Demystifying the Discount for Lack of Marketability

Many stocks -- such as Walmart, Dell and Google -- trade on the New York Stock Exchange (NYSE) or another public stock exchange. Shares in public companies can be converted to cash within a few days. But privately-held business investors do not have the same luxury. Their investments can take months or even years to sell. Discounts for lack of marketability (DLOM) attempt to capture the disadvantages of owning a relatively illiquid investment without a ready market on which to trade it.

When to Take a DLOM

Public stocks are often used to value private firms. Public stock prices may be used to derive pricing multiples under the market approach, for example. Or returns on public stocks may be used to derive discount or capitalization rates under the income approach.

Somewhere in their calculations, valuators need to address the fact that private business interests cannot be traded on public market. That's where the DLOM factors into the valuation paradigm. An adjustment for lack of marketability usually occurs after the appraiser has made a preliminary estimate of value.

For purposes of this article, we will refer only to DLOM in the context of valuing minority interests that lack control over the business. That is generally considered to be any interest with less than fifty percent of the voting equity of a business. Marketability discounts for controlling interests -- sometimes referred to as illiquidity discounts -- are beyond the scope of this article.

How to Quantify a Defendable DLOM

It's a novice mistake for a valuator to spend most of his or her time determining the value of a business interest on a marketable basis and then, in five minutes time, "whack" that value by 35% or more. An experienced valuator knows that you cannot simply refer to the mean or median from a pre-IPO or restricted stock study. If you want your DLOM to survive IRS or court scrutiny, more work needs to be done tying the empirical data to the specific attributes of the subject company.

Deciphering all the empirical studies can be daunting, however. By one count, there are at least 72 methods of determining a DLOM. There is no consensus on what methods are definitive or acceptable. And none is likely to gain universal acceptance in the foreseeable future. Interestingly, both of the original go-to sources for quantifying DLOM -- pre-IPO and restricted stock studies -- have faced criticism.

What Data Supports DLOM?

As academic theory regarding DLOM continues to evolve, more appraisers turn to regression analyses and other mathematical formulas to better support their DLOM calculations. Sources of empirical support for DLOM that are currently in-vogue can be organized into the following categories:

• Benchmark Studies. Pre-IPO and restricted stock studies are long-time favorites in this category. Most valuators analyze these studies to determine which stocks are most comparable to the subject business interest.
• Option Pricing Models. These techniques quantify the cost of an option based on the price of comparable publicly traded stock options and inputs related to the subject interest. Common methods include the Black-Scholes, Finnerty and Chaffee option pricing models.
• Quantitative Marketability Discount Model (QMDM). This model essentially determines the cash flow available to a non-controlling interest (instead of cash flow to the entity as a whole) to determine to value of the minority interest at hand. The IRS has criticized the number of subjective inputs required to arrive at a DLOM conclusion under this method, however.
• Mandelbaum Analysis. In Mandelbaum v. Commissioner, Judge David Laro proposed a list of nine factors for valuators to consider when quantifying a DLOM:

1. Financial statement analysis;
2. Company dividend policy;
3. Nature of the company (history, position in industry, economic outlook);
4. Company management;
5. Amount of control in subject business interest;
6. Restrictions of transferability of stock;
7. Holding period for stock;
8. Company redemption policy; and
9. Cost associated with making a public offering.

There are many other methods appraisers use to develop DLOM, such as flotation cost or bid-ask spread methodologies. Whatever method your valuator selects, the keys are to intimately understand the underlying data and assumptions and then to customize the methodology to the business interest at hand.

Nowadays, valuators who simply "whack" their preliminary value conclusion by 35% (or more) based on the average from an empirical study are likely to get "whacked" in court.