What is a Discount for Lack of Marketability or DLOM? Essentially, BA F|G 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?
How to Understand DLOM
How Discounts for Lack of Marketability (DLOM) May Impact Your Business Valuation
If you are a business owner, you have likely considered obtaining a business appraisal of your enterprise. A business appraisal, or business valuation, reflects the current economic value of a business. Such valuations are often conducted for various reasons, usually at the onset of a financing or equity event within the business lifecycle.
Although the approach to conducting an appraisal may vary among evaluators and industries, the factors included in such analysis tend to be the same. Overall, the financial health of a business is calculated by assessing its team, assets, earnings, growth, and profits within the context of its specific industry.
To conduct the appraisal, expert analysts like Business Appraisal FL|GA (BA F|G) must determine whether — and to what extent — the portion of the evaluated entity should be subject to discounts. One discount of particular importance is the Discount for Lack of Marketability (DLOM).
The DLOM would apply, if relevant, to private companies during its respective valuation. Private companies are considered those that are 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 and are, thus, considered to have a “market.”
Because private companies do not sell stocks or shares of their firms in a public marketplace, such companies lack a centralized market. Consequently, with all else being equal, 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 to be bought or sold. 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 F|G apply the DLOM to the valuation.
It is important to note, however, that quantifying the discount itself is difficult. There are a variety of methods that may be employed during the valuation of private companies that help capture the true value of the DLOM.
Those methods include the Restricted Stock Method, the IPO Method, and the Option Pricing Method. Despite which method is used, most valuators agree that the difference usually varies between 30% to 50%.
1. Restricted Stock Method
Public companies are required to maintain restricted stock, which refers to unregistered shares of ownership that are owned by individuals like executives and directors of a corporation. These forms of stocks are restricted because they must be traded in compliance with special Securities and Exchange and Commission (SEC) regulations and are 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 so that their personal interests align with that 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.
Thus, the Restricted Stock Method involves taking the price difference between a company’s common stock 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 that are sold pre-IPO and post-IPO varies. This is because the pre-IPO price tends to reflect the value of the private company, whereas the post-IPO value represents the worth of the newly-public company.
The percent difference between the pre-IPO and post-IPO prices is considered the DLOM under the IPO Method.
3. Option Pricing Method
An option refers to the right that an individual has 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 generally 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) was designed to employ the basic discounted cash flow model to value illiquid interests of closely held enterprises in the context of appraisals of the relevant business enterprises.
Essentially, BA F|G 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.
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 F|G involves 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 privately held stock. Business Appraisal FL |GA is ready to discuss your particular situation, our business appraisal services, and how DLOM might impact your valuation.