What is the discount for lack of marketability (DLOM) in business valuation?

What is the discount for lack of marketability (DLOM) in business valuation?

By Gregory R. Caruso, JD, CPA, CVA

When we are assessing a company in a business valuation, we look at a number of future risks, some of which I’ve discussed in previous blog posts. Discounts and premiums are adjustments we make to the estimate of value in business valuation based on risk and depending on modeling and comparisons to known sample sets. Today I want to talk about the marketability discount, which is based on both the time value of money and the risk that the value will decrease–or even disappear. 

What is the marketability discount? 

The Business Valuation Glossary defines marketability as “the ability to quickly convert property to cash at minimal cost.” Basically, can an owner in the business sell their interest quickly and with certainty about the final sales price? The marketability discount in business valuation is a discount calculated based on risk during the time involved to find a buyer and get to closing. 

How does the discount for lack of marketability (DLOM) apply to valuations?

In many ways, this discount is magnified with small and very small businesses because they tend to have limited product offerings in limited geographic markets. This limitation means situations beyond their control can very quickly cause a large loss of value. These situations might include the loss of a major client, the illness of an owner, calling of a line of credit, a loss or disruption in supplies, or the loss of a franchise or license agreement, to name a few. You might know that these are a possibility, but they are not usually foreseeable during day-to-day operations, and usually don’t apply for a valuation that takes place at a specific time (before that risk becomes reality). If larger businesses are being valued for estate or gift tax more detailed analysis and review should be applied.  

How does risk relate to marketability? 

Many risks increase over time and are very tied to marketability. One of the harder issues is that sometimes risks are all-or-nothing risks. For example, a company that has essentially one contract (and few easy replacements) which can be terminated at will has a business concentration risk. This situation would justify a large discount for marketability, even if it may have a high cash flow that continues for a long time. 

An example of this is a valuation of a business during a divorce where the business owner has a contract with a local school system that brings in $2,000,000 of revenues and the SDE cash flow is $500,000.  But, the contract is at-will of the school administration, which tends to change every two or three years.   While the revenue is good and may continue for a number of years, it could also disappear if the school administration chooses another vendor. This company has a risk that will make selling more difficult than most competitors, making a marketability discount appropriate even for a control owner. Fact patterns such as this require additional background, experience, and professional judgment.  

What are the methods used to estimate the discount for lack of marketability? 

Currently, the primary methods used to estimate the discount for lack of marketability (DLOM) in business valuation are the quantitative approach, the qualitative approach, and the option pricing models. Quantitative approaches use databases and data to attempt to quantify the DLOM. They are used for larger businesses that have clear financials and meaningful business ratios, and data can be compared carefully to database data and converted into a discount rate. Qualitative approaches provide a more general framework to compare the subject company to the databases, since detailed financial analysis is often impossible. Option pricing models such as Longstaff, Finnerty, and Chaffe each attempt to “model” the discount based on statistics and available option pricing formulas.

As I always say, business valuation is not a strict science, but an art and a science. This is especially true with the marketability discount, where there are many factors and risks that have to be taken into account. Contact me today to learn more about my professional business valuation services.

Business Valuation Firm for SBA, Mechanical Plumbing HVAC Company, and Estate and Gift Tax Business Valuations

Business Valuation Firm for SBA, Mechanical Plumbing HVAC Company, and Estate and Gift Tax Business Valuations

Here at Art of Business Valuation, Harvest Business, LCC, we evaluate businesses for a variety of reasons, including Small Business Administration (SBA) loans and Estate and Gift Tax planning. Here is a brief summary of a three recent business valuations by the business valuation firm done by Gregory Caruso, JD, CPA, CVA, lead appraiser. 

Estate and Gift Tax: Home Nursing / Eldercare Business Valuation 

The business is a franchise of home nursing and eldercare company with several locations.  The company had good relations with several hospital systems, which make constant referrals, driving new customers to the business. On the personnel front, the two owners and three strong upper middle managers made a good management team. They ensure consistent timely staffing and care. At this time they needed an evaluation because one owner wanted to gift his part of the business to his children. The buy-sell agreement was being modified and new restrictions were evaluated for estimating the discount of lack of marketability (DLOM) and the minority interest discount calculations. The business valuation cash flow did have some issues around reasonably supporting owner cash flow add backs and these were favorably resolved.   

SBA Business Valuation: Equipment Rental Company

The company primarily rents construction equipment, tent rental, and party and catering rental items. In general, these companies tend to be seasonal where summer presents stronger business and more income. This company experienced even more of that phenomenon, as it is near a popular summer beach resort. COVID-19 reduced tent and party rentals, but increased construction equipment rentals. Because of this, the equipment rental company appeared to have an almost typical year. The selling owner had several businesses and had put very little time into this company in recent years. This sale was a first step towards his retirement. The company was being purchased by a long term manager and the purpose of the business valuation was to support an SBA 7(a) acquisition loan.

Business Valuation: Plumbing, Mechanical HVAC Service

The company primarily provided HVAC service work to a large base of residential homes and some light office space in an exurban community. They had $6M in revenues and are a highly profitable company.  Much of their business was made up of small service and equipment replacement jobs, with some service contracts. They are particularly effective in internet marketing systems and have good Google and related reviews. They also had a good employee situation with plenty of trained techs. The purpose of this valuation was for partial bank financing of a family transition. 

Harvest Business, LLC also commonly called The Art of Business Valuation is an expert business valuation firm that provides business valuations nationally. Our lead valuator Gregory R. Caruso, JD, CPA, CVA, has performed hundreds and hundreds of business valuations and provided training and continuing education for leading business valuation, accounting, and legal programs. Your business value is worth our quality service and experienced business valuation judgment. If you have any questions or need a business valuation for any purpose reach out today.