The Discount for Lack of Marketability (DLOM) is a crucial adjustment in business valuation applied to the value of an ownership interest to reflect the absence of a ready, active market for its sale. It acknowledges that shares in private companies are generally less liquid and more difficult to sell than shares of publicly traded companies, which can be converted to cash quickly and at minimal cost on an established exchange58. This discount quantifies the reduced desirability of an asset that cannot be readily converted into cash or publicly traded without incurring significant time, effort, or cost56, 57. The DLOM is a key consideration within the broader field of financial valuation, ensuring that valuations accurately reflect the real-world ease (or difficulty) with which an asset can be sold.
History and Origin
The concept of a Discount for Lack of Marketability originated in the federal income tax area, with its earliest mentions appearing in federal tax cases as far back as 193455. Its significance in Anglo-American valuation practices grew rapidly in the 1970s following its consideration by U.S. tax authorities and courts54. Early empirical studies validating the existence and magnitude of marketability discounts were conducted during this period, often based on data from the late 1960s53.
A foundational document in U.S. business valuation is IRS Revenue Ruling 59-60, issued in 1959, which provides guidelines for valuing shares of closely held corporations for estate and gift tax purposes51, 52. While not directly defining DLOM, it laid the groundwork by emphasizing the factors to consider when a market for shares is not readily available50. Over the decades, the methodologies for quantifying the DLOM evolved. Initial approaches in the 1970s and 1980s often relied on "rules of thumb," such as a 35% discount, derived from averages of early restricted stock studies48, 49. Later, the U.S. Tax Court's 1995 decision in Mandelbaum v. Commissioner introduced a framework of nine specific factors for valuators to consider when quantifying a marketability discount, influencing subsequent appraisal practices45, 46, 47.
Key Takeaways
- The Discount for Lack of Marketability (DLOM) is a valuation adjustment applied to private or restricted securities to account for their limited tradability compared to publicly traded assets.
- It reflects the time, cost, and uncertainty associated with converting an illiquid asset into cash.
- Common methods for quantifying the DLOM include restricted stock studies, initial public offering (IPO) studies, and option pricing models.
- The magnitude of the DLOM can vary significantly depending on specific company characteristics, market conditions, and legal restrictions.
- DLOM is distinct from a discount for lack of control (DLOC) or discount for lack of liquidity (DLOL), though they are often applied together in comprehensive valuations.
Formula and Calculation
The Discount for Lack of Marketability (DLOM) is typically expressed as a percentage reduction from a marketable value. While there isn't one universal formula that directly calculates the DLOM across all scenarios, it is derived using various quantitative models and qualitative factors. One common quantitative approach is based on option pricing theory, specifically treating the lack of marketability as the cost of a theoretical "put option" that would allow the holder to sell the non-marketable asset at its marketable value.
The conceptual calculation can be represented as:
Where:
- Cost of Theoretical Put Option: This is the theoretical price an investor would pay to gain the right to sell an illiquid asset at a specific price (its marketable value) at a future date. This value is often derived using models such as the Black-Scholes model44.
- Marketable Value: This represents the value of the ownership interest if it were freely tradable in an active market, prior to the application of any marketability discount.
The inputs that influence the calculation of the "Cost of Theoretical Put Option" within an option pricing framework typically include:
- Volatility: The expected price fluctuations of the underlying asset. Higher volatility generally suggests a higher DLOM43.
- Time to Liquidity Event: The estimated period until the asset is expected to become liquid (e.g., through an IPO or sale). A longer period generally results in a higher DLOM41, 42.
- Expected Dividend Yield: The anticipated income stream from the asset. Higher expected dividends can reduce the DLOM as they provide some return during the illiquid holding period39, 40.
- Risk-Free Interest Rate: The return on an investment with no risk, reflecting the time value of money38.
Beyond quantitative models, qualitative factors significantly impact the applied DLOM. These include company-specific factors such as financial health, dividend policy, quality of management, and the overall capital structure35, 36, 37. External factors like the general economic outlook and industry conditions are also considered34.
Interpreting the DLOM
Interpreting the Discount for Lack of Marketability involves understanding its implication for the true economic value of a non-marketable ownership interest. A higher DLOM signifies a greater challenge in converting the asset into cash quickly and at a predictable price, meaning investors would demand a larger discount to compensate for this illiquidity risk33. Conversely, a lower DLOM suggests relatively easier marketability.
For instance, if a preliminary fair market value for a private company's equity is determined, applying a 25% DLOM means that an investor would pay 25% less for those shares than they would for an identical, publicly traded equivalent. This adjustment recognizes that the absence of an organized market means a seller might face increased transaction costs, a longer selling period, and uncertainty regarding the eventual sale price32. It is a critical component in arriving at a realistic value for assets that lack a ready market, such as closely held business interests, certain types of real estate, or restricted securities. Understanding the DLOM is vital for both buyers and sellers of such assets, as it directly impacts the price at which a transaction is likely to occur30, 31.
Hypothetical Example
Consider "InnovateTech Solutions," a successful, privately held software company. Based on its strong revenue growth and profitability, a preliminary valuation using a Discounted Cash Flow (DCF) method, assuming it were a publicly traded entity, arrives at an equity value of $50 million. However, InnovateTech is not listed on any stock exchange, and its shares have transfer restrictions requiring internal approval for any sale.
To determine a realistic value for a potential investor, a DLOM must be applied. A valuation expert analyzes comparable private companies and uses an option pricing model, factoring in InnovateTech's financial volatility, the estimated time until a potential liquidity event (e.g., an IPO in 3-5 years), its current dividend policy (it reinvests all earnings, so zero dividend yield), and prevailing risk-free interest rates.
Through this analysis, the expert determines that a 30% DLOM is appropriate for InnovateTech's shares.
The adjusted value would be calculated as:
Therefore, an investor seeking to buy a stake in InnovateTech Solutions would likely value the entire company at approximately $35 million, reflecting the inherent challenges of converting their investment into cash due to the lack of an active market for its shares.
Practical Applications
The Discount for Lack of Marketability (DLOM) is a fundamental concept with broad practical applications across various financial and legal contexts, particularly where assets lack a ready market.
- Estate and Gift Tax Valuation: One of the most common applications of DLOM is in determining the fair market value of interests in closely held businesses for estate tax and gift tax purposes. The Internal Revenue Service (IRS) requires such valuations to reflect the limited marketability of these ownership interests.
- Mergers and Acquisitions (M&A): When privately held companies are acquired or merged, valuation professionals often apply a DLOM to adjust the value derived from publicly traded comparables, ensuring the purchase price reflects the illiquidity inherent in private company shares prior to the transaction29.
- Financial Reporting: Under certain accounting standards, such as IFRS 2 (Share-based Payment) and IFRS 13 (Fair Value Measurement), as well as Section 409A valuations in the U.S. for employee stock option programs, the DLOM is relevant in determining the fair value of non-publicly traded equity instruments28. The Securities and Exchange Commission (SEC) has also provided guidance on the fair value determination of illiquid assets held by investment funds, emphasizing the need for robust valuation processes27.
- Shareholder Disputes and Buyouts: In cases involving shareholder buyouts or disputes where a minority interest in a private company is being valued, the DLOM helps determine a fair price, recognizing the challenges a shareholder would face in selling their stake on the open market26.
- Employee Stock Option Valuation: For private companies offering employee stock options, applying a DLOM ensures that the strike price and overall valuation of these options accurately reflect the lack of immediate marketability for the underlying shares.
The application of DLOM ensures that valuations for non-publicly traded assets are realistic and reflect the actual market conditions and investor expectations regarding their saleability.
Limitations and Criticisms
Despite its widespread use, the Discount for Lack of Marketability is subject to several limitations and criticisms, primarily concerning its quantification and the subjectivity involved in its application.
One significant challenge is the lack of universally accepted, definitive guidance on how to calculate the DLOM25. Valuation professionals use various methods, including historical studies (such as restricted stock studies and pre-IPO studies) and option pricing models. However, these studies often rely on outdated data, with some of the most recent well-known studies using transactions from the 1990s or earlier, making their applicability to current market conditions questionable23, 24. Furthermore, the legislation and market dynamics underlying these historical studies have changed significantly, potentially affecting the observed discounts22.
Critics also point out the inherent subjectivity in selecting the appropriate DLOM. While qualitative factors are considered, the weight given to each factor can vary between valuators. The IRS, for example, has criticized the number of subjective inputs required for certain DLOM methodologies21. Some studies have shown a wide range of discounts, from as low as 5% to as high as 90%, highlighting the variability and the importance of company-specific factors19, 20. Relying solely on average discounts from benchmark studies without thorough analysis of the subject company's unique characteristics is generally viewed as insufficient and has been rejected by courts17, 18.
Additionally, there can be overlaps or confusion with other discounts, such as the Discount for Lack of Liquidity (DLOL) or Discount for Lack of Control (DLOC), making the isolation and precise quantification of the DLOM challenging. Professional valuation firms continuously work to refine methodologies and support their conclusions with robust analysis to withstand scrutiny15, 16.
Discount for Lack of Marketability vs. Discount for Lack of Control
The Discount for Lack of Marketability (DLOM) and the Discount for Lack of Control (DLOC) are two distinct but often co-applied valuation adjustments that reduce the perceived value of an asset, particularly in the context of private company interests. While both result in a lower valuation, their underlying rationales differ significantly.
Discount for Lack of Marketability (DLOM) focuses on the difficulty of selling an asset due to the absence of a readily available public market. It reflects the time, effort, and cost involved in converting an ownership interest into cash13, 14. An investment in a private company's shares is less marketable because finding a buyer can be challenging, and the transaction might incur high costs and take a considerable amount of time12. The DLOM accounts for this frictional cost and uncertainty of sale.
In contrast, the Discount for Lack of Control (DLOC), also known as a minority interest discount, reflects the reduced value of an ownership interest that does not provide the holder with control over the company's decisions and operations10, 11. A minority shareholder generally cannot influence strategic decisions, appoint management, determine dividend policies, or dictate exit strategies9. The lack of such control rights makes a minority stake less valuable than a controlling interest on a pro-rata basis.
While DLOM relates to how easily an asset can be sold, DLOC relates to the power (or lack thereof) associated with the ownership stake. Both discounts are crucial for arriving at a fair market value for minority, non-marketable interests in private entities8. It's common for both to be applied cumulatively in valuations, as a minority interest in a private company typically lacks both control and marketability7.
FAQs
What assets typically require a Discount for Lack of Marketability?
The Discount for Lack of Marketability is primarily applied to interests in private companies, family limited partnerships, or other closely held entities where shares are not traded on public exchanges. It also applies to restricted stock of public companies that cannot be freely traded for a specific period due to regulatory or contractual restrictions.
How does the DLOM affect the value of a company?
The DLOM reduces the overall per-share value of a company's stock or ownership interest to reflect the fact that it cannot be easily or quickly converted into cash without significant costs or delays, unlike publicly traded shares6. This means the actual value an investor would pay for a non-marketable interest is lower than its pro-rata share of the company's overall business valuation assuming public market access.
Are there different methods to calculate the DLOM?
Yes, several methods are commonly used to estimate the DLOM. The most prominent include the Restricted Stock Method (comparing prices of restricted vs. unrestricted shares), the Initial Public Offering (IPO) Method (comparing pre-IPO private sales to post-IPO public prices), and Option Pricing Models (treating illiquidity as a put option)4, 5. Additionally, qualitative factors specific to the company are often considered3.
Is the DLOM the same as a lack of liquidity discount?
While closely related, "lack of marketability" and "lack of liquidity" are sometimes distinguished. Marketability refers to the ease and certainty of selling an asset at a fair price in an active market, whereas liquidity refers to the ability to convert an asset into cash quickly without significant loss of value1, 2. In practice, the terms are often used interchangeably, and the DLOM is the quantifiable adjustment that accounts for this lack of ready saleability.