often set to 30%.

The tax authority’s view on the illiquidity discount

So what does the tax authority, Skatteverket, say about the illiquidity discount? The tax experts we have talked to are of the opinion that Skatteverket generally does not accept the illiquidity discount, but there is no court ruling that form a precedent. In other words: There is a logical basis in favour of the illiquidity discount, there is a high likelihood that Skatteverket will say no, but there is also the possibility that Skatteverket would lose on appeal to the highest court.

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