Discount for Lack of Marketability (Stock) - Explained
What is a Discount for Lack of Marketability?
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Table of ContentsWhat is a Discount for Lack of Marketability?How Does a Discount for Lack of Marketability Work?Academic Research on Marketability Discount
What is a Discount for Lack of Marketability?
The Discount for Lack of Marketability, often called a liquidity discount, is a fixed amount or percentage deducted from the selling price of a block of shares that lacks marketability. These are the closely held or restricted shares that cannot be resold in the market easily.
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How Does a Discount for Lack of Marketability Work?
The publicly traded stocks have a ready market and can be converted into cash easily with minimum administrative costs and a high degree of certainty as to the net amount. On the other hand, the privately held stocks lack the marketplace. Depending on its nature, the discount rate is calculated by various methods including IPO method, restricted stock method, and the option pricing method. The IPO method calculates the price difference between the shares issued before the initial public offering and after it. The percent difference between the two is considered to be the discount for lack of marketability. The restricted stock method assumes the only difference between restricted stock and common stock is that the restricted stocks are not marketable. This difference leads to the price variance of these two types of share. In option pricing method, the option price as a percentage of the strike price is the DLOM. Studies have shown the discount for lack of marketability ranges between 30% and 50%. It is often difficult for the valuation analysts to evaluate the DLOM during disputes in generation-skipping transfer tax, estate tax, gift tax, income tax, property tax, and others. In the U.S. the Internal Revenue Service (IRS) provides some guideline for dealing with these issues.
Academic Research on Marketability Discount
- An average-strike put option model of themarketability discount, Finnerty, J. D. (2012). Journal of Derivatives,19(4), 53. This paper focuses on the ability to sell a stock as a marketability discount without restrictions. In this paper, the author argues that a better assumption is that the investor has no special timing ability, so the option to sell should be closer to a put on the average price. Using this model, he finds that it tends to understate the observed marketability discount, but the theoretical option value is highly significant in regressions on the discount in over 200 private placements.
- A MinimumMarketability Discount, Seaman, R. M. (2005).Business Valuation Review,24(4), 177-180. The objective of this study of LEAPS is to contribute to improved substantiation of the discount for lack of liquidity, long a concern of both valuation practitioners and courts. The study shows that the stocks of even the largest and most secure companies have discounts of 10% or more. For companies with sales revenues under $500 million, discounts of 23% to 36% are common.
- Discount for lack of marketability: A theoretical model, Abrams, J. B. (1994).Business Valuation Review,13(3), 132-139. The purpose of this article is to examine and quantify the factors that determine the discount for lack of marketability. The article reviews some recent literature and develops a logical framework to segment the discounts into several components. It also presents a model for calculating the transactions cost components of the discount for lack of marketability.
- A note on using regression models to predict themarketability discount, Feldman, S. J. (2002). Business Valuation Review,21(3), 145-151. The regression models of Silber, and Hertzel and Smith have provided both the intellectual and empirical basis for forecasting the size of marketability discounts. These models were initially developed to study the determinants of the marketability discount. It has been suggested that they should now be used as a basis for forecasting the marketability discount. This paper demonstrates that these models should not be used for this purpose because the forecast errors are likely to be large.
- A primer on the quantitativemarketability discountmodel, Mercer, Z. C. (2003). The CPA Journal,73(7), 66. This paper discusses the application of the Quantitative Marketability Discount Model (QMDM) for business valuation. It states the factors to consider regarding the expected growth in value and the expected dividends in business valuation. It also discusses the features of the QMDM, and the application of this model in commercial partnerships.
- Estimating the Discount For Lack of Marketability-Using Proportional Bid-Ask Spreads, Chipalkatti, N. (2001).Business Valuation Review,20(1), 3-10. This article offers an alternative model for the computation of discount for lack of marketability (DLOM) that is based on a bid-ask spread data. The methodology proposed in this paper permits a business appraiser to obtain a market based assessment of the DLOM as of the date of valuation that incorporates the industry-specific and firm-specific information.
- The use of theoretical models to estimate the discount for lack of marketability, Lance, T. R. (2009). BVR's Guide to Discounts for Lack of Marketability. This chapter offers insights on the published studies related to the theoretical discount for lack of marketability (DLOM) models. It further provides insights related to the appropriate application of the theoretical DLOM models (options pricing model, and discounted cash flow models).
- The QuantitativeMarketability DiscountModel: A Shareholder Level DCF Model, Mercer, Z. C., & Harms, T. W. (2012). Business Valuation Discounts and Premiums, 213-224. This paper explores the Quantitative Marketability Discount Model (QMDM) for valuation of income method.
- Discount for Lack of Marketability: Do IPO Studies Tell Us Anything?, Hatch, J. (2004). Business Valuation Review,23(1), 10-13. This article analyzes some of the criticisms made by analysts in connection with the use of IPO studies for the purpose of estimating discounts for lack of marketability applicable to equity transactions in private companies. A simple model is presented that shows that the discounts observed in such studies may underestimate the true marketability discount, as the price discount required by investors will fall with the likelihood of a successful IPO. The model suggests a bias in the opposite direction of that commonly mentioned.
- Dissecting the Discount for Lack of Marketability, Bogdanski, J. A. (1996). ESTATE PLANNING-BOSTON-,23, 91-95.
- A General Option Valuation Approach to Discount for Lack of Marketability, Brooks, R. (2016).Business Valuation Review,35(4), 135-148. In this paper, a general option-based approach to estimating the discount for lack of marketability is offered. The model is shown to contain several option-based models as special cases. The model also contains two weighting variables that provide valuation professionals much needed flexibility in addressing the unique challenges of each non-marketable valuation assignment. Selected prior empirical results are reinterpreted with this approach. An Empirical Examination of theMarketability Discounton Closely Held Companies, Von Olfers, J., Farinella, J., Schuhmann, P., & Graham, E. (2012). Annals of the International Masters of Business Administration at UNC Wilmington,5(1). This paper measures the marketability discount for closely held companies and provides new evidence regarding the size of this discount. Furthermore, the paper examines key variables that impact the size of this discount.
- Option pricing as a proxy fordiscountforlackofmarketabilityin private company valuations, CHAFFE III, D. B. (1993). Business Valuation Review,12(4), 182-188.
- How much canmarketabilityaffect security values?, Longstaff, F. A. (1995). The Journal of Finance,50(5), 1767-1774. This paper suggests that how marketability affects security prices is one of the most important issues in finance. The paper derives a simple analytical upper bound on the value of marketability using option-pricing theory. It shows that discounts for lack of marketability can potentially be large even when the illiquidity period is very short. This analysis also provides a benchmark for assessing the potential costs of exchange rules and regulatory requirements restricting the ability of investors to trade when desired.
- Quantitative support fordiscountsforlackofmarketability, Johnson, B. A. (1999).Business Valuation Review,18(4), 152-155.
- Discountsforlackofmarketabilityfor closely held business interests, Maher, J. M. (1976).Taxes,54, 562.
- Thediscountforlackofmarketabilityin privately owned companies: a multiples approach, Paglia, J. K., & Harjoto, M. (2010).Journal of Business Valuation and Economic Loss Analysis,5(1). This study investigates a valuation adjustment, known as the discount for lack of marketability (DLOM) for private firms. By matching private company transactions with publicly traded counterparts, the paper finds discounts that average 65-70% and exceed 80% in some sectors of the economy. These findings put into question the sizes of discounts typically applied in valuation engagements for privately-held companies.