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The Discount for Lack of Marketability (DLOM) is a critical adjustment in business valuation that reflects the reduced liquidity of privately held shares compared to publicly traded securities. This concept is especially important when valuing minority interests in closely held businesses, where converting ownership into cash is not readily possible. Accurately estimating the DLOM can have a significant impact on the concluded value, affecting negotiations, tax planning, estate transitions, and litigation. This article explores common methodologies for determining DLOM, including restricted stock and pre-IPO studies, option pricing models, as well as company-specific factors. We aim to provide a practical and defensible framework for selecting an appropriate DLOM in the valuation of private U.S. businesses.

Introduction

In business valuation, the concept of marketability refers to how quickly and easily an equity interest can be converted into cash. For publicly traded companies, shares can be sold on stock exchanges with relative ease. Private company interests, however, typically face legal, contractual, or market constraints limiting prompt liquidation. As a result, investors demand a discount to compensate for this lack of marketability. This adjustment is known as the Discount for Lack of Marketability, or DLOM.

Determining the DLOM is not a one-size-fits-all process. Analysts must employ empirical evidence, financial models, and professional judgment to arrive at a supportable conclusion. Selecting an appropriate DLOM requires a balanced understanding of financial theory, empirical studies, and the specific characteristics of the subject company and interest being valued.

Why DLOM Matters in Business Valuations

The DLOM can range from 10 percent to over 40 percent of equity value, depending on the facts and circumstances. A misapplied DLOM can materially distort the concluded value and may not withstand scrutiny from the IRS, a court, or a prospective buyer. Business owners, legal advisors, and investors must understand the basis for DLOM decisions to properly interpret and defend valuation conclusions.

For estate and gift tax purposes, the IRS and tax courts have historically scrutinized DLOM estimates. In shareholder disputes, a well-supported DLOM can be the difference between an equitable settlement and a protracted legal battle. Similarly, in buy-sell transactions, accurate DLOM application ensures fair pricing for both buyer and seller. Thus, determining a defensible discount is not only an academic exercise but also a practical necessity.

Key Valuation Insights or Factors

Restricted Stock Studies

Restricted stock studies compare the prices of restricted shares (which cannot be sold freely for a period of time) to their freely traded counterparts of the same company. Since the only difference is the lack of immediate marketability, the resulting price differential sheds light on the market’s valuation of illiquidity. Several landmark studies from the SEC and academic researchers have shown average discounts typically ranging from 20 percent to 35 percent, although the range varies based on factors like company size, profitability, and holding periods.

Notable studies include those by Silber (1991), FMV Opinions (2001), and the Stout Restricted Stock Study (updated quarterly), which provide empirical benchmarks. While these studies are helpful, they may not account for how investor sophistication, holding periods, and market conditions affect valuation today.

Pre-IPO Studies

Pre-IPO studies analyze stock transactions occurring before companies go public and compare those prices to the IPO price. This method isolates the discount investors placed on companies when those shares were not yet marketable on a stock exchange. Unlike restricted stock, pre-IPO interests often represent private ownership without immediate access to exit strategies.

Research such as the Willamette Management Associates pre-IPO study and the Emory studies found DLOMs ranging from 20 percent to over 50 percent, particularly for smaller or riskier companies. However, the data is sometimes dated, and not all pre-IPO companies are directly comparable to small private businesses.

Option Pricing Models

Option pricing models estimate DLOM by valuing the right to delay a sale, framing illiquidity as akin to a put option on the underlying shares. Models like the Longstaff or Chaffe approach use inputs such as volatility, holding period, and risk-free rate to simulate what an investor would pay to hedge against illiquidity risk.

The advantage of option models is their responsiveness to company-specific risk factors and time horizons. Although more complex, they allow valuation analysts to tailor the discount based on quantifiable elements, often resulting in a more defensible and dynamic estimate. Still, they require access to data on volatility and a strong grounding in financial modeling techniques.

Company-Specific Factors

No matter the empirical method used, the DLOM should reflect the specific attributes of the subject company and the interest being valued. Key considerations include:

• Revenue size and growth trajectory
• Profitability and cash flow generation
• Dividend policy and expected distributions
• Transfer restrictions (e.g., shareholder agreements or operating agreements)
• Buy-sell agreement provisions or exit opportunities
• Management control and voting rights
• Market conditions and industry liquidity norms

For example, a minority interest in a profitable company with no foreseeable exit strategy and restrictive transfer covenants would likely merit a higher DLOM than a similar stake in a firm with active acquisition interest and periodic distributions.

Real-World Applications for DLOM

Consider a 30 percent minority interest in a family-owned manufacturing business generating consistent EBITDA margins, with no intention of going public or selling. The shares are subject to transfer restrictions, and there is no documented buy-sell agreement. Based on analysis of restricted stock studies and an option model incorporating a three-year expected holding period and 35 percent volatility, the valuation analyst may conclude a DLOM of 28 to 32 percent is reasonable.

In contrast, a minority stake in a private technology startup undergoing early investor rounds, with exit potential via IPO or acquisition within 18 months, may warrant a reduced DLOM of 15 to 25 percent depending on estimated timeline and investor preferences. Each scenario demonstrates the importance of aligning quantitative models with qualitative understandings of marketability risk.

Common Mistakes or Misconceptions

One of the most common mistakes is relying on a flat or benchmark discount with no clear tie to the facts of the engagement. While average DLOMs of 25 to 35 percent often surface in empirical studies, applying such figures without context exposes the analysis to scrutiny or rejection in tax or legal settings.

Another misstep is misunderstanding the difference between control and marketability. A controlling interest may still lack marketability if it cannot be sold readily. Similarly, over-reliance on outdated or limited-sample studies without proper calibration to the target company’s profile may result in unsupported conclusions.

Lastly, practitioners sometimes ignore or undervalue the role of shareholder agreements. Clauses affecting transferability, rights of first refusal, or mandatory offers can drastically shape the liquidity profile of an interest and should be evaluated carefully.

Conclusion

The Discount for Lack of Marketability is a nuanced but essential element of private business valuation. Selecting the appropriate DLOM requires an integrated approach that considers empirical evidence, financial theory, and company-specific dynamics. Whether using restricted stock studies, pre-IPO transactions, or option models, credible conclusions rely on thoughtful application and sufficient support.

For business owners, investors, and advisors, understanding how marketability affects value is critical to informed decision-making. If you are exploring a sale, preparing for succession, or planning your estate, we invite you to connect with our valuation professionals to discuss how marketability may factor into your company’s value.