Discount For Lack of Marketability
The term “discount for lack of marketability” is often referred to, but it isn’t always fully understood. Markets in which public and private equity stakes (i.e., companies) can be negotiated are not exactly the same; the trading conditions are substantially different, especially in terms of marketability (liquidity). This can and often does have a significant impact on the value of your private business. In this article, we cover the basics of how it works.
Marketability is the degree of which the shares of a business can be quickly converted to cash. In other words, marketability refers to how easily a business ownership interest can become liquid in a short period of time.
The discount for lack of marketability (DLOM) is the amount in which the value of the shares in a private company are reduced compared to the value of stock for public companies (a fully liquid ownership position) to reflect a reduction in value that represents the lack of marketability. Because it takes longer to potentially sell the shares or realize a cash position from the ownership of the private business, these shares are usually less valuable.
To find the value the shares need to be reduced by for the DLOM, first you need to know the original share value, if you need help with this, see our article, “How do I Value My Business?” that explain this.
What’s The Purpose of the Discount for Lack of Marketability?
The main purpose is to reflect the difficulty in selling shares in a private business compared to a public business, which shows the level of liquidity that one has towards the other. As a result, the DLOM should be considered to estimate the true value of the business ownership interest.
What to Consider:
- The value of the shares that are privately traded compared to the value of publicly traded shares
- Comparability of the company under valuation and any listed/public companies being used to develop a DLOM
- Timing and the age of data points from listed/public companies that are used in developing a DLOM
Different Methods of Identifying DLOM
There are several techniques or methods to identify the DLOM. Below, we explain three very common techniques:
Restricted Stock: This term refers to the number of shares in a company that are issued to its key employees, such as executives and directors. However, these shares are not transferable, or, in other words, not available to be traded publicly until certain restrictions have been met (KPIs, length of employment, etc.), meaning that the restricted stocks/shares are not marketable and are therefore valued less than a freely tradable share. The DLOM under the restricted stock method is the price difference between the company’s common stock and its restricted stock.
Option Pricing Method: There are several techniques to calculate the DLOM under the option pricing method. In its simplest form, it uses the option price and strike price to determine the implicit DLOM, the DLOM is the option price as a percentage of the strike price.
Initial Public Offering: An initial public offering (IPO) refers to the process in which a private company offers shares to public investors to raise capital. In other words, when a private company goes public, the private share ownership converts to public ownership, and therefore the private share ownership is worth the publicly trading price.
The DLOM under the IPO method is the difference between the public share price and the private share price. This DLOM is then used for other similar or comparable companies when performing their valuation.
The calculation of the difference between the pre- and post-IPO share price usually takes the pre-IPO price as at the latest transaction prior to the IPO (this generally must be within several months of the IPO) and the IPO share price, reflective of the price in a public and freely traded market.
Example of the Discount for Lack of Marketability
In the example below, we have chosen the initial public offering (IPO) technique.
Company X Ltd. is a private business that wants to sell a 100% ownership interest to another private buyer, meaning they’re not offering shares (or a particular number of shares) to the public. Now, think of the illiquidity part as this: it is harder to find another private buyer to buy the company as opposed to selling shares in an actively traded public stock exchange. As it is less liquid, we apply the DLOM. So then, we take the average of similar and comparable public companies and apply the discount (18%) to the enterprise value.
Note: For the above example, we used the average of the difference between private and IPO as a percentage to find the premium. Then we used the formula shown to the left to calculate the DLOM (which incorporates the premium). Next, we multiply the enterprise value by 1 – DLOM to find the total adjusted fair market value of the company.
The discount for lack of marketability is a method used to calculate the value of private companies, which inherently have a lower level of liquidity/marketability when compared with public companies. There are various techniques available, as well as several debates among academics and practitioners, regarding the most appropriate or accurate method. Regardless, if applied, a DLOM must be thoroughly analyzed and justified using professional judgement.