DLOM Decoded: Busting Myths and Mastering Marketability Discounts

Business valuation is a critical process that determines the economic value of a company or an ownership interest within it. Accurate valuation is essential for making informed investment decisions, negotiating sales or mergers, and complying with legal and tax requirements. One key component of business valuation is understanding the Discount for Lack of Marketability (DLOM), which adjusts the value of a business interest to reflect its illiquidity.

DLOM is significant due to its large magnitude (25-40% of marketable value) and its straightforward application. We’ll focus on three purposes of business valuation where DLOM is often encountered: estate and gift tax, divorce settlements, and shareholder disputes/buyouts.

What is Discount for Lack of Marketability (DLOM)?

A DLOM is an adjustment considered after determining the fully marketable value of a business interest using primary valuation approach (income, market, or asset). While primary methodologies account for cash flows, risk, and growth, they don't explicitly adjust for non-marketability. The discount rates used are often based on publicly traded companies or marketable aggregate equity interests. Therefore, applying a DLOM adjusts for the illiquidity of private interests.

Marketability is the ability to create liquidity. Non-controlling, minority interests in privately held businesses usually lack marketability. A willing buyer would pay less for a non-marketable interest relative to a marketable one, making DLOM a necessary adjustment to achieve fair market value.

 Situations Where DLOM Would Be Applied

1. Estate and Gift Tax Valuations

- Purpose: To determine the value of private business interests for tax reporting purposes. Revenue Ruling 59-60 identifies factors of value including “the marketability, or lack thereof, of the securities.”

- Scenario: When an individual transfers ownership of a privately held business interest through gifting or as part of an estate.

- Example: If the marketable value of gifted shares is $1 million, applying a 25% DLOM might reduce the taxable fair market value to $750,000.

2. Divorce Settlements

- Purpose: To value a spouse’s business interest for equitable distribution of marital assets.

- Scenario: During divorce proceedings, one spouse owns an interest in a private business, and its value needs to be determined for fair asset division.

- Example:** If a spouse’s 25% interest in a private business is valued at $500,000, applying a 30% DLOM might lower the value to $350,000.

3. Shareholder Disputes and Buyouts

- Purpose: To determine the fair value of a shareholder’s interest in a buyout or dispute.

- Scenario: When a shareholder in a privately held company is exiting or being bought out, or in legal disputes among shareholders.

- Example: If a minority shareholder holding a 10% stake in a private company seeks a buyout and the pro-rata value suggests $200,000, applying a 30% DLOM might reduce the buyout amount to $140,000.

Common Misconceptions about DLOM

DLOM is often misunderstood. Many think it's arbitrary or uniformly applicable, but DLOM varies based on business size, industry, financial health, and risk factors. It's not a static figure; it changes with the company's circumstances. A critical misconception is that DLOM arises from a single factor. In reality, it involves both contractual restrictions (restrictions on transferability in agreements) and market restrictions (lack of a ready and active market). Properly understanding and separating these factors is essential.

Proper Support of a DLOM

Supporting DLOM involves using empirical studies and theoretical models. Empirical data comes from pre-IPO and restricted stock studies. Pre-IPO studies compare prices before and after IPOs, showing high discounts due to factors like appreciation. Restricted stock studies compare restricted and unrestricted stock prices on the same date, providing better DLOM estimates if applied correctly.

Theoretical models, like the Black-Scholes option pricing model (BSOPM), help understand DLOM by treating illiquidity as an option. For example, if a stock with a marketable value of $100 has an at-the-money option costing $30, we infer a 30% DLOM. Inputs like term and volatility influence DLOM, with higher values increasing the discount.

The Best Methodology

A robust approach to DLOM uses both empirical data and theoretical models. The two-step model combining Restricted Stock Equivalent Discount (RSED) and Private Equity Discount Increment (PEDI) is effective. The RSED estimates a base marketability discount using restricted stock comparisons, reflecting liquidity constraints (contractual restrictions). The PEDI then adjusts this discount for the fact that the company isn't publicly traded (market restrictions). This approach ensures a comprehensive and defensible DLOM, addressing both contractual and market restrictions for precise valuation.

Anthony Venette, CPA/ABV is a Senior Manager, Business Valuation & Advisory, DeJoy & Co., CPAs & Advisors in Rochester, New York. He provides business valuation and advisory services to corporate and individual clients of DeJoy.