“A discount for lack of marketability (DLOM) is used to compensate for the difficulty of selling shares of stock that are not traded on a stock exchange compared with those that can be traded publicly.”(Trugman) The discount is intended to reflect the market’s perceived reduction in value for not providing liquidity to the unit holder. DLOMs may also be appropriate when the shares have either legal or contractual restrictions placed upon them. This may be in the form of restricted stock, restrictions resulting from buy-sell agreements, bank loan restrictions or other types of contracts that restrict the sale of shares.
Factors Influencing the Discount for Lack of Marketability
The following factors influence the discount for lack of marketability and how they could potentially reduce the discount for lack of marketability. For the purposes of charitable gifting, donors want to reduce the discount for lack of marketability. This is because the discount for lack of marketability reduces the overall value of the gift, thereby reducing the tax deduction.
Put Rights - One effective tool to increase the marketability of a minority interest is to issue a “put option” to the beneficiary. A put option gives the owner of the option the right to sell the minority interest at a specified price up to a predetermined time in the future. The put option should have a reasonable prospect of being enforced and funded, should the beneficiary wish to execute the option.
Prospects for liquidity - The shorter the expected holding period, and the more certain the prospective transaction, the lower the discount. For example, if there are prospects for a public offering or sale of the business, the discount for lack of marketability would be lower than if there were no prospects for liquidity.
Transfer Restrictions - Restrictions on transfers of the stock of the company make the stock less marketable because of the inherent difficulty in selling them.
Information Access and Reliability - The degree to which information is or is not available to minority owners affects the discount for lack of marketability. The more available company information is to minority owners, the smaller the discount for lack of marketability will be.
High Dividend Yield - Companies that pay dividends tend to be more marketable than companies that do not, resulting in a smaller discount for lack of marketability.
Size and Mood of the Market - The larger the market is for the interest being valued, or imminent sale of the company, the smaller the discount for lack of marketability will be. The mood of the investing public also influences the marketability of the company. When the market is bullish, investors are more willing to invest, making the company easier to market and thus reducing the discount for lack of marketability.
Growth Prospects - Companies that have positive growth prospects are easier to sell than companies that do not. These prospects can be for the company itself or its industry. The more growth prospects, the smaller the discount for lack of marketability will be.
Integrity of Controlling Shareholder - The integrity of the controlling shareholder can make a significant difference in the ability to sell a minority interest. If the controlling shareholder tends to deal with the other shareholders honestly and with integrity, minority interests tend to be more marketable.
Buy-Sell Agreements - Buy-sell agreements can result in a higher or lower discount, depending on the terms of the agreement. The agreement can create a market for the stock and make it more marketable, or put restrictions on the sale and make the stock less marketable.
Level of Risk - Studies show that companies with stable earnings tend to have lower marketability discounts, while earnings volatility creates larger discounts.
Summary
The average discount for lack of marketability is 35%.
The largest factor influencing the discount for lack of marketability is the existence of a put option. A put option can almost eliminate a discount for lack of marketability.
A discount for lack of marketability cannot be completely eliminated, as there will always be some factor reducing the marketability of a minority interest.
