When valuing a business, recent market volatility may well translate into higher discounts for lack of marketability (DLOM) because investors generally will pay less for illiquid, risky investments. However, there's a silver lining to economic uncertainty: It provides an opportunity for wealthy individuals to gift private business interests at significant discounts, potentially saving a substantial amount in taxes.
Marketability is the ability to quickly or readily convert property to cash at minimal cost, according to the International Valuation Glossary — Business Valuation. Also implied is a high degree of certainty that an expected selling price will be realized.
The two most popular sources of empirical data valuators use to support DLOMs are restricted stock and pre-initial public offering (IPO) studies. These studies suggest that discounts for minority interests in private companies range from 30% to 50%. But the DLOM can vary significantly depending on the specific characteristics of the subject business interest.
High volatility typically lowers marketability by making investments less attractive. But estimating private stock price volatility can be difficult because there aren't published stock prices for privately held shares — and private transactions are few and far between. Recently, valuators have turned to public volatility metrics to capture the specific effect volatility has on private marketability discounts.
One popular gauge of market volatility is the Chicago Board Options Exchange Volatility Index® (VIX®). VIX measures the expected volatility of Standard & Poor's (S&P) 500 index options over the next 30 days. Also known as the "fear index," VIX tells whether investors expect sharp changes in market prices — either upward or downward.
Volatility is just one factor that affects marketability. Other considerations when estimating a DLOM include:
Valuators consider these same factors in other parts of their analyses. For example, these considerations may come into play when quantifying the discount for lack of control, blockage discounts, or the cost of equity (under the income approach). To avoid undervaluing a business interest, it's important not to double-count risk factors.
When quantifying a DLOM, it's important to look beyond medians or averages from empirical studies. Experienced valuation professionals will make specific connections between the transaction data from the studies and the business interest in question. Contact us to discuss what's appropriate for your situation.
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