Discounts For Lack Of Marketability (DLOM)

Discounts for Lack of Marketability (DLOM) is an important yet complex concept in valuation, especially when it comes to valuing private companies or non-publicly traded shares. The DLOM represents the reduction in value due to the inability to quickly sell or market the asset, usually because it is not traded on a public exchange. In this comprehensive examination, we will delve into the importance, methodology, application, and criticism of DLOM in valuation.

Importance of DLOM

Understanding DLOM is critical for various stakeholders, including investors, business owners, financial analysts, and legal professionals:

• Investors: Investors may want to know the DLOM to assess the viability and true value of private equity investments.
• Business Owners: Business owners may need to apply DLOM when planning for liquidity or exit strategies.
• Financial Analysts: Financial analysts use DLOM in valuation models to provide a more accurate picture of an asset’s market value.
• Legal Professionals: Legal professionals might consider DLOM in divorce settlements, estate planning, and disputes over company ownership.

Factors Influencing DLOM

Multiple factors can influence the DLOM, making it a nuanced and variable figure:

• Size of the Company: Smaller companies often face higher DLOMs due to limited resources and market presence.
• Profitability: Companies with higher profitability may have lower DLOMs as they attract more interest from potential buyers.
• Growth Prospects: Firms with high growth potential might experience a reduced DLOM because of the anticipated future returns.
• Dividend Policy: Consistent dividend payments can lower the DLOM as they offer some liquidity to shareholders.

Methodology

Determining the DLOM can be done through various methods, each with its own set of assumptions, advantages, and drawbacks:

Empirical Models

Empirical models use historical data to estimate the DLOM by comparing public and private companies. These models include:

• Restricted Stock Studies: These studies compare the prices of restricted shares, which cannot be sold immediately, with the prices of unrestricted shares of the same company.
• Pre-IPO Studies: These studies compare the prices at which private companies sell their shares shortly before going public with the prices of their shares immediately after the IPO.

Theoretical Models

Theoretical models employ financial theories to estimate DLOM, which include:

• Option Pricing Models: These models, such as the Black-Scholes model, can estimate the DLOM by treating marketability as an option to sell.
• Qualitative Models: These models assess qualitative factors like company size, growth rate, and dividend policy to estimate the DLOM.

Hybrid Models

Hybrid models combine aspects of both empirical and theoretical approaches to provide a more nuanced estimation:

• Longstaff Model: This model uses financial options theory to estimate DLOM by considering the cost of hedging against marketability risk.
• Finnerty Model: A refinement of restricted stock studies, this model considers both the time frame and the underlying volatility of the stock.

Application in Valuation

DLOM finds its application in multiple contexts, including but not limited to:

Business Valuations

In business valuations, particularly for private and family-owned businesses, applying a DLOM provides a more accurate estimate of the company’s worth. This is crucial for transactions such as mergers and acquisitions, where the illiquidity of non-public shares must be factored in.

Estate Planning and Taxation

DLOM is often applied in estate planning and gift taxation to assess the fair market value of business interests or shares transferred within a family. The IRS guidelines also consider DLOM when evaluating assets.

Divorce Settlements

During divorce proceedings, a business might need to be valued to divide marital assets. Applying a DLOM ensures that the valuation reflects the reduced marketability and, consequently, the fair division of assets.

Employee Stock Ownership Plans (ESOPs)

The valuation of shares within an ESOP often includes a DLOM to account for the restricted nature of these shares, which cannot be easily liquidated.

Criticism and Controversies

Despite its widespread application, DLOM has faced several criticisms:

Subjectivity

One of the primary criticisms is the subjectivity involved in estimating the DLOM. Different analysts may arrive at different estimates due to the wide range of factors and models available.

Lack of Transparency

Another criticism is the lack of transparency in how DLOM is calculated. Without clear guidelines, the process can appear arbitrary, raising questions about the reliability of the valuation.

Market Dynamics

Markets and the factors influencing DLOM are dynamic. A model that worked well in one market condition might not be applicable under different conditions, challenging the consistency of DLOM estimates.

Legal Challenges

Due to its subjective nature, DLOM estimates are often challenged in courts, particularly in cases of divorce settlements and estate disputes. The lack of standardization can lead to contentious legal battles.

Future Directions

Given the criticisms and complexities associated with DLOM, several advances are on the horizon to improve its accuracy:

Technological Advancements

The use of machine learning and artificial intelligence to analyze vast amounts of data can provide more refined estimations of DLOM. These technologies can identify patterns and correlations that might not be apparent through traditional methods.

Regulatory Framework

There is a push for creating standardized regulatory frameworks to provide clear guidelines on estimating DLOM. Organizations like the IRS and accounting bodies could play a pivotal role in this standardization.

Continued Research

Ongoing academic and industry research can contribute to developing more robust models that take into account a wider range of factors, improving the reliability of DLOM estimates.

Conclusion

Discounts for Lack of Marketability (DLOM) play a crucial role in valuation by accounting for the illiquidity of private assets. While its application is widespread in business valuations, estate planning, and legal contexts, it also faces criticism due to its subjective nature and lack of standardization. Nonetheless, advancements in technology, ongoing research, and potential regulatory frameworks offer promising avenues for refining DLOM estimates, making them more reliable and transparent for all stakeholders involved.