Debating the Incremental DLOM: A Nuanced Approach to Asset Valuation

When it comes to business valuation, understanding an asset’s marketability is essential. Marketability refers to the ease with which an asset can be sold, and the Discount for Lack of Marketability (“DLOM”) accounts for the reduced liquidity of an asset that is not easily traded in the open market, particularly within privately held companies. In business valuation, the DLOM is a critical yet contentious adjustment. Numerous empirical studies have supported the existence and necessity of DLOM. Research examining restricted stock transactions, pre-IPO stock studies, and other methodologies consistently show that private shares are sold at significant discounts compared to their publicly traded counterparts. These studies provide a data-backed rationale for including DLOM in valuations. This brings us to the introduction of the “Incremental DLOM” in cases where the common stock (or other security) is relatively illiquid compared to the preferred stock of the private company, and a layered approach is applied.

One of the most compelling arguments favoring incremental DLOM is its ability to enhance precision in valuations. Appraisers can achieve a more nuanced and realistic valuation by applying discounts based on specific factors such as the business size, industry, or growth stage. This precision is particularly beneficial in complex scenarios where a one-size-fits-all discount is insufficient. Applying an incremental discount allows appraisers to reflect a diverse set of risks associated with each security.

For example – One way to calculate the incremental discount would be to determine the value of two protective put options on the LP interest – one on a completely marketable security and one with partial marketability. The difference between these two securities would be utilized proportionally to carve out the incremental discount for a complete lack of marketability and arrive at the non-marketable value of the Interest. A few drawbacks to this method would be making a variety of assumptions with the volatilities and other inputs for each put option valuation since every input must cater to the specific nuances of the type of asset the put option is tied to – illiquid or partially liquid. A few alternative methods for completely non-marketable securities are the Longstaff model and the Average Strike Put “ASP” Model, which attempt to capture the opportunity costs associated with holding certain illiquid securities for a specific period.

The complexity involved in calculating the Incremental DLOM may outweigh the effort to achieve precision in deriving value. One may argue that Incremental DLOM can lead to over-adjustment, where the cumulative effect of multiple layers of discounts could significantly undervalue an asset, potentially undermining its true worth and deterring potential investors.

Based on the current scenario, a handful of appraisers believe that an additional DLOM must not be applied since the securities reflect the inherent discounted value. On the flip side, some believe that an additional DLOM must be applied even while using data derived from the Company’s internal stock transactions (the “Backsolve” method). Ensuring that each discount is justified and appropriate is a critical challenge, especially in the context of a 409A valuation, where accuracy is paramount to uphold the credibility of the valuation process.

Source

• Kam, D. Steven and Wan, Darren. “Measuring The Incremental Discount for Lack of Marketability”; Valuation Strategies – November/ December 2010.