What is a Discount for Lack of Marketability or DLOM? Essentially, BA FL|GA|HI determines the net terminal value of selling the company at fair market value in 2 years (or the time it is forecasted to sell in the future) and then calculates the difference between the fair market value today and the calculation above.
How Does a DLOM Affect My Company’s Value?
Table of contents
- How Does a DLOM Affect My Company’s Value?
- How to Understand DLOM
- What is a DLOM?
- Methods Used to Determine the Discount for Lack of Marketability
- DLOM Conclusion
How to Understand DLOM
How Discounts for Lack of Marketability (DLOM) May Impact Your Business Valuation
What is a DLOM or a Discounts Lack of Marketability? Now, if you are a business owner, you are considering obtaining a business appraisal of your enterprise. A business appraisal, or business valuation, reflects the current economic value of a business. There are various reasons to conduct such valuations. This is usually at the onset of a financing or equity event within the business lifecycle.
You can also read our article on company valuations for estate planning, wealth transfer, and the IRS.
The approach to conducting an appraisal may vary among evaluators and industries. But the factors included in such analysis tend to be the same. Overall, calculating the financial health of a business includes an assessment of its team, assets, earnings, growth, and profits within the context of its specific industry.
What is a DLOM?
To conduct the appraisal, expert analysts like Business Appraisal FL|GA|HI (BA FL|GA|HI) must determine whether — and to what extent — the portion of the evaluated entity should be subject to discounts. The Discount for Lack of Marketability (DLOM) is a discount of particular importance.
The DLOM would apply, if relevant, to private companies during its respective valuation. Private companies considered are those held under private ownership. These firms may issue stock and have shareholders. But such stakes are not traded on public exchanges, nor would they be issued through an initial public offering (IPO).
Public companies, on the other hand, access capital differently. Such companies can sell their own enterprises publicly in a marketplace like a stock exchange. This makes them considered as having a “market.”
Private companies do not sell stocks or shares of their firms in a public marketplace. As such, companies lack a centralized market. Consequently, private companies should be valued less than public companies. The DLOM, thus, reflects this difference.
Methods Used to Determine the Discount for Lack of Marketability
As established earlier, private companies fail to have a centralized marketplace for their shares or stocks for buying or selling. This reality makes the shares of private companies theoretically worth less than that of a public company. To reflect this lower level of marketability when appraising private companies, expert qualifiers like BA FL|GA|HI apply the DLOM to the valuation.
However, it is important to note that quantifying the discount itself is difficult. A variety of methods may be employed during the valuation of private companies. This helps capture the true value of the DLOM.
Those methods include the Restricted Stock Method, the IPO Method, and the Option Pricing Method. Despite the method used, most valuators agree that the difference usually varies between 30% and 50%.
1. Restricted Stock Method
Maintaining restricted stock is a requirement for public companies. This refers to unregistered shares of ownership owned by individuals like executives and directors of a corporation. These stocks must be traded in compliance with special Securities and Exchange and Commission (SEC) regulations. Thus, their restriction. They are also often unable to be sold for several years upon acquirement.
Such stock ownership is often issued in companies that want to motivate employees by giving them a share of the firm’s equity. Specifically, executives and directors are often required to hold a certain number of shares themselves. This is so that their personal interests align with those of external shareholders.
Restricted stock is often worth less than other publicly traded common stock. Thus, one can assume that the primary difference between a company’s common stock and its restricted stock is the lack of marketability of the restricted stock. The ownership interest percentage can affect the DLOM, too.
Thus, the Restricted Stock Method takes the price difference between a company’s common and restricted stock to calculate the DLOM.
2. IPO Method
An IPO is a process by which a private company offers shares of its corporation to the public for the first time through the issuance of stock. This process enables a company to raise capital from public investors.
The price of shares pre-IPO and post-IPO varies. This is because the pre-IPO price tends to reflect the value of the private company. On the other hand, the post-IPO value represents the worth of the newly-public company.
The DLOM is the percentage difference between the pre-IPO and post-IPO prices under the IPO Method.
You can also read our article on valuing startup equity in a new company.
3. Option Pricing Method
An option refers to an individual’s right to purchase a stock at an agreed-upon price — known as the strike price — at a specified time in the future. The prices of options can provide insight into the true value of a stock.
The market for options is independent of the market for stocks, so the difference between a particular strike price and the price of an option would reflect the DLOM.
4. Quantitative Marketability Discount Method
We calculated the lack of marketability adjustment based on the Quantitative Marketability Discount Method. The value of a business today is expressed as the present value of all expected future cash flows to be derived from the enterprise, discounted to the present, at an appropriate discount rate.
The Quantitative Marketability Discount Model (QMDM) employs the basic discounted cash flow model to value the illiquid interests of closely held enterprises in the context of appraisals of the relevant business enterprises.
Essentially, BA FL|GA|HI determines the net terminal value of selling the company at fair market value in 2 years (or the time it is forecasted to sell in the future) and then calculates the difference between the fair market value today and the calculation above.
You can also read obtain a business valuation before you sell your company.
Since private companies do not publicly disclose information about their corporation regularly, determining the true value of such companies tends to be difficult for analysts. Regardless, analyses of private companies’ true market worth conducted by expert qualifiers like BA FL|GA|HI involve determining whether and to what extent the portion of the entity being valued should be subject to discounts like the DLOM.
Accounting for the DLOM is effective because a valuation discount tends to exist between a stock that is publicly traded and has a market and the market for the privately held stock. Business Appraisal FL|GA|HI is ready to discuss your situation, our business appraisal services, and how DLOM might impact on your valuation. Whether for income tax or estate tax purposes, we stand ready to help you at this critical juncture.