What is the Discount for Lack of Marketability (DLOM)?
The discount for lack of marketability (DLOM) is applied to private companies when valuing them. It relates to the company not being publicly traded on a financial exchange.
Publicly-traded companies are perceived to have a “market” since the shares can be bought or sold in a centralized marketplace. Private companies do not have a centralized market and are perceived as having less of a market. As a result, in theory, private companies – with all else being equal – should be valued at a lower amount than a public company to reflect the lack of a market.
Understanding the Discount for Lack of Marketability
As mentioned, private companies do not have a centralized market to trade their shares. Such a fact makes it much more difficult to buy and sell shares, and the lack of marketability makes the shares theoretically worth less. The discount is difficult to quantify; however, certain methods can be applied to measure the discount, including:
Restricted stock method
Option pricing method
The consensus is that the value of DLOM varies for different companies, but it usually ranges between 30% to 50%.
Restricted stock method
For a public company, restricted stock consists of the unregistered shares of ownership that are not publicly traded and are usually held by insiders such as executives and directors. They are restricted since they have restrictions in terms of being non-transferable and non-sellable to deter the early selling of the shares. Since executives and directors need to have a vested interest in the company, they must hold a certain number of shares themselves so that their interests align with shareholders.
The Securities Exchange Commission (SEC) enacted restricted stock regulations to reduce agency problems, where the interests of management conflict with the interests of general shareholders. Restricted stock is generally worth less than other publicly-traded common stock.
The restricted stock method of measuring the DLOM assumes that the difference between the regular common stock and restricted stock is the amount of the DLOM.
An initial public offering (IPO) is the process of offering shares of a private company to the public through a new stock issuance on a financial exchange. It allows a private company to gain access to a broader range of investors, as well as improve the legitimacy of the company.
The IPO stock goes through a process of moving from a pre-IPO price to a post-IPO price. The pre-IPO price potentially represents the value of the private company, and the post-IPO price represents the value of the now-public company.
The IPO method of measuring the DLOM assumes that the difference between the two prices is the amount of the DLOM.
Option pricing method
Options on a stock give the right to purchase or sell that stock at a specified price, known as the strike price, at a specified date in the future. The market for options, and more specifically, the prices of options, can provide information on the value of a stock.
Since the market for options is independent of the market for the stock themselves, the difference between a certain strike price and the price of a certain option can inform the value of the DLOM.
Issues with the DLOM
Analyzing private companies is a great challenge for analysts due to the lack of information – most notably, the pricing information. There are also tax issues that arise with non-controlling and non-marketable ownership interests in closely held companies.
It is widely understood that selling an interest in a private company is much more costly and time-consuming. Selling an interest in a private company also comes with a lot more uncertainty, as well as the variability arising from the negotiations.
Also, if it is a closely held private company where there are only a few shareholders, there are costs associated with losing control of the company as well. It gives rise to other discounts that may overlap with the DLOM, such as:
Discount for Lack of Control (DLOC)
Discount for Lack of Liquidity (DLOL)
When comparing the prices of public companies and private companies, the discounts must also be considered. Looking at the differing discount values much more difficult to quantify the DLOM of privately held companies.
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