What is a Discount for Lack of Marketability?
Discount for lack of marketability (DLOM) is a method companies use to calculate the value of closely held or restricted shares in their business.
DLOM only applies to private companies because they aren’t publicly traded on a financial exchange. Unlike publicly traded stocks, there isn’t a market for private stockholders to convert their shares to cash. This is “marketability,” or the ability to quickly convert shares into cash.
Publicly traded companies have a “market.” This is because their shareholders can sell shares to another interested investor. Private shareholders can’t liquidate their shares as easily, and that’s why a discount for lack of marketability (DLOM) might apply to a private company’s valuation. Because of this lack of a market, a private company should be valued at a lower price than a public company.
3 DLOM calculation methods
It’s difficult to quantify DLOM in practice. Every business is different, but generally speaking, DLOM usually ranges between 30 - 50%. Depending on the situation, organizations calculate DLOM using one of three potential calculation methods.
1. Restricted stock method
Restricted stock is the unregistered shares a public company gives to insiders like executives and directors. Restricted stock is a perk, but it’s non-transferable and non-sellable, which makes it worth less than publicly traded stock.
If a business’s restricted stock isn’t marketable but its common stock is, you might use the restricted stock calculation method. With this method, you assume that the difference between public stock and restricted stock will be the amount of the DLOM.
2. IPO method
An initial public offering (IPO) sells shares of a private company to the public. This allows private companies to access more investors at a larger scale. Your IPO stock will move from its pre-IPO price (the value of the private company) to the post-IPO price (the value of the public company). Your DLOM is the difference between the private and public IPO prices.
3. Option pricing method
The final DLOM calculation method is option pricing. Options on a stock give the shareholder the right to sell their stock at a specific price (also known as the strike price) on an agreed-upon date. If you look at prices on these stock options, you can understand their true value. That’s because the option price (expressed as a percentage of the strike price) is considered your DLOM.
The challenges of DLOM
Discount for a lack of marketability is difficult to quantify. Because private companies don’t have a history of pricing information, it’s a huge challenge to analyze their financials and determine a fair price.
To complicate matters, other discounts like discount for a lack of control (DLOC) and discount for a lack of liquidity (DLOL) can overlap with DLOM. This gets especially complicated during tax time, although the IRS does provide some guidance.
Generally speaking, interests in private companies are more costly and time-consuming for investors than shares in a public company. DLOM accounts for the increased risk and uncertainty that comes with investing in a private business, but it needs to be calculated carefully to determine a fair price.