Discount for lack of marketability (DLOM) is a crucial concept in business valuation. It adjusts the value of assets with limited liquidity, recognizing that investments that can't be easily converted to cash are worth less. DLOM is especially important when valuing closely-held or restricted securities.

Applying DLOM involves considering factors like company size, financial health, and market conditions. Valuation experts use both quantitative methods, such as option pricing models and restricted stock studies, and qualitative considerations to determine an appropriate discount. The typical DLOM ranges from 30% to 50%, varying by industry and specific circumstances.

Definition and concept

• Discount for Lack of Marketability (DLOM) adjusts value of assets with limited liquidity in business valuation
• DLOM recognizes reduced worth of investments that cannot be easily converted to cash
• Crucial concept in accurately determining fair market value of closely-held or restricted securities

Marketability vs liquidity

• Marketability refers to ease of converting an asset to cash without significant loss in value
• Liquidity measures speed of asset conversion to cash without price concession
• Marketable securities trade on public exchanges (NYSE, NASDAQ) with readily available prices
• Illiquid assets (private company shares) lack active market, making valuation more challenging

Impact on valuation

• DLOM reduces estimated value of an asset to account for limited marketability
• Typically applied as percentage discount to preliminary value estimate
• Can significantly affect overall valuation, especially for private companies or restricted stock
• Reflects increased risk and holding costs associated with less marketable investments

Factors affecting DLOM

• DLOM magnitude varies based on multiple company-specific and market-related factors
• Proper assessment requires comprehensive analysis of business characteristics and external environment
• Factors interact and may have compounding effects on marketability discount

Company size

• Smaller companies generally warrant higher DLOM due to limited investor pool
• Larger companies may have more potential buyers, reducing marketability concerns
• Company size impacts access to capital markets and potential exit strategies

Financial health

• Strong financial performance and stability may decrease DLOM
• Companies with consistent profitability and growth attract more potential buyers
• Poor financial health increases perceived risk, potentially expanding DLOM

Ownership restrictions

• Contractual limitations on stock transfers increase DLOM
• Right of first refusal provisions restrict potential buyer pool
• Buy-sell agreements may impact marketability by dictating sale terms

Market conditions

• General economic climate affects overall market liquidity
• Industry-specific trends influence investor interest and potential exits
• Market volatility can impact DLOM by altering risk perceptions

Quantitative methods

• Empirical approaches provide data-driven basis for DLOM estimation
• Multiple methods often used in conjunction to support DLOM conclusion
• Quantitative analysis complements qualitative factors in determining appropriate discount

Option pricing models

• Utilize put option valuation to estimate cost of hedging against price decline
• Black-Scholes model adapted to calculate theoretical put option value
• Chaffe model applies put option pricing to estimate DLOM based on time to liquidity event

Restricted stock studies

• Compare prices of restricted shares to freely tradable shares of same company
• Analyze discounts observed in private placements of restricted stock
• Silber Study and Management Planning, Inc. Study provide benchmark data for DLOM estimation

Pre-IPO studies

• Examine price differences between pre-IPO transactions and subsequent public offering prices
• Emory Studies analyze discounts observed in transactions occurring within 5 months of IPO
• Willamette Management Associates study provides comprehensive dataset of pre-IPO discounts

Qualitative considerations

• Supplement quantitative analysis with company-specific qualitative factors
• Holistic approach considers both numerical data and subjective elements
• Qualitative factors often explain variations in DLOM beyond empirical studies

Industry-specific factors

• Cyclicality of industry affects marketability of company shares
• Regulatory environment impacts ease of ownership transfers
• Industry growth prospects influence potential buyer interest

Management quality

• Strong management team can enhance company marketability
• Succession planning affects long-term investment attractiveness
• Key person dependencies may increase perceived risk and DLOM

Growth prospects

• Companies with high growth potential may warrant lower DLOM
• Future expansion plans influence investor interest and exit opportunities
• Innovation and competitive advantages impact long-term marketability

Application in valuation

• DLOM applies in various valuation contexts, each with unique considerations
• Proper application requires understanding of specific valuation purpose
• Consistency in DLOM methodology across similar engagements enhances credibility

Private company valuations

• DLOM typically higher for closely-held businesses due to limited market for shares
• Consider company-specific factors like size, profitability, and growth prospects
• Analyze potential exit strategies and time horizon to liquidity event

Minority interest valuations

• Apply DLOM to non-controlling interests in addition to minority interest discount
• Assess transferability restrictions and rights associated with minority stake
• Consider marketability impact of shareholder agreements and buy-sell provisions

Estate and gift tax purposes

• IRS scrutinizes DLOM in tax-related valuations
• Revenue Ruling 77-287 provides guidance on valuing restricted securities
• Consider recent relevant Tax Court decisions when determining appropriate DLOM

DLOM ranges

• DLOM varies widely based on specific circumstances of each valuation
• Understanding typical ranges helps benchmark individual DLOM determinations
• Deviations from typical ranges require thorough explanation and support

Typical discount percentages

• Average DLOM ranges from 30% to 50% based on various empirical studies
• Restricted stock studies generally indicate discounts of 30% to 35%
• Pre-IPO studies suggest higher discounts, often 40% to 45% or more

Variations by industry

• Technology companies may have lower DLOM due to frequent M&A activity
• Highly regulated industries (banking, utilities) may exhibit higher DLOM
• Cyclical industries show DLOM fluctuations based on economic conditions

Legal and regulatory aspects

• DLOM application subject to scrutiny in legal and regulatory contexts
• Understanding relevant guidelines and precedents crucial for defensible valuations
• Compliance with applicable standards enhances credibility of DLOM determination

IRS guidelines

• Revenue Ruling 77-287 addresses valuation of restricted securities for tax purposes
• IRS Job Aid for DLOM provides framework for analyzing and supporting discounts
• Consider IRS challenges to high discounts in recent tax court cases

Court precedents

• Mandelbaum factors from Tax Court case provide qualitative DLOM considerations
• Estate of Jorgensen v. Commissioner case highlights importance of company-specific analysis
• Holman v. Commissioner emphasizes consideration of actual restrictions on transferability

Challenges and controversies

• DLOM determination involves inherent complexities and potential disagreements
• Awareness of common challenges helps in developing robust valuation approaches
• Addressing controversies proactively strengthens overall valuation credibility

Subjectivity in determination

• DLOM often relies on professional judgment in weighing various factors
• Difficulty in precisely quantifying impact of qualitative considerations
• Different valuation experts may arrive at varying DLOM conclusions

Overuse concerns

• Criticism of applying large DLOMs without sufficient support
• Potential for double-counting when combined with other discounts (minority interest)
• Scrutiny of DLOM application in contexts where marketability may not be significantly impaired

Alternative approaches

• Exploring alternative methodologies provides additional perspectives on marketability impact
• Understanding relationship between different valuation adjustments enhances overall analysis
• Consider appropriateness of alternative approaches based on specific valuation context

Control premium vs DLOM

• Control premium represents value of controlling interest in a company
• Inverse relationship between control premium and DLOM in some valuation scenarios
• Assess whether control premium implicitly accounts for marketability differences

Embedded vs separate DLOM

• Embedded approach incorporates marketability considerations in overall discount rate
• Separate DLOM applied as discrete adjustment to preliminary value conclusion
• Evaluate pros and cons of each approach based on available data and valuation purpose

Documentation and support

• Thorough documentation critical for defending DLOM conclusions
• Clear explanation of methodology and reasoning enhances valuation credibility
• Anticipate potential challenges and address them proactively in valuation report

Valuation report requirements

• Clearly state DLOM percentage and rationale for selection
• Discuss quantitative and qualitative factors considered in DLOM determination
• Provide relevant market data, comparative analysis, and industry benchmarks

Defending DLOM calculations

• Prepare comprehensive work papers supporting DLOM analysis
• Maintain consistency in DLOM approach across similar valuation engagements
• Be prepared to explain and justify DLOM conclusion in potential litigation or regulatory review