What Is Discount for Lack of Marketability?
The Discount for Lack of Marketability (DLOM) represents a reduction applied to the value of an ownership interest in a business or asset because it cannot be readily converted into cash or publicly traded. This concept is central to business valuation, particularly when assessing private company interests. Unlike shares of a publicly traded entity that can be bought and sold quickly on a financial exchange, a private interest lacks instant liquidity. The DLOM accounts for the time, effort, cost, and uncertainty involved in selling such an unmarketable asset.
History and Origin
The recognition of a discount for lack of marketability has evolved alongside the field of business valuation. Historically, valuation methods often focused on intrinsic value without fully accounting for the practical realities of transferring ownership. However, as the valuation of privately held shares became more sophisticated, particularly for tax and litigation purposes, the inherent challenges of illiquidity became apparent.
A foundational document in U.S. business valuation, Revenue Ruling 59-60, issued by the Internal Revenue Service (IRS), emphasizes various factors to consider when valuing closely held businesses for estate and gift tax purposes, including the degree of marketability. This ruling laid groundwork for the consideration of qualitative factors that influence value beyond just financial performance. Over time, empirical studies, such as those examining restricted stock and pre-Initial Public Offering (IPO) transactions, provided quantitative evidence supporting the existence and magnitude of the discount for lack of marketability. These studies helped establish methodologies for calculating the DLOM, cementing its role as a critical adjustment in comprehensive valuations.
Key Takeaways
- The Discount for Lack of Marketability (DLOM) reduces the value of an asset or business interest that cannot be easily or quickly converted to cash.
- It is primarily applied in the business valuation of privately held companies, as their interests lack a ready public market.
- The DLOM compensates a buyer for the illiquidity and the associated risks and costs of owning an unmarketable asset.
- Several methodologies, including the restricted stock method, IPO method, and option pricing models, are used to quantify the DLOM.
- The estimated range for DLOM often falls between 30% and 50% in practice, though it varies significantly based on specific factors.8
Formula and Calculation
While there isn't a single universal formula for the Discount for Lack of Marketability, it is generally expressed as a percentage reduction applied to a marketable value. The estimation of this percentage typically involves various methods designed to quantify the lack of marketability:
- Restricted Stock Studies: This method compares the trading prices of unrestricted, publicly traded stock with the prices of restricted shares of the same company. Restricted stock, often issued to insiders, is subject to transfer limitations (e.g., U.S. Securities and Exchange Commission Rule 144 restrictions), making it less marketable. The observed discount between restricted and unrestricted shares is used as a proxy for the DLOM.
- Pre-IPO Studies: This method analyzes the difference between the price of private company equity sold in transactions before an IPO and the price of the same equity once it becomes publicly traded in the IPO. The discount observed reflects the increased marketability gained upon listing.
- Option Pricing Models: These models, such as Black-Scholes, treat the ability to sell a private interest as an option. The cost of this hypothetical "put option" (the right to sell) can be an indicator of the marketability discount. The greater the cost of exercising this hypothetical option to convert the interest to cash flow, the larger the implied DLOM.
The choice and application of methods depend on the specific circumstances of the asset being valued. The resulting discount is applied after an initial enterprise value or fair market value has been determined using methods that often assume marketability, such as those derived from publicly traded comparable companies.
Interpreting the Discount for Lack of Marketability
Interpreting the Discount for Lack of Marketability requires understanding its purpose: to reflect the economic reality that an illiquid asset is inherently less valuable than a liquid one, all else being equal. A higher DLOM percentage indicates a greater reduction in value due to limited marketability.
Valuation analysts consider numerous factors when determining the appropriate DLOM, including:
- Financial Health of the Company: A financially stable and profitable private company may command a smaller DLOM than a struggling one, as its prospects for future liquidity events (like an IPO or acquisition) might be perceived as higher.
- Dividend Policy: Regular cash flow distributions can partially offset a lack of immediate marketability, potentially leading to a lower DLOM.
- Restrictions on Transferability: Legal or contractual agreements (e.g., shareholder agreements, rights of first refusal) that restrict the sale of an interest can increase the DLOM.
- Size of the Interest: A larger minority interest or a controlling interest might have different marketability characteristics, affecting the discount.
- Availability of Potential Buyers: A specialized or niche business may have a smaller pool of prospective buyers, suggesting a higher DLOM.
While studies often suggest DLOMs can range from 30% to 50% or more, applying a specific discount is not an arbitrary act. It requires careful analysis of the asset's unique characteristics and prevailing market conditions to arrive at a defensible conclusion.7
Hypothetical Example
Consider XYZ Corp., a successful, privately held manufacturing business. An investor, Alice, owns a 10% minority interest in XYZ Corp. that she wishes to sell. The valuation analyst determines that, based on XYZ Corp.'s projected cash flow and a discount rate derived from comparable publicly traded companies, Alice's 10% interest would have a pro-rata value of $1,000,000 if it were freely marketable.
However, since XYZ Corp. is a private entity, there is no public stock exchange where Alice can quickly sell her shares. Finding a buyer would involve considerable effort, time, and potentially legal and brokerage fees. Furthermore, as a minority owner, Alice has limited ability to influence major company decisions or force a sale of the entire company.
The valuation analyst, after conducting an analysis using methodologies like the restricted stock studies, determines an appropriate Discount for Lack of Marketability for Alice's interest is 35%.
The calculation for Alice's interest would be:
Marketable Value = $1,000,000
DLOM = 35%
Discount Amount = Marketable Value × DLOM = $1,000,000 × 0.35 = $350,000
Adjusted Value = Marketable Value - Discount Amount = $1,000,000 - $350,000 = $650,000
Thus, the value of Alice's 10% interest, adjusted for its lack of marketability, is $650,000. This reflects the reality that a buyer would demand a lower price for an investment that is difficult to sell quickly.
Practical Applications
The Discount for Lack of Marketability plays a crucial role in several financial and legal contexts:
- Estate and Gift Tax Planning: When transferring interests in privately held businesses to heirs or trusts, the DLOM can significantly reduce the taxable value of these assets. This can lead to substantial savings in tax liabilities for individuals engaged in estate planning. The IRS recognizes that these interests are less marketable than publicly traded securities and permits appropriate valuation adjustments for tax purposes.
*6 Mergers and Acquisitions (M&A): In transactions involving private companies, the DLOM can influence the negotiation of purchase prices. Buyers often apply such discounts to reflect the illiquidity premium they demand for investing in a non-public entity. - Shareholder Disputes and Litigation: When a private company's shares are valued for divorce proceedings, shareholder buyouts, or other legal disputes, applying a DLOM ensures a fair market value that accounts for real-world market constraints.
- Employee Stock Ownership Plans (ESOPs): Private companies with ESOPs require regular valuations of their stock for compliance purposes. The DLOM is a standard adjustment in these valuations.
- Financial Reporting: For some privately held entities, especially those with complex ownership structures or significant illiquid assets, the DLOM may be considered in preparing financial statements under certain accounting standards.
The application of the DLOM ensures that the valuation reflects the true economic value of an interest, considering the practical challenges of its sale. For example, restricted stock, due to its limitations on transferability, is typically valued with a marketability discount as per Securities and Exchange Commission (SEC) regulations like Rule 144, which governs the resale of such securities.(h4, 5ttps://www.sec.gov/education/capitalraising/smallbusiness-k/rule144)
Limitations and Criticisms
While widely accepted in business valuation, the Discount for Lack of Marketability is not without its limitations and criticisms. One primary challenge lies in its quantification. Unlike publicly traded assets with readily observable prices, the exact percentage for a DLOM is not derived from a transparent market. Valuators often rely on empirical studies (like restricted stock or pre-IPO studies) that may not perfectly match the specific characteristics of the subject company or the prevailing market conditions. This introduces an element of judgment and potential variability in the concluded discount.
Another criticism pertains to the subjectivity of inputs in certain DLOM models, such as complex option pricing models or quantitative models like the Quantitative Marketability Discount Model (QMDM). These models require various assumptions and inputs, and small changes in these assumptions can lead to significant differences in the calculated DLOM. The Internal Revenue Service (IRS) has, at times, scrutinized the subjective nature of inputs used to derive DLOM conclusions in tax cases, underscoring the need for rigorous support and documentation.
3Furthermore, the DLOM assumes a hypothetical market of willing buyers and sellers. In reality, the specific circumstances of a potential transaction, such as a distressed sale or a unique strategic buyer, might lead to outcomes that deviate from a theoretically derived discount. The concept of a liquidity premium, which is inversely related to a lack of marketability, is also an area of ongoing academic discussion and research, highlighting the complexities in precisely measuring the impact of illiquidity on asset values.(h2ttps://www.frbsf.org/economic-research/publications/economic-letter/2012/october/liquidity-premium/)
Discount for Lack of Marketability vs. Discount for Lack of Control
The Discount for Lack of Marketability (DLOM) is often confused with the Discount for Lack of Control (DLOC), but they address distinct aspects of value in private business interests.
The Discount for Lack of Marketability (DLOM) accounts for the lack of a ready market to sell an ownership interest quickly and at a fair price. It reflects the time, effort, and cost involved in converting an unmarketable asset into cash. This discount applies because private company interests cannot be easily traded on a financial exchange like publicly traded shares.
In contrast, the Discount for Lack of Control (DLOC) applies to a minority interest that does not possess the power to direct the company's policies, compel distributions, or liquidate the business. A controlling interest in a company typically commands a premium because it confers the power to make key operational and strategic decisions. Conversely, a minority shareholder lacks this power, making their interest less valuable on a per-share basis compared to a controlling stake.
While distinct, DLOM and DLOC are frequently applied together in the valuation of non-controlling, non-marketable interests in private businesses, particularly for estate planning and gift tax purposes. Both discounts aim to adjust a preliminary valuation (often based on marketable or controlling equivalents) to reflect the actual characteristics of the interest being valued.
1## FAQs
What is marketability in finance?
In finance, marketability refers to how easily and quickly an asset or security can be bought or sold in the market without significantly affecting its price. Highly marketable assets, like publicly traded stocks, can be converted to cash flow rapidly. Less marketable assets, such as private company shares, require more time and effort to find a buyer.
Why is a discount applied for lack of marketability?
A discount for lack of marketability is applied because investors generally demand a higher return for investments that are difficult to sell quickly. The discount compensates a buyer for the illiquidity, additional risk, time, and costs associated with owning an unmarketable asset compared to a similar, freely traded asset. This is a critical consideration in business valuation.
Does Discount for Lack of Marketability apply to publicly traded stocks?
Generally, the Discount for Lack of Marketability does not apply to regular shares of publicly traded companies because they are highly liquid and can be bought and sold on financial exchanges. However, it can apply to "restricted stock" of publicly traded companies, which are subject to limitations on transferability (e.g., holding periods or volume limits) as per Securities and Exchange Commission (SEC) regulations. These restricted shares are less marketable than the company's regular common stock.
What factors influence the size of the Discount for Lack of Marketability?
Several factors influence the size of the DLOM, including the financial performance and stability of the private company, its dividend policy, the existence of any legal or contractual restrictions on the transfer of shares, the anticipated time required to sell the interest, the overall economic climate, and the size and nature of the ownership interest being valued (e.g., minority interest vs. controlling interest).
Is the Discount for Lack of Marketability always the same percentage?
No, the Discount for Lack of Marketability is not a fixed percentage. It varies significantly based on the specific characteristics of the asset being valued, the industry, current market conditions, and the methodologies used by the valuation professional. While various studies provide observed ranges, the precise DLOM applied in any given valuation must be supported by thorough analysis and defensible reasoning.