Discount for Lack of Marketability (DLOM)

What is the Discount for Lack of Marketability (DLOM)?

The Discount for Lack of Marketability refers to a reduction in the value of closely held or restricted shares due to their limited marketability.

Unlike publicly traded stocks, these shares cannot be easily sold in the market. A discount for lack of marketability is applied to private companies during valuation to account for the absence of a centralized market for their shares.

There are several methods used to calculate the discount for lack of marketability.

• The restricted stock method
• The IPO method 
• The option pricing 

Discount for lack of marketability typically ranges between 30% and 50%. However, quantifying the discount can be challenging, especially during disputes related to taxes or property valuation. 

The IRS in the United States provides guidelines for addressing these issues.

Marketability means that an asset may be converted into cash quickly, with minimal costs and a high degree of assurance as regards the proceeds. 

A lack of marketability does not necessarily mean a lack of liquidity, but it involves assessing the transaction risk and the anticipated proceeds' realization.

When calculating the discount for lack of marketability, valuation analysts consider various factors known as the Mandelbaum Factors.

These factors include:

1. Costs associated with making a public offering
2. The company's redemption policy, holding period for stock
3. Restrictions on transferability of shares, control of transferred shares
4. Company management
5. Nature of the company
6. Dividend policy
7. Financial Statement Analysis
8. The choice between the private and public sale of shares. 

These factors help determine the discount for lack of marketability and are commonly used worldwide as standards for calculating the discount for lack of marketability.

Impact of Discount for Lack of Marketability on Valuation

The discount for lack of marketability is a reduction in the value of closely held or restricted shares due to their limited marketability. 

Private companies lack a centralized market and are typically subject to this discount. Valuation analysts use various methods and factors to quantify the discount, recognizing the challenges in assessing such shares' marketability.

It significantly impacts the overall valuation of a private company. By applying the DLOM, the value of the company's shares is reduced to reflect their limited marketability compared to publicly traded stocks. Here's how DLOM affects the valuation:

1. Lower valuation

The DLOM reduces the value of the company's shares compared to their intrinsic value. This lower valuation accounts for the illiquidity and lack of marketability associated with private company shares.

2. Risk adjustment

The DLOM is considered a risk adjustment because the limited marketability of shares in a private company introduces additional risks for investors. The discount compensates for the increased uncertainty and the potential difficulty of selling the shares.

3. Transaction considerations

The DLOM reflects the costs, time, and effort required to convert the shares into cash. Buyers of private company shares typically require a discount to account for the challenges and expenses associated with selling these shares.

How to calculate DLOM

When comparing the prices of private and public companies, it's important to consider the discounts associated with a lack of marketability. 

A market in which shares are freely acquired and sold by privately held companies does not exist, leaving them with a lower value than those on public markets. 

Calculating a discount for lack of marketability can be challenging due to limited information, especially pricing information, in private companies. 

It is time-consuming, costly, and uncertain to sell an equity stake in a private firm, which means that methods for simplifying the process will have to be developed. 

There are 3 methods of calculating DLOM; they are:

1. Restricted Stock Method

One method to calculate the discount for lack of marketability is the Restricted Stock Method. Restricted stock refers to unregistered shares of ownership in a public company, typically held by insiders such as directors and executives. 

These shares have restrictions on their sale and transfer to discourage early selling. Restricted stock is valued less than publicly traded common stock. 

The discount for lack of marketability is determined by calculating the difference between restricted stock and common stock, resulting in the estimated discount.

2. Option Pricing Method 

Another method is the Option Pricing Method. Options are rights granted to individuals in a company to purchase or sell company stock at a predetermined price (strike price) on a future date. 

The prices of these options can provide insights into the value of a stock. Since the options market operates independently from the stock market, the difference between the strike and option prices can inform the discount for lack of marketability.

3. The Initial Public Offering Method 

The IPO Method is the third approach to calculating DLOM. IPO occurs when a private company makes its shares available to the general public for the first time using new stock issuances on an exchange. 

Going public allows the company to attract a broader range of investors and enhance its credibility. The IPO method involves calculating the DLOM by determining the difference between the pre- and post-IPO prices.

The Main Issues with the DLOM

Valuation analysts face unique challenges when assessing noncontrolling, nonmarketable ownership interests in closely held companies, especially in the context of taxation disputes.

The Internal Revenue Service (IRS) guides on two key issues that complicate the analysis: 

1. Discount for Lack of Liquidity (DLOL) 
2. Discount for Lack of Control (DLOC) 

Privately held companies generally sell at a discount to their intrinsic value due to the additional costs, increased uncertainty, and longer time horizons associated with selling unconventional securities. 

This section will explore the limitations and challenges associated with these discounts and their impact on the valuation of private companies.

1. Lack of Information

Analyzing private companies is challenging due to the scarcity of information, particularly pricing information. The absence of a pricing history for private companies makes it difficult to assess their financials and determine a fair price.

2. Tax Issues

Noncontrolling, non-marketable ownership interests in closely held companies often raise tax-related concerns. These issues can further complicate the valuation process, adding to analysts' challenges.

3. Cost and Time Intensiveness

Compared to liquidating a position in a public entity, selling an interest in a private limited liability company generally costs more time, money, and uncertainty. 

The increased costs, uncertainties, and longer time horizons associated with selling unconventional securities contribute to the need for discounts in valuing private companies.

4. Uncertainty and Variability

Selling an interest in a private company involves negotiations introducing significant uncertainty and variability. 

These factors make it challenging to accurately assess the value of the ownership interest, leading to difficulties in determining an appropriate discount for lack of marketability.

5. Overlapping Discounts

The discount for lack of marketability can overlap with other discounts, such as the Discount for Lack of Control (DLOC) and the Discount for Lack of Liquidity (DLOL).  

Other costs related to the loss of control arise when an extremely small number of shareholders own a privately held company. These costs give rise to discounts that may overlap with the DLOM, further complicating the valuation analysis.

Discount for lack of marketability Vs. Discount for lack of control

In business valuations, the discount for lack of marketability (DLOM) and the discount for lack of control (DLOC) are distinct discounts with different purposes. 

The DLOM is applied to account for the restricted ability to sell shares, reflecting the limited marketability of those shares. 

On the other hand, the DLOC addresses the value reduction associated with not having control or influence over a company's strategic decisions and operations. 

While DLOM focuses on the limitations in selling shares, DLOC considers the lack of control in shaping the company's direction. These discounts serve separate functions and are often evaluated and applied independently during the valuation process. 

By understanding the differences between DLOM and DLOC, analysts can more accurately assess the impact of marketability and control on the overall value of a business.

Industry-specific considerations when calculating DLOM

Industry-specific considerations refer to the unique factors and issues that are specific to a particular industry or sector. These considerations arise due to the distinctive characteristics, regulations, practices, and challenges that are prevalent within that industry. 

Understanding and addressing these industry-specific considerations is crucial for businesses operating within a specific sector to effectively plan, strategize, and navigate the associated opportunities and risks.

Industry-specific considerations and variations can exist when calculating the DLOM. Here are a few examples:

1. Technology startups

Technology startups often have high growth potential but limited operating history. Valuation analysts may consider factors such as the company's intellectual property, market size, competitive landscape, and access to funding when assessing the DLOM.

2. Real estate

Real estate valuations may involve considerations such as the type of property (residential, commercial, industrial), location, lease terms, and market conditions.

3. Healthcare industry

Valuing shares in healthcare companies may require additional considerations, such as regulatory compliance, reimbursement policies, competitive landscape, and potential changes in healthcare regulations that can influence the DLOM in the healthcare sector.

4. Natural resources

Companies involved in natural resource exploration and extraction face industry-specific risks such as commodity price fluctuations, regulatory challenges, and environmental considerations. These risks may be factored into the DLOM calculation for such companies.

It's important to note that industry-specific considerations may vary, and the application of DLOM should be tailored to the specific circumstances of the company being valued, its industry dynamics, and market conditions.

Researched and Authored by Rishit Danani | Linkedin

Free Resources

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• Assessed Value
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• Dividend Discount Model
• Liquidation Value