Understanding the Valuation Discount for Lack of Marketability

By Russell T. Glazer

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Discount for Lack of Marketability

Perhaps the most common valuation discount is the discount for lack of marketability (DLOM). The DLOM can be the valuation adjustment with the largest monetary impact on the final determination of value. Marketability is defined as the ability to convert an investment into cash quickly at a known price and with minimal transaction costs. The DLOM is a downward adjustment to the value of an investment to reflect its reduced level of marketability.

Two general types of empirical studies provide evidence for the existence and magnitude of the DLOM. The first type, restricted stock studies, compares the trading prices of a company’s publicly held stock sold on the open market with those of unregistered or restricted shares of the same company sold in private transactions. The second type, pre-IPO studies, examines the prices of transactions while the company was still private, compared to the eventual IPO price. The restricted stock studies have found average DLOMs in the range of 30% to 35%, while the pre-IPO studies have reported average DLOMs generally around 45%. The studies also have found a very wide range of discounts, depending upon the transactions, from 90% to –10% (i.e., a premium).

In 1990, the SEC removed the requirement that all transactions in restricted stock be registered; Rule 144A permits qualified investors to trade unregistered securities without filing registration statements. And in 1997, the SEC reduced the required holding period for restricted securities from two years to one. Both of these steps increased the liquidity of restricted stocks. Unsurprisingly, restricted stock studies relying on transactions since 1990 show lower DLOMs than did previous studies. Because of the significantly enhanced liquidity after the regulatory changes, however, the later studies are not as relevant to privately held companies as were the earlier studies.

Great care and judgment must be exercised in using the results of these studies to estimate the DLOM of a small, privately held company. Restricted stocks, by definition, are stocks of companies that already trade on the open market. When the restrictions are lifted or expire, an active and efficient market for the formerly restricted shares immediately exists. This is simply not true for privately held companies. For the pre-IPO studies, in many cases the buyers and sellers were aware of the possibility of future marketability. For most privately held companies, this is not true.

A valuation professional cannot simply apply the average or median discounts found in the studies to the subject company, but must analyze the characteristics of the subject company to determine a rational and supportable DLOM.

The Size of the Discount

Empirical evidence suggests that the primary factors in determining the size of the DLOM are as follows:

• Size of distributions or dividends
• Size of revenues
• Size of earnings
• Revenue growth and stability
• Earnings growth and stability
• Product risk
• Industry risk.

Companies with higher distributions, revenues, earnings, growth, and stability generally exhibited lower discounts. Additionally, if liquidity is expected within a reasonable timeframe—through an IPO, liquidation of the company’s assets, or a sale of the company—it follows that the DLOM will be less. Only after a reasoned analysis of the subject company can an appraiser develop an informed opinion as to the proper magnitude of the DLOM.

The studies cited above were studies of minority interests. No empirical studies have observed or quantified DLOMs for controlling interests. It is generally accepted that such a discount for privately held companies exists, although the fundamental underlying reasons are quite different. It is also generally accepted that a DLOM for a controlling interest in a privately held company is significantly smaller than for a noncontrolling interest, all other things being equal.

Indirect Evidence

Indirect evidence of a DLOM for controlling interests in privately held companies includes:

• The time and expense required to create financial statements and records that are satisfactory to potential buyers or regulators
• The time and legal expense necessary to prepare certain representations and warranties
• The significant demands on management time to accomplish the above
• The time and expense to find and qualify buyers
• The potential length of time for a buyer to conduct due diligence
• The extended time period to negotiate price, terms, non-compete clauses, and other factors.

Even though the DLOM is fairly common, its magnitude should be determined only after a thorough understanding of the empirical studies used, and a careful analysis of the relevant characteristics of the company.