Understanding Discounts for Lack of Marketability (DLOM)

Discounts for Lack of Marketability (DLOM) represent a crucial concept in the valuation of closely held and restricted shares, which are not traded on public exchanges. This discount acknowledges the inherent differences between public stock, which enjoys liquidity due to a readily available market, and private stocks, which struggle to find willing buyers. DLOM serves to reflect these differences in valuations, affecting buy-sell agreements, estate planning, and various taxation matters.

The Theory Behind DLOM

DLOM is founded on the premise that an illiquid asset is less valuable than a liquid asset. When valuing ownership interests in privately held companies, the absence of a straightforward exit strategy results in a valuation discount. Investors in private companies typically face longer waiting periods, potential higher costs, and greater uncertainty in selling their shares compared to their publicly traded counterparts.

Calculation Methods for DLOM

Valuation professionals employ various techniques to determine the appropriate DLOM to apply in their analyses. The most common methods include:

1. Restricted Stock Method
   The restricted stock method contends that the only distinction between a company's common stock and its restricted stock is the marketability of the latter. The price difference between the two forms of stock is attributed to this lack of marketability. Analysts use historical data of restricted stock sales to ascertain a market-based DLOM.

2. IPO Method
   The IPO method assesses the price difference between shares sold before an Initial Public Offering (IPO) and those sold afterwards. The percentage difference in the stock price before and after the IPO provides insights into the DLOM associated with private shares.

3. Option Pricing Method
   This method applies the principles of options trading to estimate DLOM. By comparing the price of an option (which is a financial derivative) to its strike price, professionals derive a ratio that represents the discount for lack of marketability. The price of the option, as expressed as a percentage of the strike price, helps in establishing a DLOM consistent with market behaviors.

DLOM Range and Consensus

Research into DLOM indicates that it typically falls within a range of 30% to 50%, although this can vary significantly based on factors such as the company’s financial health, industry volatility, and the overall economic environment. Factors influencing the specific percentage include the nature of the company’s assets, the length of time until a sale can be made, and the financial performance and projections of the business.

Challenges Associated with DLOM

The evaluation of noncontrolling and nonmarketable ownership interests in closely held firms raises unique challenges for valuation analysts, especially in the context of taxation. DLOM is frequently considered during:

• Gift and estate tax assessments
• Generation-skipping transfer tax considerations
• Income tax obligations
• Property tax disputes

Additional Considerations: DLOL and DLOC

Compounding the challenges of DLOM are two related concepts: the Discount for Lack of Liquidity (DLOL) and the Discount for Lack of Control (DLOC). Both factors further complicate the valuation of closely held shares:

• Discount for Lack of Liquidity (DLOL): Refers to the additional discount applied to assess an investment's value when it cannot be converted to cash easily or quickly.

• Discount for Lack of Control (DLOC): Addresses the value reduction of shares that do not provide the shareholder the ability to influence company decisions or operations. Noncontrolling shares are generally considered less valuable due to the lack of voting rights or decision-making power.

Conclusion

In summary, Discounts for Lack of Marketability are essential when valuing closely held stocks. Understanding DLOM, alongside its calculation methods and related challenges, is vital for professionals dealing with private equity, estate planning, and tax assessments. While the principles behind DLOM may seem straightforward, navigating the nuances of valuation in an illiquid market can be complex, requiring judicious analysis and insight into specific market conditions and company attributes.