How to Determine the 'Lack of Marketability' Discount for Private Technology Companies?
In the valuation of private technology companies, the 'lack of marketability' discount (DLOM) is an important adjustment item. This article analyzes its definition, common determination methods (such as option pricing models, restricted stock studies, etc.), and emphasizes that valuators need to make comprehensive judgments based on company characteristics, industry environment, and transaction conditions, while also pointing out that this discount involves significant subjectivity and uncertainty.
When valuing private technology companies, determining the Discount for Lack of Marketability (DLOM) is a core and complex valuation issue. This discount reflects the reduction in value of private company equity due to its inability to be quickly converted to cash in a public market, compared to publicly traded stocks. Because technology companies typically have characteristics such as high growth potential, a high proportion of intangible assets, and unique equity structures, calculating DLOM requires a combination of quantitative models and qualitative judgment.
I. Basic Concepts and Applicable Scenarios of DLOM
DLOM is applicable when valuing equity in private companies, especially in minority equity transactions, estate or gift tax filings, employee stock incentive pricing, and merger and acquisition transactions. Its theoretical basis is that liquidity itself has value—investors are willing to pay a premium for assets that can be sold at any time, and conversely, they require a discount for assets that cannot. For private technology companies, DLOM is typically significantly higher than for private companies in traditional industries due to the lack of a public trading market, transfer restrictions (such as rights of first refusal in shareholder agreements), information asymmetry, and uncertain exit paths.
1. Key Influencing Factors
- Company size and profitability: Smaller, unprofitable technology companies have less liquid equity, and DLOM tends to be higher.
- Nature of assets: Technology companies rely primarily on human capital and intellectual property, with few tangible assets, making liquidation difficult and increasing the discount.
- Expected exit timeline: If the company plans an IPO or acquisition in the near term, DLOM may be lower; conversely, a long-term lack of exit plans increases the discount.
- Transfer restrictions: Lock-up periods, rights of first refusal, and other clauses in the company's articles of association or shareholder agreements exacerbate the lack of marketability.
- Industry volatility: The technology industry changes rapidly, leading to high uncertainty in future cash flows, and investors demand greater compensation for illiquidity.
II. Common Determination Methods
There is currently no unified standard in the industry, but the following four main methods are used, each with its own assumptions and limitations.
1. Restricted Stock Studies
This method is based on the difference between the issuance price of restricted stock (i.e., unregistered stock) in the U.S. public market and the price of the same company's publicly traded stock. Historically, several studies (such as the SEC Institutional Investor Study and Management Planning, Inc. studies) have shown that the median restricted stock discount ranges from 20% to 35%. However, these studies mostly target mature industries and require careful adjustment when applied directly to technology companies.
2. Pre-IPO Studies
This method infers DLOM by comparing the difference between the price of private transactions before an IPO and the IPO offering price. Research indicates that pre-IPO discounts typically range from 30% to over 50%, but this method is heavily influenced by IPO market conditions, and the samples are often high-tech companies from specific periods, which may overestimate the discount.
3. Option Pricing Models (e.g., Chaffee Model)
This model treats lack of marketability as a put option—the opportunity cost borne by investors due to their inability to sell immediately. Using the Black-Scholes or binomial model, inputs such as expected holding period, volatility, and risk-free rate are used to calculate the discount percentage. This method is relatively objective, but parameter selection (especially volatility and holding period) has a significant impact on the results, and for early-stage technology companies, volatility is difficult to estimate reliably.
4. Quantitative and Qualitative Comprehensive Analysis
In practice, valuation professionals often combine multiple methods and calibrate using quantitative marketability discount studies (such as FMV Opinions' DLOM database). Additionally, company-specific factors must be considered, such as the number of shareholders, transparency of financial reporting, and the range of potential buyers. For technology companies, it is also necessary to assess their technological barriers, customer concentration, and dependence on key personnel.
III. Uncertainties in Practical Application
It must be emphasized that determining DLOM is highly subjective. Different valuation professionals may arrive at vastly different discount rates for the same company, ranging from 10% to over 50%. The U.S. Internal Revenue Service (IRS) often challenges the discounts adopted by taxpayers in tax disputes and requires sufficient evidence. Therefore, it is recommended to disclose in detail the method selection, parameter basis, and sensitivity analysis in the valuation report.
Illustrative Example (Not Real Data)
Assume a private SaaS company with annual revenue of $5 million, a net profit margin of 10%, and plans to go public within 3 years. Using an option pricing model with an assumed volatility of 60%, a risk-free rate of 2%, and a holding period of 3 years, the DLOM would be approximately 25%. However, if the company faces intense competition and a high risk of losing key technical personnel, the valuation professional might increase it to 35%. Conversely, if the company has already signed a letter of intent for acquisition with a strategic investor, the discount might decrease to 15%.
IV. Conclusions and Recommendations
There is no single formula for determining DLOM for private technology companies; it requires combining the company's life cycle, industry characteristics, transaction context, and available data. It is recommended that valuation professionals:
- Prioritize cross-validation using multiple methods to avoid relying on a single model.
- Make qualitative adjustments for risks specific to technology companies (such as technological iteration and intellectual property protection).
- Clearly state all assumptions and uncertainties in the report so that stakeholders can understand them.
- Regularly update reference data, as market liquidity conditions change over time.
Ultimately, DLOM is not just a number, but a prudent assessment of the true marketability of equity in a private technology company. In the absence of a public market, maintaining transparency and logical consistency in professional judgment is key to ensuring a fair valuation.