Understanding Discounts for Lack of Marketability (DLOM) and its critical impact on the valuation of noncontrolling, nonmarketable ownership interests. Explore methods, examples, and implications.
The Discount for Lack of Marketability (DLOM) is a reduction applied to the valuation of securities or investments that are not readily marketable. This discount reflects the diminished liquidity and the additional risks associated with selling a stake that cannot be quickly or easily converted to cash in the marketplace. DLOM is particularly significant in the valuation of noncontrolling, nonmarketable business interests.
One common method to estimate DLOM is the Comparative Approach. This involves comparing the subject company to publicly traded companies with similar characteristics and determining an appropriate discount based on differences in marketability.
Another method is analyzing Restricted Stock Studies, which examine the price differences between restricted shares (which cannot be sold for a certain period) and their freely traded counterparts. The gap in prices represents the DLOM.
Liquidity, or the ability to quickly sell an asset at its fair market value, is a major factor in determining DLOM. Assets that lack liquidity generally warrant a higher marketability discount.
The expected holding period for the investment is also crucial. Longer holding periods typically lead to higher DLOMs because the investor must wait longer to realize their return on the investment.
Prevailing market conditions can influence DLOM. In bullish markets, the demand for less liquid investments tends to increase, potentially reducing the required discount. Conversely, bearish markets can increase the discount due to heightened risk and reduced liquidity.
The concept of DLOM has evolved significantly over the past few decades. Initial studies in the mid-20th century began to address the impact of liquidity on asset prices, leading to formal recognition and development of empirical methods to quantify DLOM.
Pivotal studies, such as the SEC’s Rule 144 study and the Mandelbaum case, have shaped the understanding and application of DLOM in financial valuations. These studies provided foundational evidence on the price discounts associated with restricted stock and the factors influencing marketability.
In business valuations, particularly for family-owned or closely-held businesses, DLOM adjustments are critical. The lack of a public market for these shares means an investor requires a higher return, achieved by purchasing at a discounted price.
For estate and gift tax purposes, applying DLOM to nonmarketable minority interests can significantly reduce the tax liability. This is because the value of the gifted or inherited interest is reduced by the marketability discount, resulting in a lower taxable value.