Free-Float Liquidity and Trading Constraints: Enhancing Family Firms’ Financing Decisions

Abstract

Volume-based liquidity ratios suffer from potential measurement bias due to share restriction and may misrepresent actual liquidity. To address this issue, we develop a modified metric, the free-float liquidity ratio. We argue that this measure is well suited to estimate liquidity in the presence of trading constraints as can be found in closely-held/state-owned entities, IPOs/SEOs with lockup restrictions, dual-class share structures, and family-owned businesses. Traditional measures understate illiquidity (overstate liquidity) as the fraction of free trading shares is limited by design or circumstances. Our empirical testing indicates that the free-float liquidity ratio compares favorably with other volume-based methods. Furthermore, we use family firms as a restricted-share setting to demonstrate the validity of the free-float liquidity ratio. The proposed metric offers informational gains for family leaders to aid in their financing decisions and for non-family outsiders to guide their investment choice. As a constrained free float inhibits price discovery processes, we also discuss how restricted stock issuers may alleviate the attendant negative effects on governance and information opacity.