Has the Discount for Lack of Marketability Really Doubled?

July 24, 2009 at 9:47 am

Discounts for Lack of Marketability (“DLOM”) often play an important role in the valuation of privately held companies. This is because we often develop an indication of the value of a company as if it were publicly traded, and then adjust the value to reflect the fact that its stock cannot be rapidly sold on a public exchange.

In light of the turmoil in the equity markets over the past eighteen months, some have conjectured that the difference in values between public and private companies has gotten wider. An intriguing set of studies conducted by Ronald M. Seaman shine some light on this issue.

LEAPS Study Provides Insight

Seaman studied a form of stock options referred to as LEAPS (“Long-Term Equity Anticipation Securities”). These are stock options (call and put options) listed on the Chicago Board of Exchange and elsewhere, with extended terms until maturity (Seaman has studied LEAPS with maturities that have typically ranged from 14 to 30 months). Put options can be purchased by an investor to hedge against a decline in stock value. According to Seaman, “…the cost of a LEAPS put option, expressed as a percentage of the price of the underlying stock, measures the cost of price protection against a loss of value of the stock.” Seamans postures that this cost of price protection is a proxy for the relative lack of marketability.

Most notably, Seaman conducted a study of LEAPS prices in 2006 which he has updated with prices measured in November 2008. The changes in discounts between these two periods of time are eye-opening. Obviously, equity markets in 2006 were relatively benign, while the markets in November of 2008 were in a state of extraordinary turmoil. For instance, Seaman found that the median cost of price protection for companies with revenues less than $100 million went from 27.3% (for 18 month terms) in 2006 to 47.2% (for 14 month terms) in 2008. Overall, Seaman observed, “Discounts in November 2008 were double or greater the discounts in October 2006”.

The use of options models (and the supporting LEAPS studies) has been gaining increasing visibility as a method for quantifying DLOMs used in valuation studies. At a minimum, evidence of the kind supplied by Seaman challenges the analyst to consider both company specific facts and circumstances, as well as the overall economic climate and equity market conditions, in the determination of marketability discounts.

(The source of all quotes is “Minimum Marketability Discounts”–4th Edition, A Study of Discounts for Lack of Marketability Based on LEAPS Put Options in November 2008 by Ronald M. Seaman, FASA, March 2009. A copy of the study may be obtained at http://www.dlom-info.com/)

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

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