One of the most contentious issues in business valuation is the discount for lack of marketability (DLOM). Reasons include that the DLMO varies significantly, depending on the rights and restrictions attached to the business interest, and also because it can lower a business interest’s value by as much as 35% or more.
Here’s more on the mechanics of applying a DLOM, as well as a methodical approach to quantifying a meaningful DLOM for a particular business interest.
A Closer Look at the DLOM
According to the International Glossary of Business Valuation Terms, Marketability is “The ability to quickly convert property to cash at minimal cost.” Publicly traded stocks are considered to be marketable, but noncontrolling interests in privately held businesses often require significant time, money and effort to sell. Fair market value is often derived from public stock data, so appraisers usually discount private business interests for their relative lack of marketability.
For example, if $100 represents 100 percent of a business, 5 percent would be worth $5 on a noncontrolling, marketable basis. If the appropriate DLOM is 10 percent, a 5 percent interest would be worth $4.50 (90 percent of $5) on a noncontrolling, nonmarketable basis.
Quantifying the DLOM
The tricky part is how valuators pick the “right” discount. They typically use empirical evidence, such as restricted stock studies and pre-initial public offering studies, to quantify a percentage DLOM for the specific business interest.
In general, empirical studies suggest a range of median DLOM from 35 to 50 percent, but the actual DLOM that an appraiser assigns to a specific business can vary significantly from the norm, depending on the investment’s characteristics.
The U.S. Tax Court provided a list of nine factors to consider when quantifying the DLOM in Mandelbaum (T.C. Memo 1995-255) in order to eliminate some of the guesswork. This landmark case dealt specifically with marketability in a gift and estate tax context, but it’s likely to be cited in any case where litigants can’t agree on the appropriate DLOM, including in shareholders buy-outs and divorces. In 2009, the IRS issued its 116-page DLOM Job Aid for IRS Valuation Professionals, which leverages and expands the factors set forth in Mandelbaum.
Here’s a 41-point checklist of items to consider when quantifying a DLOM, based on these resources. It’s a useful tool for anyone who’s quantifying or scrutinizing a DLOM for tax purposes and beyond. The checklist can also help buyers and sellers of business interests understand the attractiveness of an investment in the marketplace.
Like Judge David Laro in Mandelbaum, you can start with the average or median DLOM from empirical data, then increase or decrease it, depending on how the subject company measures up in these 41 criteria:
Factors that Affect the Holding Period
There is a lengthy list of factors that affect the holding period, have an impact on risk or volatility, and that affect dividend payments. A valuation professional has the training and expertise needed to interpret and apply these factors to a specific business interest, because not all will apply to every business interest.