Discount for Lack of Marketability (DLOM)

Discount for lack of marketability is the discount on value due to the asset being illiquid and lacking an active market where the asset can be traded.

But the base on which the discount is applied will determine the extent of discount. The bases can be the value of minority and value of control.

While there is some overlap, the list of factors that affect the size of the DLOM for controlling interests are completely different from the factors affecting DLOM for minority interests. The marketability discounts applicable to minority interests is clearly different from the illiquidity discount applicable to controlling interests.

The difference exists due to the origin of lack of marketability. In case of minority interest, the benchmark for lack of marketability is whether the asset is listed in exchanges or not. Publicly traded minority interests have a higher value than the minority interests that do not have such vibrant markets.

In case of controlling interests, the reason for discount for lack of marketability is not illiquidity but the following:

A) Uncertain time horizon to complete an offering or sale,
B) Cost to prepare for and execute the sale
C) Risks concerning eventual sale price
D) Non cash and deferred transaction proceeds
E) Inability to hypothecate or the inability to borrow against the estimated value of the stock.

The difference in the DLOMs applicable on the two bases is evident from the court cases that have ruled in favor of higher marketability discounts on minority interests.

The range of DLOM for minority interests is from 30 to 45% whereas it is 3 to 33% in cases of controlling interests.

DLOM for Minority Interests and Controlling Interests

While there is some overlap, the list of factors that affect the size of the DLOM for controlling interests are completely different from the factors affecting DLOM for minority interests. The marketability discounts applicable to minority interests is clearly different from the illiquidity discount applicable to controlling interests. They are obviously applicable to different valuation bases – for values of businesses on control and minority basis.

Where DLOMs are appropriate for controlling interests, they typically are much smaller than those for minority interests. DLOM for controlling interests allowed in the U.S. Tax Court range from 3 to 33%, compared with the more typical 30 to 45% for minority interests.

Even though the controlling interests have full ownership, it is impossible to sell the company instantly and receive cash payments for it. This problem can be called a lack of liquidity more than lack of marketability. However, by whatever term known, the discount is appropriate.

Bases on which DLOM should be applied

A discount is meaningless until the base on which it is applied is appropriate. The bases on which the discounts are applicable are:

a) Control Buyout value
b) Publicly traded stock value
c) Net asset value

Control buyout value: The price that the control owner could expect to receive upon sale should be the logical basis for a DLOM. This price could be estimated by market approach, observing similar sale transactions.

This value could also be estimated by the income approach, discounting or capitalizing estimated cash flows that a control owner could expect to realize.

Another possible way of estimating a buyout price is the excess earnings method.

Publicly traded stock value: Unlike a minority stockholder, a controlling stockholder may register for a public offering of the stock. Thus the estimated potential public trading price could be the basis for a control value.

When public markets are strong, especially for the industry in which the company operates, the potential public trading price could be much more than the control owner could expect to receive for the sale of the company. Therefore, under such circumstances, a control owner might maximize the price by going public. However, the owner is not likely to be able to sell all the stock. Hence, the balance retained should be discounted in value as restricted stock.

Alternatively, if buyouts of public companies are rampant in the industry, one might estimate a control value by using guideline public company method plus some premium for control.

Net asset value: Net asset value is generally construed as control value rather than a minority value. This is because the control owner has the option of liquidating, hypothecating or otherwise utilizing the assets, an option not available to the minority owner. The assets are usually valued at their realizable value, either on going concern or liquidation premise.

Source: Business Valuation Discounts and Premiums, Shannon Pratt, John Wiley & Sons, 2001