What Does Discounts for Lack of Marketability Mean?
I need you to understand that Discounts for Lack of Marketability (DLOM) refer to the valuation difference between publicly traded stocks and privately held shares that have limited tradability. You should know the key methods to quantify DLOM include the restricted stock, IPO, and option pricing methods. Grasping these discounts is crucial if you're valuing noncontrolling interests in privately held companies, especially in tax-related valuations.
Key Takeaways
- Discounts for Lack of Marketability (DLOM) are used to determine the value difference between public and privately held stock.
- DLOM is often calculated using methods such as restricted stock, IPO, and option pricing approaches.
- DLOM challenges arise in tax disputes and valuation of nonmarketable ownership interests.
- Selling privately held company shares is generally more costly and time-consuming than publicly traded shares.
- The typical DLOM range, according to studies, is between 30% to 50%.
How DLOM Impacts Valuations
Let me explain how the restricted stock method works: it assumes the only difference between a company's common stock and its restricted stock is the lack of marketability in the restricted stock. Therefore, the price difference between them should stem directly from this lack of marketability.
With the IPO method, you look at the price difference between shares sold pre-IPO and post-IPO. The percentage difference between those two prices gives you the DLOM in this approach. For the option pricing method, it uses the option's price and the strike price as key factors; the option price as a percentage of the strike price becomes the DLOM.
From what many studies show, the consensus is that DLOM ranges between 30% to 50%.
Challenges in Applying DLOM
You face unique challenges when valuing noncontrolling and nonmarketable ownership interests in closely held companies. These often come up in gift, estate, and generation-skipping transfer taxes, as well as income, property, and other tax disputes.
The Internal Revenue Service (IRS) offers guidance to help with these, particularly on related issues like Discount for Lack of Liquidity (DLOL) and Discount for Lack of Control (DLOC).
There's no doubt that selling an interest in a privately held company is more costly, uncertain, and time-consuming than liquidating a position in a publicly traded entity. An investment that allows quick liquidity is worth more than one that doesn't, so privately held companies should be valued at a discount to their intrinsic value due to the extra costs, uncertainty, and longer sales processes.
The Bottom Line
Discounts for Lack of Marketability (DLOM) are essential when you're valuing noncontrolling, nonmarketable ownership interests in closely held companies. By quantifying the difficulty of selling these investments, DLOM accounts for their reduced value compared to publicly traded stocks. Methods like restricted stock and IPO help determine these discounts, which usually range from 30% to 50%. As a valuation analyst, you deal with challenges from taxes and marketability issues, but understanding DLOM helps you accurately assess investment worth. Always factor in liquidity and control implications when evaluating these holdings.
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