Business valuation and Lack of Marketability Discount-What do we Choose (Part 1) ?
Business valuation and lack of marketability discount
The Discount for Lack of Marketability (DLOM) is used by most valuation practitioners when valuing the shares of private-owned companies. The DLOM is one of the most controversial inputs in valuation because of its subjectivity and its ability to swing the valaution results. We think that the best way to decide on which DLOM to use is to first understand the theoretical foundation of each and second, the pros and cons. Valuation practitioners can then decide more confidently the right DLOM to use.
In Valuation, what is the Discount for Lack of Marketability (Business valuation and lack of marketability discount)
Business valuation and lack of marketability discount
The Discount for Lack of Marketability (DLOM) is a critical factor in the valuation of privately owned companies. This discount reflects the relatively lower liquidity of privately held shares compared to publicly traded shares.
Liquidity is the ease with which an asset can be bought or sold in the market without affecting its price. Shares in publicly traded companies are typically more liquid due to the established markets where they are traded. In contrast, shares of privately owned companies may not be as easily sold and often face restrictions on transferability.
The factors contributing to DLOM are:
Lack of Ready Market - Private companies often lack a ready market where shares can be sold quickly and easily. This inherent illiquidity commands a discount in valuation.
Transfer Restrictions - Shareholder agreements in private companies often include restrictions on share transfers, making it harder for investors to sell their stakes.
Longer time to sell - Selling shares of a private company usually takes longer than selling public shares, contributing to the DLOM.
An easy way to understand why a DLOM exists is to use an example. There are two companies - one is a listed company and one is private company. Both companies have exactly the same cashflows. It is much easier for a shareholder to sell his shares in the listed company compared to a shareholder of the private company who wants to sell his shares.
The private company shareholder has to spend more time, effort and money to look for buyers compared to the shareholder of the listed company who can sell his shares immediately in the stock market. Therefore, all things equal, there is a discount for the value of the private company shares compared to that of the listed company.
Quantification of the DLOM in the Valuation of Private Companies - Incredible Diversity amoung Valuation Practitioners (Business valuation and lack of marketability discount)
There are many ways to quantify the DLOM and herein lies the problem - there is no authoritative guidance on how, when and which type of DLOM should be applied. As a result, there is wide diversity in how valuation practitioners use the DLOM. We summarise the information obtained from the BVR survey on Methods Used for Estimating a Discount for Lack of Marketability July 2021).
Based on the survey results, the top three most commonly used DLOM methods are the Restricted Stock Studies, Pre-IPO Studies and Option Pricing Models. Beyond this observation, the diversity of sub-level DLOM methods is incredible.
Criticism of the Diversity of DLOM Practices in the Valuation of Companies (Business valuation and lack of marketability discount)
The diversity and choices of DLOM methods has become a double-edged sword for valuation practitioners. The choice of the DLOM can swing the valuation results so that it is possible to "game" the valuation result.
In the United States, the Internal Revenue Service (IRS) is increasingly critical of using the benchmark approach, specifically restricted stock and pre-IPO studies, as the only method for determining the Discount for Lack of Marketability (DLOM).
The key issue with restricted stock studies is that they are based on unrepresentative samples, lacking detailed information about the transactions and companies involved, and often use outdated data not reflective of current market conditions.
These studies also typically have small sample sizes, leading to a wide variance in reported DLOMs (13% to over 35%). On the other hand, pre-IPO studies usually show higher DLOMs (30% to over 60%), but their applicability is limited as they reflect unique characteristics of companies planning for IPOs. Therefore, the findings of pre-IPO studies do not accurately represent the subject interest unless the company is considering going public.
A Landmark Tax Case - Mandelbaum v. Comm (1995) to determine the DLOM in Valuation (Business valuation and lack of marketability discount)
Mandelbaum v. Comm is a landmark tax case which sets out the factors for consideration of DLOM (Mandelbaum Factors). Judge Laro opined that "ascertaining the appropriate discount for limited marketability is a factual determination...)
The Mandelbaum Factors comprise of ten factors and forms forms a good conceptual basis to help valuation practitioners justify the DLOM. The Mandelbaum Factors are:
Value of company's privately traded securities vs. its publicly traded securities (or the cost of a smilar corporation[s public and private stock).
Analysis of the company's fianncial statements
The company's dividend paying capacity and its history of paying dividends
The nature of the corporation, its history, its position in the industry, and its economic outlook
The corporation's management
The degree of control transferred with the block of stock to be valued
Any restriction on the transferability of the corporation's stock
The period of time for which an investor must hold the subject stock to realize a sufficient profit
The corporation's redemption policy
The cost of effectuating a public offering of the stock to be valued, e.g., legal, accounting, and underwriting fees.
Overview of the Benchmark Approaches of DLOM in Valuation (Business valuation and lack of marketability discount)
Restricted Stock Studies for DLOM in Valuation
The core idea is to compare the sale prices of publicly traded shares with those of "restricted shares" from the same company. Restricted shares are identical to publicly traded shares in all respects except for their marketability. The marketability of these restricted shares is time-limited, usually under SEC rules, for a period of one or two years, depending on when the shares were issued. This limited marketability impacts the holder's ability to trade the shares during the restriction period.
There are two components to restricted stock study data: a market access component (liquidity), and a holding period component.
The studies exhibit average means and medians of 31.4% and 33%, therefore many analysts use a discount of about 35% or attach a subjective premium to the average discount to account for the perceived greater illiquidity of a private company’s stock versus the restricted stock.
The Courts in the United States have increasingly rejected the use of the average restricted stock study results in favor of performing a detailed, comprehensive comparison with underlying restricted stock data.
Pre-IPO Studies for DLOM in Valuation
These studies focus on analysing the price of a company's stock before it is publicly traded and comparing it to the price at the time of a liquidity event, such as an Initial Public Offering (IPO). The aim is to establish a stable and reliable pre-IPO stock price for comparison with the IPO price.
Researchers conducting these studies use various time frames for measuring the pre-IPO stock price, ranging from several days to several months before the IPO. One of the key findings from these studies is the derivation of measures of central tendency for the Discount for Lack of Marketability (DLOM), which typically range from over 30% to over 60%.
Generally, the discounts implied by pre-IPO studies tend to be higher than those suggested by restricted stock studies. This indicates that the lack of marketability before an IPO tends to result in a more significant reduction in stock value compared to the restrictions faced by holders of restricted stock.
Put Option Pricing Models for DLOM in Valuation
Put Option Pricing Models (POPM) are being used increasingly to quantify the DLOM for private compnay interests. POPM simulate the value of an option to sell (put option) a security at a predetermined price. In the context of DLOM, they help quantify how much less a private company's shares are worth due to their lack of marketability.
POPM are applied based on the foundations of restricted stock studies.
In recent years, five commonly used POPM have emerged:
The Chaffe Model
The Shout Put Option Model
The Longstaff Model
The Finnerty Model
The Ghaidarov Model
Chaffe Model - Uses a derivation of the Black Scholes Method where the price of the protective put option is the DLOM. The price of the protective put is the price which the holder of the shares of the private company would be willing to pay to sell the company shares at fair market value. The DLOM is excessively high at higher volatilities. Typical DLOM is between 14% to 33.5%.
Shout Put Model - The shout put option value is a modification of the Chafee Model and it serves as an estimate of the marketability and liquidity value embedded within the marketable share value:
Marketable Share Value = Shout Put Value + Nonmarketable Share Value
Another form of put option, a shout put or shout floor option, more closely mimics marketability than do the previously mentioned forms of put option because both marketability and a shout put option give a stockholder the right to lock in a selling price (the prevailing marketable stock price) for the stock at any point in time over the term of the option.
For longer holding periods (longer than one year), the Shout Put Model may provide a more accurate estimate of DLOM than the Chaffe Model. However, for shorter holding periods, the improvement in accuracy is not significant compared to that of the Chaffe Model. Typical DLOM is between 14% to 33.5% for shorter holding periods.
Longstaff Model - The Longstaff model attempts to estimate the upper bound of a DLOM for a privately-held company. The model considers risk of price increases during the holding period. Typical DLOM is between 24% to 48% for shorter holding periods.
In its DLOM Job Aid, the Service states that the Longstaff model is not often applied by valuation analysts in estimating the DLOM for a privately held company.
Finnerty Model - Unlike the Chaffe model that uses a standard European put option, the Finnerty model employs an average strike put option. This type of option's strike price is based on an average of the underlying asset's prices over a certain period, making it more reflective of the stock's value over time, especially in volatile markets. Typical DLOM is between 8% to 19%. Indicated DLOM is limited to 32.3% regardless of higher volatilities or longer time;
The Finnerty model incorporates a long-term growth rate for the stock, which is not a component of traditional put option models. This accounts for the expected growth of the company over the holding period, impacting the stock's future value.
The calculation of the DLOM using the Finnerty model is iterative. It involves estimating the expected future price of the stock, calculating the average strike price over the holding period, and determining the put option's value. This process is repeated until the model converges on a stable DLOM value.
Ghaidarov Model - The Ghaidarov model is distinguished by its use of a sequential put option strategy. Unlike traditional models that utilize a single put option, the Ghaidarov model employs a series of short-term put options exercised consecutively over the illiquidity period. This approach aims to more accurately reflect the reality of an investor who may have opportunities to sell at intervals during the period of illiquidity. Typical DLOM is between 8% to 25%.
The POPM primarily focus on two factors: the holding period of the securities and their volatility. While other factors are considered in these models, holding period and volatility are the most influential on option prices. However, POPM might underestimate the DLOM because they do not fully account for other elements that can affect the marketability of privately held securities, such as contractual transferability restrictions. Despite this limitation, the DLOM indicated by a POPM is considered a suitable starting point for conducting a more comprehensive DLOM analysis.
POPM were designed to produce results that align with the discounts of restricted stock studies. But restricted stocks are merely a proxy for estimating the DLOM based on temporary trading restrictions; they do not reflect all of the marketability issues faced by typical privately held companies.
How to choose the DLOM in Valuation
In the next article, we will propose a framework to help practitioners better decide on which DLOM method to use in their valuation reports.