What is Discounts For Lack Of Marketability ?

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Discounts for lack of marketability (DLOM) refer to the method used to help calculate the value of closely held and restricted shares. The theory behind DLOM is that a valuation discount exists between a stock that is publicly traded and thus has a market, and the market for privately held stock, which often has little if any marketplace.Various methods have been used to quantify the discount that can be applied including the restricted stock method, IPO method, and the option pricing method.

Definition

The Discount for Lack of Marketability (DLOM) is a method used to help calculate the value of non-public and restricted shares. The theory behind DLOM is that there is a valuation discount between publicly traded stocks and non-public stocks because publicly traded stocks have a market, whereas non-public stocks often have a very small market or none at all.

Origin

The concept of DLOM originated from the need to value illiquid assets. As financial markets evolved, investors and appraisers recognized the impact of liquidity on asset value. This concept gained wider application in the late 20th century, particularly with the rise of private equity and venture capital.

Categories and Features

The methods for calculating DLOM mainly include the Restricted Stock Method, the Initial Public Offering (IPO) Method, and the Option Pricing Method. The Restricted Stock Method estimates the discount by comparing the price differences between restricted and public stocks. The IPO Method determines the discount by analyzing stock price changes before and after a company's IPO. The Option Pricing Method uses option pricing models to assess the impact of lack of liquidity. Each method has its pros and cons: the Restricted Stock Method is straightforward but may not apply to all situations; the IPO Method provides market validation but has limited data; the Option Pricing Method is more complex and requires more assumptions.

Case Studies

A typical case involves a startup tech company undergoing private financing, where investors require the application of DLOM to assess its share value. Since the company's stock is not publicly traded, investors used the Restricted Stock Method to calculate a discount of about 20% to reflect the risk of its lack of liquidity. Another case is a family-owned business planning an IPO, where appraisers used the IPO Method to estimate DLOM, finding that its pre-IPO share value needed a 15% discount to attract potential investors.

Common Issues

Common issues investors face when applying DLOM include choosing the appropriate calculation method and determining a reasonable discount rate. A common misconception is that DLOM is fixed, but in reality, it should be adjusted based on specific circumstances and market conditions.

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