What Does Discounts for Lack of Marketability (DLOM) Mean?
Discounts for Lack of Marketability (DLOM) are reductions applied to the fair value of an ownership interest to reflect the reduced ability to convert that interest to cash quickly and without large transaction costs. DLOM is most commonly applied when valuing noncontrolling, privately held shares that cannot be freely traded on a public market. Because a private interest generally takes longer, costs more, and involves more uncertainty to sell than a publicly traded share, investors require a lower price—hence a discount.
Key takeaways
– DLOM measures the value reduction for the inability to quickly and easily sell an ownership interest.
– It is most relevant for noncontrolling, privately held interests—common issues arise in gift, estate and tax valuations.
– Common methods to estimate DLOM include restricted-stock studies, IPO (pre‑/post‑IPO) studies, option‑pricing models, and empirical transaction comparables.
– Studies and practitioner consensus frequently place typical DLOMs in the range of roughly 30%–50% (varies by facts and method).
– Best practice: use multiple methods, reconcile results, and document assumptions and supporting evidence.
Why DLOM matters
– Tax and transfer cases: Gift and estate tax valuations commonly require DLOM adjustments to reflect marketability differences between privately held and public securities.
– Transaction pricing: Buyers of private-company stakes will pay less than a public-market price for the same proportionate economic rights if liquidity is limited.
– Financial reporting and disputes: DLOM affects reported value in litigation, shareholder disputes, and financial statement valuations.
Common approaches to estimating DLOM (overview and practical notes)
1) Restricted‑stock studies (empirical market approach)
– What it is: Compare prices of publicly traded unrestricted shares with restricted shares (restricted securities of the same issuer subject to transfer limitations). The observed price difference is attributed to lack of marketability.
– Practical use: Use when comparable restricted vs. unrestricted trades are available for similar companies or periods. Adjust for differences in size, volatility, and company-specific factors.
– Strengths/weaknesses: Market‑based and intuitively direct, but samples may be skewed toward larger, publicly traded companies and may not match closely held company characteristics.
2) Pre‑IPO vs post‑IPO (IPO studies)
– What it is: Compare prices paid by investors for shares before an IPO with the public trading price immediately after IPO. The percent difference can be interpreted as a DLOM for pre‑IPO shares.
– Practical use: Useful when you can find robust pre/post IPO transaction data for firms similar in industry, size and stage. Be careful: pre‑IPO investors often accept other risks (e.g., business risk, dilution, control differences), so not all of the price difference is pure marketability.
– Strengths/weaknesses: Reflects a real sale outcome, but sample selection and timing issues can bias results.
3) Option‑pricing methods
– What it is: Model lack of marketability as the value of a put/call/lockup option – effectively the option to sell/lock up the shares for a period. Use option‑pricing (Black‑Scholes, binomial or Monte Carlo) with inputs such as volatility, time to expected liquidity, risk‑free rate, and dividends to estimate the value of marketability (or its absence).
– Practical use: Appropriate when there is a clear notion of the expected period of illiquidity and when reliable inputs for volatility and timing exist.
– Strengths/weaknesses: Theoretically sound but highly sensitive to input assumptions (especially volatility and time to liquidity). Can produce a wide range of outcomes, so sensitivity analysis is essential.
4) Comparable transaction discounts and empirical studies
– What it is: Use documented discounts observed in closed private transactions, academic studies, or practitioners’ databases that report typical discounts for different types of shares and companies.
– Practical use: Useful as a cross‑check. Make sure the comparables are similar in company size, industry, ownership rights, and expected liquidity timeline.
– Strengths/weaknesses: Empirical and pragmatic, but risk of apples‑to‑oranges comparisons; often needs adjustment.
Factors that influence the size of DLOM
– Time to expected liquidity: Longer expected hold-to-sale periods raise the DLOM.
– Company size and investor base: Smaller, less visible firms typically have higher DLOMs.
– Financial performance and stability: Higher revenue/earnings volatility and weaker financials increase the discount.
– Transfer restrictions and bylaws: Contractual or statutory sale restrictions (e.g., buy‑sell agreements, consent requirements) increase DLOM.
– Control and voting rights: Minority, noncontrolling interests usually have higher DLOM than control positions (separate DLOC considerations).
– Market conditions: Credit market tightness, buyer demand and macro conditions affect marketability.
– Tax considerations and costs: Transfer taxes, broker fees, escrow costs, and other sale costs matter.
How DLOM impacts valuations (practical examples)
– Example: A minority interest’s pre‑DLOM fair value is $1,000,000. If a reasoned DLOM of 35% is applied, adjusted value = $1,000,000 × (1 − 0.35) = $650,000.
– For gift/estate tax: A DLOM reduces the taxable value transferred. Valuators should document the method and evidence because tax authorities may scrutinize the discount.
– For buy‑sells and corporate planning: Appropriately applied DLOMs produce fairer buyout prices and align expectations between buyers and sellers.
Challenges in applying DLOM
– Data limitations: Direct market evidence for closely held firms is sparse and heterogenous.
– Method sensitivity: Option models and other quantitative approaches are sensitive to inputs (volatility, time horizon). Small changes can produce large swings.
– Separating effects: DLOM must be distinguished from Discount for Lack of Control (DLOC). A minority discount often reflects both lack of marketability and lack of control—analysts should separate these logically and document the split.
– Judicial and tax scrutiny: Courts and tax authorities often require thorough documentation and may prefer market‑based evidence.
– One‑size‑fits‑all traps: Applying a standard percentage mechanically (e.g., always 30%) is poor practice—facts and circumstances drive the appropriate discount.
Practical, step‑by‑step approach for valuators
1) Gather facts and define the interest being valued
– Identify the type of interest (minority vs. controlling), legal transfer restrictions, shareholder agreement terms, buy/sell provisions, and expected time to liquidity.
– Document historical transactions in the company, investor pools, and past sales of similar interests.
2) Determine the base (pre‑discount) fair value
– Use standard valuation approaches (income, market, and/or asset approaches) to estimate the appropriate base equity or share value before marketability adjustments.
3) Analyze marketability factors and comparable evidence
– Collect restricted‑stock studies, IPO pre/post pricing data, and private transaction evidence relevant to the company’s size, industry and geography.
– Identify contractual or statutory impediments to transfer that could increase DLOM.
4) Select and apply one or more DLOM estimation methods
– Apply at least two defensible methods where possible (e.g., restricted‑stock study + option pricing + comparable transactions).
– For option models, carefully document inputs: volatility (use public comps or company metrics), time to liquidity, risk‑free rate, expected dividends, and model choice.
5) Reconcile and perform sensitivity analysis
– Reconcile different method results: explain why one method’s result is preferred or how a weighted conclusion is reached.
– Conduct sensitivity testing (e.g., vary time-to-liquidity and volatility) to show how the DLOM changes with key assumptions.
6) Document and present conclusions
– Provide a clear narrative for chosen methods, data sources, adjustments, and rationale for the final DLOM. Include ranges and a point estimate.
– If the valuation is for tax or litigation, anticipate points of challenge and provide supportive empirical evidence and expert testimony if needed.
Practical guidance on choosing and defending a DLOM
– Use multiple methods and favor market‑based evidence when available.
– Adjust generic empirical results to reflect company‑specific facts (size, volatility, contractual constraints).
– Separate DLOM from DLOC and other discounts; do not double count.
– Be conservative where data is weak, and disclose limitations.
– Provide sensitivity ranges and explain which assumptions drive changes.
Typical ranges and practitioner consensus
– Empirical studies and practitioner surveys commonly report DLOMs broadly in the 30%–50% range for many private minority interests, but actual discounts can be much lower or higher depending on facts. Treat ranges as context, not a substitute for fact‑driven analysis.
The bottom line
DLOM recognizes that a nonmarketable, privately held interest is worth less than an easily tradable public share because of increased time, costs and uncertainty of sale. Valuation professionals should: (1) thoroughly document facts about transferability and expected time to liquidity, (2) apply multiple reasonable methods (restricted‑stock, IPO studies, option pricing, comparables), (3) reconcile results and present sensitivity analyses, and (4) carefully separate lack of marketability from lack of control. Well‑documented, fact‑based DLOM analyses are essential in tax, litigation, and transaction contexts where valuation conclusions will be examined.
Source
– Investopedia: “Discounts For Lack Of Marketability (DLOM)” — https://www.investopedia.com/terms/d/dlom.asp
If you want, I can:
– Walk through a numerical DLOM example using an option‑pricing model with inputs you provide.
– Pull sample restricted‑stock or IPO study numbers for particular industries to help form a defensible DLOM range.