The discount for lack of marketability (DLOM) is often a contentious issue. Why? First, the DLOM can have a significant impact on the value of a business interest, reducing it by, say, 15%, 30% or more. Moreover, quantifying the appropriate discount for a specific business interest requires subjectivity and an in-depth understanding of key empirical studies. Here’s more on the art and science underlying the DLOM.
What is marketability?
The International Glossary of Business Valuation Terms defines marketability as “the ability to quickly convert property to cash at minimal cost, with a high degree of certainty of realizing the anticipated amount of proceeds.” It defines the DLOM as “an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.”
Investments in shares of closely held companies are considered to have an indefinite holding period (a long-term illiquid investment) and thus are inherently less marketable. And business interests that are expected to take a long time to sell and/or incur high transaction costs may warrant a higher DLOM. When quantifying this discount, experts also factor in the risk that investors might not receive their expected returns.
What factors affect the DLOM?
Empirical studies (see “Quantifying the DLOM”) are typically the starting point for quantifying a DLOM. From there, experts gauge a business interest’s marketability using these factors:
- Expected holding period,
- Level of risk or volatility, and
- Expected dividend payments.
Experts consider a mental checklist of questions when quantifying the DLOM for a specific business interest. Here are some examples:
Does the interest include “put” rights? The right to sell an interest back to the company, if certain conditions are met, creates a limited market for the interest. However, an expert must evaluate whether the company will have the financial ability to redeem these interests. If not, the liquidity associated with put rights may be illusory.
What are the prospects of an initial public offering (IPO) or sale? The higher the likelihood the company will conduct an IPO or sale — and the sooner such an event is likely to occur — the lower the DLOM. An expert must consider whether the company is a strong candidate for an IPO or sale, based on its performance and conditions in its industry, as well as the intentions of its controlling owners.
Do shareholder or partner agreements restrict transfers of shares? Contractual transfer restrictions typically warrant a higher DLOM to reflect the increased time and cost associated with selling the business interest.
How large is the business or business interest? Generally, investors perceive large businesses as less risky than small ones. Moreover, as the size of an interest increases, the pool of potential buyers eventually decreases and the likelihood that a sale will “flood” the market increases. This could make a sale more challenging.
How solid is the company’s historical performance and what are expectations for the future? Strong performance — in terms of profitability, earnings stability and revenue growth — along with stable historical and expected returns translates into lower risk and higher marketability.
Are there any company-specific risk factors? The existence of these risks — such as lack of geographic or product diversification, heavy dependence on key customers or suppliers, poor management quality and pending litigation — generally adds to the DLOM.
Does the company have a history of paying generous dividends? Higher historical dividends may be associated with lower DLOMs.
How much in dividends is the company expected to pay out in the future? A company may cut back on expected dividends if performance is likely to decline — or if shares in a family business are transferred to nonfamily members.
Marketability is a complex issue. Experienced valuation professionals ask the right questions to customize a DLOM that fits a particular business interest.
Quantifying the DLOM
Valuation experts use various empirical studies when estimating the discount for lack of marketability (DLOM) for a business interest. Common sources of empirical data include:
Restricted stock studies. These studies quantify the DLOM by comparing trading prices of public company stocks with prices paid in private transactions involving restricted stock of the same company. Restricted shares are generally identical to their publicly traded counterparts, except that they’re subject to a minimum holding period. Because the restriction will eventually be lifted, restricted stocks tend to be more marketable than comparable closely held stocks. Average discounts from restricted stock studies generally range from 20% to 45%.
Initial public offering (IPO) studies. These studies compare IPO prices with prices of the same stock in private transactions before the IPO. The increase in stock price before an IPO and at the time of the IPO represents the stock’s relative lack of marketability. These studies may be adjusted to exclude non-arm’s-length transactions, such as sales to insiders or exercises of stock options. Average discounts from IPO studies generally range from 30% to 60%.
The mean or median discounts from these studies may serve as a starting point that needs to be adjusted up or down, based on the characteristics of the specific business interest. Experts also use other methods to quantify the DLOM, including discounted cash flow models and stock option pricing models.