March 2010

DLOMs: Trends in Quantifying Discounts for Lack of Marketability

Valuation adjustments (discounts and premiums) are necessary to account for levels of risk and marketability associated with the ownership interest subject to valuation. There are no prescribed levels of valuation adjustments; i.e., they cannot be determined by relying on a few set formulas applied in the same manner to every set of facts and circumstances. The facts and circumstances will require careful analysis so that any valuation adjustments selected are rationally supportable, specific to the valuation being performed, and appropriate to the facts and circumstances.

"Marketability" is defined by the International Glossary of Business Valuation Terms as "the ability to quickly convert property to cash at minimal cost." Unlike an investor in a publicly traded company, the investor wishing to sell his interest in a closely held entity must often exert significant effort to find a willing buyer. Investors prefer equity investments that have access to a liquid secondary market and that may be readily converted to cash. Equity interests without such marketability characteristics normally sell at a discount in order to compensate an investor for this lack of liquidity.

We believe that the most probative evidence for quantifying the relevant "discount for lack of marketability" (DLOM) is found in transactions involving companies that are as similar as possible to the subject entity. Two of the restricted stock studies utilized by appraisers to quantify the DLOM published all of the data points used to develop the studies. This data can be used to more closely compare the investment characteristics of the subject interest with the most comparable restricted stock transactions to derive an appropriate discount for the subject interest. Accordingly, a more rigorous use of the DLOM databases, to select transactions in companies having characteristics as close as possible to the subject entity, would be a more relevant approach to estimate the appropriate DLOM.

These sentiments are echoed in a new BVWire™ survey on the current methods for calculating the DLOM. The survey suggests a growing level of sophistication among business appraisers in their understanding and appreciation of the factual, legal and empirical underpinnings of any DLOM conclusion. ■