Value and Marketability - Determinants of the discount for lack of marketability

Abstract

The valuation of private companies is a matter of interest for many stakeholders, including valuation professionals, auditors, courts, and tax authorities. The matter is deceptively complex, notably because there is no consensus on the nature, size, and determinants of the so-called discount for lack of marketability (DLOM). The DLOM can be defined as an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. Indeed, most valuation methods lead to value indications for a marketable interest, and it is generally accepted that investors attach a lower price to assets that are not readily marketable. The DLOM is oftentimes oversimplified as the difference in value between an illiquid (unlisted) stock and an all-else-equal liquid (listed) security. This value gap is important but ill understood. Leading scholars have noted time and time again that fair market value calculations often boil down to taking a marketable value estimate and reducing that amount by a contrived percentage. In practice, DLOMs of 20% to 40% are routinely used for valuing private businesses. The extant literature has proposed various DLOM estimation methods that fall into two broad categories: theoretical and empirical models. All of these models have been challenged, either because they require the input of information that cannot be objectively determined for private companies (theoretical models), or because estimates based on the comparisons between liquid and illiquid valuation subjects are by nature always imperfect and thus prone to discussion (empirical models). Nevertheless, and in the absence of better information, the empirical models, especially, have received lots of attention and the averages presented in these studies are often used in practice without much formal reasoning or economic justification. In order to shed more light on the determinants of the DLOM we have turned to an alternative source of information that can bring additional insights. Specifically, we have turned to court decisions that decide on private company valuations, including the DLOM to be applied. The court typically justifies its decision by referring to how the specific company is situated, and the rights and obligations attached to the valuation subject. This contextual information provides more background than the pure financial information that can be found in traditional data sources. This method which combines elements of qualitative and quantitative analysis has allowed us to demonstrate that the company’s ownership structure, its operations, the transfer restrictions on shares, the exit possibilities for shareholders, and the level of control attached to the valuation subject have a significant impact on the DLOM.