Discount for lack of liquidity: Meaning, Criticisms & Real-World Uses

Discount for Lack of Liquidity: Definition, Application, and Considerations

The Discount for Lack of Liquidity (DLOL) is a reduction applied to the value of an asset or business interest to account for the difficulty and time it may take to convert that asset into cash without a significant loss in value. This concept is fundamental within business valuation, reflecting the economic principle that investors demand a lower price (or higher rate of return) for assets that cannot be readily sold in active capital markets. Unlike publicly traded shares that offer immediate liquidity, private or restricted investments often involve extended investment horizon and higher transaction costs, making them less attractive and thus subject to a discount.

History and Origin

The need to quantify the value impact of illiquidity became particularly prominent in the mid-20th century, especially in the context of valuing interests in closely held businesses for estate and gift tax purposes. A foundational document in this area is the U.S. Internal Revenue Service's (IRS) Revenue Ruling 59-60, issued in 1959. This ruling provides guidelines for appraising the value of shares in closely held corporations, acknowledging that such shares do not have an active market like those traded on public exchanges. While Revenue Ruling 59-60 doesn't explicitly mention the "discount for lack of liquidity" or "discount for lack of marketability," it laid the groundwork for considering factors that affect the "fair market value" of unlisted securities, implicitly recognizing the challenges associated with illiquid assets.¹⁹, ²⁰ Over time, as financial markets evolved and the complexity of private equity and venture capital investments grew, valuation professionals and courts developed methodologies to formally quantify the DLOL.

Key Takeaways

The Discount for Lack of Liquidity (DLOL) accounts for the reduced value of an asset due to the difficulty of converting it to cash quickly without a significant price concession.
It is a critical adjustment in the business valuation of privately held companies, restricted stock, or other illiquid assets.
The magnitude of the DLOL is influenced by factors such as the asset's type, market conditions, transaction costs, and the expected time to exit the investment.
The concept is closely related to, and often used interchangeably with, the discount for lack of marketability.

Formula and Calculation

There isn't a single, universally accepted formula for calculating the Discount for Lack of Liquidity, as its quantification is often a complex exercise tailored to specific circumstances. Valuation professionals typically rely on various empirical studies and theoretical models that inform the discount. These include:

Restricted Stock Studies: These compare the trading prices of publicly held stock with the prices of unregistered or restricted stock of the same company sold in private transactions. The difference in price is attributed to the lack of liquidity.¹⁷, ¹⁸
Pre-Initial Public Offering (IPO) Studies: These examine the prices of private company shares before their initial public offering and compare them to the public trading price after the IPO. The spread often indicates the illiquidity premium or discount.¹⁴, ¹⁵, ¹⁶
Option Pricing Models: Some theoretical approaches, like variations of the Black-Scholes model, treat the inability to sell an illiquid asset as the forfeiture of a put option. The cost of this hypothetical put option can be used to estimate the DLOL.¹¹, ¹², ¹³

While no simple formula exists, the underlying principle is that the present value of future cash flows from an illiquid asset may be reduced to reflect the risk associated with its constrained transferability.

Interpreting the Discount for Lack of Liquidity

Interpreting the Discount for Lack of Liquidity involves understanding that a higher discount indicates greater illiquidity and, consequently, a lower valuation for the asset in question. For example, a 20% DLOL means that an asset that would otherwise be valued at $100,000 in a liquid market is valued at $80,000 due to its lack of ready convertibility to cash.

The appropriate discount depends on several factors, including:

Type of Asset: Real estate or private business interests typically command higher discounts than, for example, shares in a thinly traded public company.
Size and Financial Health of the Company: Larger, more profitable private companies may have lower DLOLs as they might attract a broader pool of potential buyers.¹⁰
Industry Conditions: Certain industries may have more active private transaction markets, affecting the ease of sale.
Restrictions on Transferability: Legal or contractual limitations on selling an asset can significantly increase the DLOL.

A robust due diligence process is essential for valuers to assess these factors and arrive at a defensible DLOL.

Hypothetical Example

Consider XYZ Corp., a successful, privately held software company. An investor, Sarah, owns a significant minority stake in XYZ Corp. A business valuation of XYZ Corp., assuming it were publicly traded and highly liquid, might indicate a proportional fair market value for Sarah's stake of $5 million.

However, since XYZ Corp. is private, Sarah cannot simply sell her shares on a stock exchange. Finding a buyer for a minority interest in a private company can take months or even years, and involves significant legal and advisory fees. To account for this, a valuation professional determines an appropriate Discount for Lack of Liquidity.

Let's assume the valuation professional, after considering various factors like typical transaction times for similar private software companies and the absence of a readily available market, applies a 25% Discount for Lack of Liquidity.

Calculation:
Initial Fair Market Value (liquid basis) = $5,000,000
Discount for Lack of Liquidity = 25%

DLOL Amount = $5,000,000 * 0.25 = $1,250,000

Adjusted Fair Market Value (after DLOL) = $5,000,000 - $1,250,000 = $3,750,000

Therefore, despite the company's strong performance, the illiquidity of Sarah's stake means its current value is appraised at $3,750,000.

Practical Applications

The Discount for Lack of Liquidity is applied across various financial scenarios, primarily in areas where assets are not freely traded on public exchanges.

Estate and Gift Tax Valuations: When gifting or inheriting shares of a private company, the IRS requires a business valuation that often includes a DLOL to determine the taxable value of the assets. This is rooted in long-standing guidance such as IRS Revenue Ruling 59-60.⁹
Mergers and Acquisitions (M&A): While a buyer acquiring an entire private company might not apply a DLOL to the total enterprise value (as they gain control and the ability to liquidate the entire entity), it can be relevant when valuing partial interests or in certain deal structures.
Private Equity and Venture Capital Fund Valuations: These funds hold portfolios of illiquid assets (e.g., stakes in startups). The fair value of these underlying assets often incorporates a DLOL.⁸ Investors in private markets expect higher returns to compensate for this inherent illiquidity.⁷
Employee Stock Ownership Plans (ESOPs): Valuations for ESOP purposes must account for the illiquidity of the company shares.
Litigation and Shareholder Disputes: In cases involving dissenting shareholders or divorce proceedings, a DLOL may be applied to determine the fair value of an owner's interest.

Beyond individual asset valuation, the broader concept of liquidity risk and its associated discounts becomes pronounced during periods of financial stress. For instance, during the 2008 financial crisis, the Federal Reserve undertook significant measures to provide liquidity to financial markets, recognizing that a lack of liquidity could severely impair the economy.⁶

Limitations and Criticisms

While widely used, the Discount for Lack of Liquidity faces several limitations and criticisms:

Subjectivity: Quantifying the DLOL is inherently subjective. There is no precise formula, and the range of discounts can vary significantly depending on the valuation method and the specific factors considered. Studies on the magnitude of the discount often show wide ranges, from 10-30% in general practice to much higher figures (e.g., 30-70%) in academic research, especially for private firms compared to public counterparts.⁴, ⁵
Data Scarcity: Unlike public markets with abundant transaction data, private transaction data is often scarce and not readily available, making it challenging to derive robust empirical evidence for specific discounts.
Overlap with Discount for Lack of Marketability: The terms "liquidity" and "marketability" are often used interchangeably, leading to confusion. While related, a distinction can be made: marketability refers to the ability to sell an asset at all (i.e., finding a buyer), whereas liquidity refers to the ability to sell it quickly without a significant loss in value. An asset can be marketable (a buyer exists) but illiquid (it takes a long time to find that buyer at an acceptable price).², ³
Impact of Control: The presence of control (e.g., owning a majority stake) can influence the perceived liquidity, as a controlling owner has more options for exiting an investment. However, even controlling interests in private companies are subject to illiquidity factors like the time and cost to sell the entire enterprise.¹

The debate over the precise magnitude and appropriate application of the DLOL continues among valuation experts, highlighting the complexity of valuing illiquid assets.

Discount for Lack of Liquidity vs. Discount for Lack of Marketability

The terms Discount for Lack of Liquidity (DLOL) and Discount for Lack of Marketability (DLOM) are often used synonymously in business valuation, but a subtle yet important distinction exists.

Feature	Discount for Lack of Liquidity (DLOL)	Discount for Lack of Marketability (DLOM)
Primary Focus	The ease and speed with which an asset can be converted into cash without affecting its price.	The ability to readily sell an asset; the absence of a broad, active trading market.
Consequence	A discount applied because the asset cannot be sold quickly at its intrinsic value due to few buyers.	A discount applied because there is no established marketplace for the asset, making it harder to find a buyer.
Example	A large block of shares in a small, publicly traded company (marketable but potentially illiquid).	An interest in a privately held family business (both non-marketable and illiquid).

Generally, an asset that lacks marketability is also illiquid, as the absence of a ready market makes it difficult to sell quickly. However, an asset can be marketable but still illiquid; for example, a large block of shares in a thinly traded public stock might eventually find a buyer (marketable) but would likely require a significant price concession to sell quickly (illiquid). Valuation professionals typically consider both aspects when assessing the overall discount.

FAQs

What is the primary reason for applying a Discount for Lack of Liquidity?

The primary reason is to compensate for the economic disadvantage of not being able to convert an asset into cash quickly and easily without a material loss in its value. Investors demand a lower price for investments that restrict their ability to exit.

Is the Discount for Lack of Liquidity always applied to private companies?

In most cases, yes. Unlike public companies, private companies do not have a ready market for their shares, making them inherently less liquid. Therefore, a business valuation of a private company or a non-controlling interest in one will almost always consider a Discount for Lack of Liquidity.

How does market volatility affect the Discount for Lack of Liquidity?

High market volatility can potentially increase the Discount for Lack of Liquidity. In uncertain or volatile markets, buyers may become more cautious and demand a greater discount for taking on illiquid assets, as the risk of holding such assets (and the difficulty of selling them) increases.

Does the Discount for Lack of Liquidity apply to real estate?

Yes, the concept applies to real estate and other tangible assets that are not easily or quickly convertible to cash at their full value. Selling a property can take time, incur significant transaction costs, and be subject to market conditions, warranting a liquidity discount.