Discount for lack of Marketability

Definition:

The discount for lack of marketability (DLOM) is the discount from the calculated value of shares applied
to private companies when valuing them.
It relates to the company not being publicly traded on a financial exchange, because of which the
marketability of the company decreases and consequently it’s value.

How to Calculate DLOM?

Quantitativ
Qualitative
e
Methods
Methods
securities-
restricted
based
stock studies
approaches

pre-IPO
studies
Discount for lack of Marketability

Quantitative Methods

securities-based approaches

Introduction:

These methods are based on option-pricing models in which the value of a theoretical put option is
calculated using the Black-Scholes Model.

Generally, the holder of a put option would have at-will liquidity. Thus, the calculated value of this
theoretical put option for the security would represent the value of immediate liquidity, or marketability.

There are several variations of these securities-based approaches for determining a reasonable DLOM:

 Protective put
 Finnerty
 Asian protective put
 Differential put
Discount for lack of Marketability

Protective Put
The protective put estimates the discount for lack of Marketability by calculating the value of an at-the-
money put option for the security using Black-Scholes.

Why at the money?

Suppose the value of a security is calculated at 100 and we have to calculate the DLOM. Now, the put option
give us a right to sell. So, an At the Money Put Option will give us the premium or the money we have to
pay to gain the right to sell at 100.

Now this premium only is the discount value for lack of marketability. This premium divided by the value of
security will give us the Percentage of DLOM.
Discount for lack of Marketability
Example showing calculation of DLOM
Let’s say we have a company called A Ltd., and after conducting the company valuation using the
income approach, market approach, and asset based approach, and reconciling the values, we
conclude the value of the company to be ₹1,00,00,000 and there are 1,00,000 shares outstanding
so the value of a share came out to be ₹100.

Now in order to calculate DLOM using protective put method,

we have to calculate the value of
an at the money put option of the
company at a strike price of ₹100.

To Calculate the value of put we

will use the BSM model of valuing
options.

As per BSM value of a put option

is=>
Discount for lack of Marketability
 Stock Price (S) = 100
 Strike Price (X) = 100

 r = The risk free rate. Here we assume to be fixed at 2.0%

 T = The term of this put option, which serves as variable in Black-Scholes, is equal to the term of the formal
restriction of the security or the expected time to liquidity (via a marketable exit).
The company estimates that there will be a potential exit in 2 years.

 The last step here is to calculate the company volatility. Now as the firm is a private company, it does not have an
inherent volatility of its company stock, unlike public companies where shares are traded in the market. Therefore in
this case you would need to find similar publicly traded companies and calculate their stock volatility over a certain
period of time, usually being 1 to 5 year periods.
Let’s say for A Ltd. the company’s comparable publicly traded companies are:
 Adobe (Ticker ADBE),
 Avid Technology (AVID),
 Salesforce (CRM),
 IBM (IBM),
 Microsoft (MSFT).
In this case we can calculate the volatility of these companies, say over a 3 year period, from 1/1/2018 to
12/31/2020. After running the calculations, we find the volatility of these companies’ stocks to be:
Discount for lack of Marketability

Company Volatility
ADBE 64.22%
AVID 105.30%
CRM 67.94%
IBM 51.99%
MSFT 55.78%
Median Volatility 64.22%

In this case we can see the highest volatility during the 3 year period was with AVID at 105.30% compared with
the lowest volatility as IBM at 51.99%.
For calculating the volatility of the 5 public companies, it’s common to use either the average or median values.
As the spread seems to be focused in the 50-60% range, and AVID being more or less an outlier, we decided to
use the median here.
Discount for lack of Marketability

After doing all the calculations, we find the summary of the values to be:

Risk Free Rate 2.00%

Time to Exit 2 years

Volatility 64.22%

Now we will have to run the BSM formula to get the value of option. Excel

After running excel we found that the value of option is ≈32.

To calculate value of DLOM we have to divide Value of option by the price of security.
So dividing 32 by 100 we get DLOM as .32 or 32%.
Discount for lack of Marketability

What is the DLOM for my preferred securities?

 While a protective put may be appropriate for a junior security such as common stock, it likely would not be
appropriate for a preferred security with a liquidation preference.

 There are several characteristics of preferred securities that suggest they are as equally marketable as the
enterprise as a whole, equating to a nominal DLOM.

 The primary holders of preferred securities are often sophisticated institutional investors who often have
access to vast networks of buyers (i.e., a broad market) to solicit a sale of their securities that a minority
common shareholder, commonly an employee of the company, would also not have.
Discount for lack of Marketability

Why not Protective Put Everywhere?

We often find ourselves relying upon a preferred security financing to determine the implied equity value
of a private company.

This is a very important consideration because preferred investors would theoretically have considered
the lack of marketability for their securities within the price they were willing to pay for those securities.
This means that a protective put calculation for determining the DLOM would not be appropriate in this
scenario because it would represent a full DLOM.

That is an issue because the implied equity value from the preferred transaction would, again
theoretically, have a DLOM already embedded. However, that embedded DLOM would be for the recently
purchased preferred securities, not common shares.

In these cases we are tasked with identifying the incremental DLOM over and above that of preferred. To
do so, we rely upon a few of the aforementioned securities-based approaches, typically a Finnerty or
differential put method, to calculate a DLOM that would reflect an incremental instead a full DLOM.
Discount for lack of Marketability

Restricted stock method

For a public company, restricted stock consists of the unregistered shares of ownership that are not publicly traded
and are usually held by insiders such as executives and directors. They are restricted since they have restrictions in
terms of being non-transferable and non-sellable to deter the early selling of the shares. Since executives and
directors need to have a vested interest in the company, they must hold a certain number of shares themselves so
that their interests align with shareholders.

The Regulators generally enact restricted stock regulations to reduce agency problems, where the interests of
management conflict with the interests of general shareholders. Restricted stock is generally worth less than other
publicly-traded common stock.

The restricted stock method of measuring the DLOM assumes that the difference between the regular common
stock and restricted stock is the amount of the DLOM.
Discount for lack of Marketability

IPO method

An initial public offering (IPO) is the process of offering shares of a private company to the public through a
new stock issuance on a financial exchange. It allows a private company to gain access to a broader range of
investors, as well as improve the legitimacy of the company.

The IPO stock goes through a process of moving from a pre-IPO price to a post-IPO price. The pre-IPO price
potentially represents the value of the private company, and the post-IPO price represents the value of the
now-public company.

The IPO method of measuring the DLOM assumes that the difference between the two prices is the amount
of the DLOM.