Live
SPECIAL REPORT: US. President and Democrat Front Runner Joseph Biden drops His Bid for Reelection and endorses VP Kalama Harris.
Economic Report
Politics
Society & Culture
Entertainment
Art
Real Estate
By Liliana Dimitrova, LL.B., LL.M.
Published on 08 SEP 2023 8:00 am ET.
Market Dynamics Exploring the Significance of Lack of Marketability Discounts
Lack of marketability discounts (DLOM) are applied to private companies when valuing them, because they do not have a centralized market to trade their shares. This makes it harder to buy and sell shares, and reduces their value compared to public companies. S corporations in particular face restrictions on the number and type of shareholders they can have, which limits their marketability even more. Therefore, DLOM are especially significant for S corporations, as they can reduce the value of the transferred interest by 25% to 35% or more, depending on various factors.
5 Min Read
_edited_edited_edited_edited_p.png){kind=small}
What is the Discount for Lack of Marketability (DLOM)?
A discount for lack of marketability (DLOM) is a valuation adjustment that reflects the difficulty of selling a privately held business or its shares. A DLOM reduces the value of a business or its shares compared to a similar publicly traded entity that has a ready market for its shares. A DLOM is often applied when valuing a closely held S Corporation, which is a type of corporation that passes its income and losses to its shareholders for tax purposes.
A Discount for Lack of Marketability (DLOM) is “an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. Given two identical business interests, a higher price will be paid by investors in the market for the business interest that can be converted to cash most rapidly, without risk of loss in value. An example is publicly traded stock on the New York Stock Exchange, where the owner can order the sale and the proceeds are deposited in a bank account in three days.
In the alternative, a lesser price is expected for the business interest that cannot be quickly sold and converted to cash. A primary concern driving this price reduction is that, over the uncertain time frame required to complete the sale, the final sale price becomes less certain and with it a decline in value is quite possible. Accordingly, a prudent buyer would want a discount for acquiring such an interest to protect against value loss in a future sale scenario.
Publicly-traded companies are perceived to have a “market” since the shares can be bought or sold in a centralized marketplace. Private companies do not have a centralized market and are perceived as having less of a market. As a result, in theory, private companies – with all else being equal – should be valued at a lower amount than a public company to reflect the lack of a market.
The application of the Discount for Lack of Marketability (DLOM) can result in a significant value reduction as compared to the pro rata value of a business interest.
One method to estimate the DLOM for an S Corporation is to use the restricted stock method, which compares the price difference between the common stock and the restricted stock of a public company. Restricted stock is unregistered stock that cannot be sold for a certain period of time and is usually held by insiders, such as executives and directors. The restricted stock method assumes that the only difference between the common stock and the restricted stock is the lack of marketability, and therefore, the price difference represents the DLOM.
Another method to estimate the DLOM for an S Corporation is to use the IPO method, which compares the price difference between the pre-IPO and post-IPO shares of a private company that goes public. The pre-IPO price reflects the value of the private company before it has access to a public market, while the post-IPO price reflects the value of the public company after it has access to a public market. The IPO method assumes that the difference between the two prices represents the DLOM.
What to remember about DLOM:
-
DLOM is appropriate when the subject interest is non-marketable, yet the prior steps in the valuation process result in a marketable value.
-
DLOM is not appropriate if the prior valuation process has already taken marketability concerns into consideration.
-
DLOM is applied after the minority interest discount or control premium where such is appropriate to a valuation problem.
-
DLOM should be determined on its own factors and not combined with other discounts.
Marketability vs. Liquidity.
Publicly-traded companies are perceived to have a “market” since the shares can be bought or sold in a centralized marketplace. Private companies do not have a centralized market and are perceived as having less of a market. As a result, in theory, private companies – with all else being equal – should be valued at a lower amount than a public company to reflect the lack of a market.
Liquidity is the ability to readily convert an asset, business, business ownership interest or security into cash without significant loss of principal. Compare Liquidity to the definition of Marketability: the capability and ease of transfer or salability of an asset, business, business ownership interest or security.
A Discount for Lack of Liquidity (DLOL) is an amount or percentage deducted from the value of an ownership interest to reflect the relative inability to quickly convert property to cash.
Marketability and liquidity are two related but distinct concepts in the investment world. Marketability refers to the ability of an asset to be sold in a market, while liquidity refers to the ease of converting an asset into cash. Both are important factors for investors to consider when choosing their assets.
An asset is marketable if it can be easily bought or sold in a market without affecting its price. This depends on the demand and supply of the asset, as well as the availability of buyers and sellers. For example, a stock that is traded on a major stock exchange is more marketable than a stock that is traded on a small, obscure market.
An asset is liquid if it can be quickly converted into cash without causing a significant change in its price. This depends on the volatility and stability of the asset, as well as the transaction costs and time involved. For example, cash is the most liquid asset, while real estate is usually less liquid.
Marketability and liquidity are not always correlated. An asset can be highly liquid but have low marketability, or vice versa. For example, a government bond may be highly liquid, but if there is low demand for it, it may not be very marketable. Similarly, a piece of art may be highly marketable, but if it takes a long time to find a buyer, it may not be very liquid.
Investors need to balance marketability and liquidity according to their needs and preferences. Highly marketable and liquid assets are ideal for investors who want to have access to their money quickly and at a fair price, while less marketable and liquid assets may offer higher returns or other benefits for investors who are willing to wait or take more risk.
World news
Ryan Coogler-Michael B. Jordan Secret Movie Lands at Warner Bros.
6:28
EST
+11
Venezuela Asserts Military Buildup in Response to Alleged Illegal Oil Contracts Granted by Guyana.
7:10
EST
Citibank Won’t Reimburse Scam Victims Who Lost Their Savings Due to Bank’s Own Security Glitch.
8:05
EST
Arrest of Venezuelan Human Rights Activist Rocio San Miguel Raises Concerns.
8:30
EST
African Rail Projects Become Battleground For US-China Competition in Strategic Mineral Supply Chains.
9:00
EST
1
Global Resolution of Criminal and Civil Investigations with Purdue Pharma and the Sackler Family.
2
Global Resolution of Criminal and Civil Investigations with Purdue Pharma and the Sackler Family.
3
Global Resolution of Criminal and Civil Investigations with Purdue Pharma and the Sackler Family.
4
Global Resolution of Criminal and Civil Investigations with Purdue Pharma and the Sackler Family.
.jpg)
5
Global Resolution of Criminal and Civil Investigations with Purdue Pharma and the Sackler Family.
To balance marketability and liquidity, you need to consider your investment goals, time horizon, and risk tolerance. Here are some questions to ask yourself:
-
How soon do you need to access your money?
-
How much are you willing to pay in transaction costs or fees?
-
How much are you willing to lose in value if you sell your asset quickly?
-
How much are you willing to wait for the right opportunity to sell your asset?
-
How much are you willing to diversify your portfolio with different types of assets?
Depending on your answers, you may prefer assets that are more or less marketable and liquid. For example, if you need to access your money quickly and at a fair price, you may want to invest in highly marketable and liquid assets, such as cash, government bonds, or blue-chip stocks.
On the other hand, if you have a longer time horizon and are willing to take more risk, you may want to invest in less marketable and liquid assets, such as real estate, art, or private equity. These assets may offer higher returns or other benefits, but they may also require more time and effort to sell.
Marketability and Liquidity are terms often used interchangeably, although there is a technical distinction between them.
Marketability indicates the fact of “Salability”, while Liquidity indicates how fast that sale can occur at the current price.
-
If it’s liquid, it’s marketable.
-
If it’s non-marketable, it’s illiquid.
-
Being illiquid does not necessarily mean non-marketable – it may still be sellable but not quickly or without loss of value.
We are the answer!
Camilla Jones
Portfolio Manager
For Individual Accounts
Related Stories
The distinct characteristics between marketability ad liquidity are marketability focuses on finding the appropriate market, preparing the property for sale and executing the trade, while liquidity focuses on realizing cash proceeds.
Closely held enterprises account for more than 90% of all businesses in the United States. Valuation of these businesses poses certain challenges since they have no publicly traded stocks or bonds from which to obtain an indication of market value. A privately held interest is not publicly registered, and a public or secondary market does not exist for a privately held interest. The inability to readily sell an interest in a privately held entity increases the owner’s exposure to changing market conditions and increases the risk of ownership. Because of the lack of marketability and the resulting increased risk associated with ownership of a privately held interest, an investor typically demands a higher return or yield in comparison to a similar but publicly traded interest. Consequently, the privately held interest trades at a discount or a value less than it would if it were publicly traded. The size of the discount associated with a lack of marketability is generally correlated to the risk an investor would inherit in light of the inability to liquidate the interest.
The Internal Revenue Service published a document entitled, “Discount for Lack of Marketability – Job Aid for IRS Valuation Professionals.” Although it is not an official IRS position and was prepared solely for reference purposes by the treasury’s valuation engineers, the document’s content and breath of detail serves as a valuable tool to the valuation and legal communities.
The Internal Revenue Service (IRS) uses a Job Aid in applying DLOM to valuation analysis. Given two identical business interests, an investor will pay a higher price for a business that could be converted to cash quicker. Alternately, that investor will pay a lower price for a business that cannot be converted to cash quickly without the risk of loss in value.
How can DLOM be determined?
The Internal Revenue Service (IRS) uses a Job Aid in applying DLOM to valuation analysis. Given two identical business interests, an investor will pay a higher price for a business that could be converted to cash quicker. Alternately, that investor will pay a lower price for a business that cannot be converted to cash quickly without the risk of loss in value.
Using the IRS Job Aid as a guide, the following factors influence a property’s marketability:
-
Value of subject corporation’s privately traded securities vs. its publicly traded securities
-
Dividend-paying (or distribution) ability and history
-
Dividend yield
-
Attractiveness of subject business
-
Attractiveness of subject industry
-
Prospects for a sale or public offering of the company
-
Number of identifiable buyers
-
Attributes of controlling shareholder, if any
-
Availability of access to information or reliability of that information
-
Management
-
Earnings levels
-
Revenue levels
-
Book to market value ratios
-
Information requirements
-
Ownership concentration effects
-
Financial condition
-
Percent of shares held by insiders
-
Percent of shares held by institutions
-
Percent of independent directors
-
Listing on a major exchange
-
Active vs. passive investors
-
Registration costs
-
Availability of hedging opportunities
-
Market capitalization rank
-
Business risk
-
Subject Interest Factors
-
Restrictive transfer provisions
-
Length of the restriction period
-
Length of expected holding period
-
Offering size as a percentage of total shares outstanding
-
Registered vs. unregistered
-
General economic conditions
-
Prevailing stock market conditions
-
Volatility of stock
The Internal Revenue Service (IRS) uses a Job Aid in applying DLOM to valuation analysis. Given two identical business interests, an investor will pay a higher price for a business that could be converted to cash quicker. Alternately, that investor will pay a lower price for a business that cannot be converted to cash quickly without the risk of loss in value.
Regulatory
September 8th 2023
Fed plans broad revamp of bank oversight in wake of SVB collapse.
Liliana Dimitrova, LL.B., LL.M.
Section 351 Transfers to Controlled Corporations and Contributions to Capital
C Corporations
September 8th 2023
Liliana Dimitrova, LL.B., LL.M.
C Corporations
September 8th 2023
Section 351 Transfers to Controlled Corporations and Contributions to Capital
Liliana Dimitrova, LL.B., LL.M.
Section 351 Transfers to Controlled Corporations and Contributions to Capital
C Corporations
September 8th 2023
Liliana Dimitrova, LL.B., LL.M.
Digital
September 8th 2023
Digital Payments Are Having a Jolly Holiday
Liliana Dimitrova, LL.B., LL.M.
Section 351 Transfers to Controlled Corporations and Contributions to Capital
C Corporations
September 8th 2023
Liliana Dimitrova, LL.B., LL.M.
P&C
September 8th 2023
Public Debt Markets Just Got Their First Cyber-catastrophe Bond.
Liliana Dimitrova, LL.B., LL.M.
Section 351 Transfers to Controlled Corporations and Contributions to Capital
C Corporations
September 8th 2023
Liliana Dimitrova, LL.B., LL.M.
C Corporations
September 8th 2023
Section 351 Transfers to Controlled Corporations and Contributions to Capital
Liliana Dimitrova, LL.B., LL.M.
Section 351 Transfers to Controlled Corporations and Contributions to Capital
C Corporations
September 8th 2023
Liliana Dimitrova, LL.B., LL.M.
A privately held interest is not publicly registered, and a public or secondary market does not exist for a privately held interest. The inability to readily sell an interest in a privately held entity increases the owner’s exposure to changing market conditions and increases the risk of ownership. Because of the lack of marketability and the resulting increased risk associated with ownership of a privately held interest, an investor typically demands a higher return or yield in comparison to a similar but publicly traded interest. Consequently, the privately held interest trades at a discount or a value less than it would if it were publicly traded. The size of the discount associated with a lack of marketability is generally correlated to the risk an investor would inherit in light of the inability to liquidate the interest.
It is well recognized that as risk increases, the required return increases. Because of the increased risk of an investment in a privately held entity in comparison to publicly traded entities due to the lack of marketability, a hypothetical investor would require an increased return.
How much more of a return is required over marketable investments to compensate for the lack of marketability of the privately held investment?
In valuing a nonmarketable interest in a privately held entity, compensating the investor for increased risk can be accomplished by applying a discount for lack of marketability. The application of the discount for lack of marketability increases the effective return on investment to compensate the owner of the interest for the risks associated with the ownership of a nonmarketable interest.
The evaluation of the appropriateness of a discount for lack of marketability requires the collection and analysis of a substantial amount of information about the entity involved and the subject interest in that entity whose marketability is
being considered. Such typical inquiry will involve Information Document Requests. The information includes the collection of
-
History of dividend payments [cash dividends are a “liquid” return on investment, which might lower lack of marketability risk]
-
Salaries and bonuses paid to the Officers of the company, over the five years leading up to the valuation date [especially in companies that don’t pay dividends, Officers’ compensation can provide cash flow to shareholders, which might lower lack of marketability risk]
-
Compensation and/or fees paid to the Directors of the company, over the five years leading up to the valuation date [especially in companies that don’t pay dividends, Directors’ fees can provide cash flow to shareholders, which might lower lack of marketability risk]
-
List of all marketable securities (description, number, cost value) shown on the latest financial statements [cash-equivalent securities might lower liquidity risk on a company-wide basis]
-
List of all non-marketable securities and investments (description, number, cost value) shown on the latest financial statements [can provide information on how long it might take to liquidate non-marketable assets]
-
provide information on built-in capital gains tax expense to liquidate the Breakdown of adjusted cost basis for each of the marketable and Nonmarketable assets owned by the company on the valuation date [can company]
-
strategies] information on whether the company pursues available tax-deferral Section 1031 (or similar type) tax-deferred exchange [can provide non-marketable assets reflects a carry-over cost basis, pursuant to a Indicate if the adjusted cost basis of any of the company’s marketable or
-
ownership distribution and total number of shareholders] shareholder as of the valuation date [can provide information on relative shareholder/partner and the class and number of shares owned by each Current list of shareholders/partners showing the name of each shareholder/partner and the class and number of shares owned by each shareholder as of the valuation date [can provide information on relative ownership distribution and total number of shareholders]
-
marketability risk] [loans to/from shareholders might be relevant to evaluating lack of and any shareholders, over the five years leading up to the valuation date Copies of notes receivable (and/or notes payable) between the company and any shareholders, over the five years leading up to the valuation date [loans to/from shareholders might be relevant to evaluating lack of marketability risk]
-
Company articles of incorporation and amendments, by-laws and amendments or partnership agreements and amendments [by-laws might address restrictions or procedures for transfer of shares]
-
agreements might address restrictions or procedures for transfer of effect during the five years prior to the valuation date [shareholder option agreements stock purchase agreements, etc.) that have been in Copy of all shareholder agreements (such as buy/sell agreements, stock
-
All documents pertaining to any sale of the company, a division or unit of the company, or shares (interests) in the company during the five years prior to the valuation date [recent sales/transfers might be might be relevant to evaluating lack of marketability risk]
-
Board of Directors Meeting Minutes, for five years leading up to valuation date [Board meetings might address shareholder requests for sale/transfer of shares]
-
Complete financial statements of the company for the five fiscal or calendar years prior to the valuation date, including balance sheets, income statements and cash flow statements [can provide additional information for evaluating lack of marketability risk]
-
Complete income tax returns for the five fiscal or calendar years prior to the valuation date, including any audit adjustments [tax returns might include details that are not stated within the regular financial statements]
-
Brief history and/or description of the company or the company’s business (may already be included in an appraisal report) [can provide additional information for evaluating lack of marketability risk]
-
Brief statement of duties of subject shareholder’s participation in company operations [can provide additional information for evaluating lack of marketability risk]
When looking into how to calculate the discount for lack of marketability, there are instructions called the Mandelbaum Factors that can be used. These factors were created after a tax case that took place in 1995, where the judge shared multiple factors that have to be taken into consideration when we calculate the discount for lack of marketability, including:
-
Costs associated with making a public offering
-
Company redemption policy
-
Holding period for stock
-
Restrictions on transferability of shares
-
Amount of control in transferred shares
-
Company management
-
Nature of the company, which includes things like its economic outlook, history, and position in the industry
-
Company dividend policy
-
Financial statement analysis
-
Private vs. Public Sale of Shares
It is clear that private companies do not have a market to trade their shares. This just makes it very difficult for them to sell and buy shares. And the lack of marketability causes these shares to have a lower worth than otherwise. Crux of the problem is lack of information, specifically the pricing information. Due to this, selling an interest in a private company is a lot more time-consuming and costly. It also comes with a lot of uncertainty and variability that arises from the negotiations presenting a need for various methods for value gauging.
Restricted Stock Method
Restricted stock is the unregistered shares of ownership in a public company. They are the shares that are not publicly traded and are normally held by insiders including the directors and executives of the company. These stocks are called restricted since they have restrictions on them where they cannot be sold or transferred, which is there to deter the early selling of shares.
The directors and executives are given these shares so that they have the same interest in the company as the shareholders. Moreover, the Securities Exchange Commission (SEC) enacted the restricted resolutions to reduce all the agency problems where the general shareholders and management have different interests. As compared to the other publicly traded common stock, restricted stock has much less worth. This method removes the difference between the restricted stock and the common stock.
OPTION PRICING METHOD
Options are given to people in the company. They are basically rights given out to the holders to purchase or sell some of the company stock at a defined rate, which is the strike price, and at a specific date in the future. The prices of these options (also called the market for the options) can help in getting the value of a stock. With the market of options being different from the market of stocks, the difference between the strike price and the price of the options can give the value of the DLOM.
IPO METHOD
There are costs that are associated with losing control of the company such concerns introduce other discounts that overlap the discount for lack of marketability, including:
-
Discount for Lack of Control (DLOC) – The discount of lack of control is the amount deducted from the subject pro-rata share value of 100% of an equity interest to compensate for the lack of any or all powers in a control position in the company.
-
Discount for Lack of Liquidity (DLOL) – The discount of lack of liquidity which has been briefly discussed is the amount that is deducted from the ownership interest to compensate for the lack of assets that can convert to cash without the significant loss of principal. It is somewhat similar to the DLOM but marketability usually doesn’t always mean liquidity, which is why we also have this value.
Discount for lack of control (DLOC) vs discount for lack of marketability (DLOM)
The difference between DLOM and DLOC? It is important to understand the difference between the two since both are not the same and have a huge role in the calculation of the discount rate. This then helps with obtaining the final valuation of the company. Hence, these terms are very important and cannot be interchanged as well.
discount for lack of control. Control is when the ownership interest in a closely held company has a huge influence over the actions in the company. This means – whether or not the person who has the controlling interest being valued has control over things like selecting the management, acquiring or liquidating assets, and having a say in many other things in the company.
The person who wants to purchase the controlling interest in a company would have to pay a lot as the controlling shareholders are the ones who control all the actions in the company. On the other hand, the non-controlling ownership interest is the one that lacks a few or all control over the company’s actions. Hence, it is usually worthless as compared to the controlling ownership interest, on a per-share basis. Hence, there is a premium price for control and a discount associated with the lack of control, which is called the discount for lack of control (DLOC).
The person who wants to purchase the controlling interest in a company would have to pay a lot as the controlling shareholders are the ones who control all the actions in the company. On the other hand, the non-controlling ownership interest is the one that lacks a few or all control over the company’s actions. Hence, it is usually worthless as compared to the controlling ownership interest, on a per-share basis. Hence, there is a premium price for control and a discount associated with the lack of control, which is called the discount for lack of control (DLOC).
Difference Between DLOM AND DLOC
It is very simple. When we talk about the discount for lack of marketability, we are talking about whether an asset, usually shares, can be converted to cash and how fast. When it can convert to cash fast, it means that it is marketable and when it cannot be done easily, it means it lacks marketability. On the other hand, lack of control is when the shares being valued or sold do not come with any control over the company. Both of these are two different things and are usually used together for the valuation analysis.
DLOM EXAMPLE FOR CALCULATING FINAL VALUE
In this example, we will take the second option of #2 Option pricing method to ascertain the discount for lack of marketability for a subject private company. We use this method as its normally the most often used method and can be justified with data relevant to the subject company.
We need to find a few some information before applying the DLOM. First, we will need the total equity value (company valuation), time to expiration (length of holding period, or length until company expected exit), risk free rate, and the volatility.
Step 1
Let’s say we have a Saas company called Innovative Inc., and after conducting the company valuation using the income approach, market approach, and asset-based approach, and reconciling the values, we conclude the value of the company to be $10,000,000.
Step 2
The risk-free rate here we assume to be fixed at 2.0%, around the rate used for 30-year treasury bonds rate.
Step 3
The next step is we need to define the time until a company exit or major liquidity event. After forecasting the company’s future operations, the company estimates that there will be a potential exit in 2 years.
Step 4
The last step here is to calculate the company volatility. Now as the firm is a private company, it does not have an inherent volatility of its company stock, unlike public companies where shares are traded in the market. Therefore, in this case you would need to find similar publicly traded companies and calculate their stock volatility over a certain period of time, usually being 1-to-5-year periods.
Let’s say for Innovative Inc that the company’s comparable publicly traded companies are Adobe (Ticker ADBE), Avid Technology (AVID), Salesforce (CRM), IBM (IBM), and Microsoft (MSFT).In this case we can calculate the volatility of these companies, say over a 3 year period, from 1/1/2018 to 12/31/2020. After running the calculations, we find the volatility of these companies’ stocks to be:
Company
Volatility
ADBE
64.22%
AVID
105.30%
CRM
67.94%
IBM
51.99%
MSFT
55.78%
Median Volatility
64.22%
After doing all the calculations, we find the summary of the values to be:
Risk Free Rate
64.22%
Time to Exit
105.30%
Volatility
67.94%
Total DLOM
51.99%
Once the numbers have been calculated for the formula, you will get the DLOM to be 32%.
With the total value of the company being $10 million, we will divide by the company value by the company's outstanding shares for example, 1 million. That would be $10 per share, before applying the DLOM. Calculation for total value and ending share price is:
Total Value
Share price
Value of Company Before DLOM
$10,000,000
$10
DLOM (32%)
-$3,200,000
-$3.20
Ending Value
$6,800,000
$6.80
From here we can find the total value of the company after applying the DLOM to be $6,800,000, as well as the share price to be $6.80. Of course with most companies, they have more complex capital structures than just common shares, but hopefully this simple scenario can give you some practical knowledge on how to calculate the discount for lack of marketability and use it to find a company’s value.
The directors and executives are given these shares so that they have the same interest in the company as the shareholders. Moreover, the Securities Exchange Commission (SEC) enacted the restricted resolutions to reduce all the agency problems where the general shareholders and management have different interests. As compared to the other publicly traded common stock, restricted stock has much less worth. This method removes the difference between the restricted stock and the common stock.
Liliana Dimitrova, LL.B., LL.M.
RELATED Stories
Unlocking Financial Wisdom: Demystifying the Time Value of Money and Its Crucial Role in Your Financial Future.
Unpacking the Efficacy of the Capital Asset Pricing Model: Does it Stand the Test of Market Realities?
