Illiquidity Discount (Marketability Discount)
Executive Summary
Key Takeaways
- ✓ An illiquidity discount reduces value to reflect the lack of a ready market for a private or otherwise illiquid interest.
- ✓ It is distinct from a minority discount, which addresses lack of control rather than lack of marketability, though the two are frequently combined for a private minority stake.
- ✓ Illiquidity discounts are commonly referred to as a discount for lack of marketability (DLOM) in valuation practice.
- ✓ Empirical support for a specific illiquidity discount percentage typically comes from restricted stock studies or pre-IPO transaction studies.
- ✓ The size of an appropriate illiquidity discount depends on factors such as the expected holding period, the size and profitability of the business, and the presence of any contractual transfer restrictions.
Definition¶
An illiquidity discount, also called a discount for lack of marketability (DLOM), is a reduction applied to the value of a private or otherwise illiquid interest relative to a comparable, freely tradable public asset. It reflects the fact that an illiquid interest cannot readily be converted to cash: there is no active market for it, a sale process takes time and incurs transaction costs, may not achieve full value, and exposes the holder to the risk of an adverse market move during that process.
Formula¶
Illiquid Value = Marketable Value x (1 - Illiquidity Discount)
Where Marketable Value is the value the interest would carry if it were freely and immediately tradable, such as a value derived by reference to comparable publicly traded companies.
Distinguishing Illiquidity from Lack of Control¶
An illiquidity discount is conceptually distinct from a minority discount. A minority discount reflects lack of control over the business; an illiquidity discount reflects lack of a ready market for the interest itself, independent of whether that interest is controlling or non-controlling. A 100%-controlling interest in a private company, for example, carries no minority discount but may still carry a meaningful illiquidity discount, since even the controlling owner cannot sell the business instantly at a known price. For a private, minority stake, the two discounts are frequently both applicable and are typically applied sequentially.
Empirical Support¶
Because illiquidity is difficult to observe directly, valuation practice typically supports an applied illiquidity discount with reference to empirical studies — most commonly restricted stock studies, which compare the trading price of contractually restricted (illiquid) shares to the freely tradable shares of the same company, and pre-IPO transaction studies, which compare private transaction prices to the company's subsequent IPO price. The magnitude of the discount observed in these studies varies with the expected holding period, business size and profitability, and the presence of contractual transfer restrictions.
Audit Considerations¶
- Confirm the illiquidity discount is applied to a genuinely marketable base value, and is not double-counted with a minority discount addressing a separate characteristic
- Confirm the applied percentage is supported by reference to a defined empirical basis rather than an arbitrary round number
- Confirm the discount's magnitude is reasonable relative to the specific facts — expected holding period, business scale, and any transfer restrictions — rather than a single fixed percentage applied across all engagements
- Confirm the discount is disclosed and its basis documented, since it is a judgmental adjustment with a material effect on the resulting value
Common Errors¶
| Error | Description | Risk |
|---|---|---|
| Conflating illiquidity and minority discounts | Treating the two discounts as interchangeable or applying only one when both characteristics are present | Under- or overstates the adjustment for the specific interest |
| Unsupported discount percentage | A round-number discount (for example, 20%) applied without reference to any empirical study or company-specific factors | The adjustment cannot be independently verified |
| Applying the discount to the wrong base | The discount applied to a value that already reflects illiquidity, or omitted entirely from a private company valuation | Produces an inconsistent or overstated value |
Continue Reading¶
Prerequisites¶
- Discounted Cash Flow (DCF) Valuation — the parent pillar
- Equity Value
Related Glossary¶
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Frequently Asked Questions
What is an illiquidity discount?
A reduction applied to the value of a private or otherwise illiquid interest, relative to a comparable publicly traded asset, to reflect the lack of a ready market — the time, cost, and price uncertainty involved in converting the interest to cash.
Is an illiquidity discount the same as a discount for lack of marketability?
Yes, the terms are used interchangeably in valuation practice, both commonly abbreviated DLOM (discount for lack of marketability).
How does an illiquidity discount differ from a minority discount?
A minority discount reflects lack of control over the business; an illiquidity discount reflects lack of a ready market for the interest itself, regardless of whether that interest is controlling or non-controlling. A controlling interest in a private company can still carry an illiquidity discount, even though it carries no minority discount.
What evidence is typically used to support an illiquidity discount percentage?
Empirical studies comparing the prices of restricted (illiquid) shares to their freely tradable counterparts in the same company, and studies comparing private company transaction prices to subsequent IPO prices, are the most common empirical bases cited in valuation practice.
What factors affect the size of an appropriate illiquidity discount?
The expected holding period before a liquidity event, the size and profitability of the underlying business, the presence of contractual transfer restrictions, and the existence (or absence) of a defined path to liquidity such as a planned sale or IPO.
Related Articles
Minority Discount
A minority discount is the reduction applied to a non-controlling equity stake's pro-rata share of a company's control value, reflecting the fact that a minority holder cannot direct strategy, replace management, force a sale, or control the timing and amount of distributions. It is the conceptual inverse of a control premium: rather than adding a premium to reach a control value, a minority discount subtracts from a control value to reach the value realistically attainable by a non-controlling holder. Minority discounts are commonly applied in private company valuation, shareholder disputes, and estate and gift tax valuation.
Control Premium
A control premium is the additional amount, expressed as a percentage above the per-share trading or minority value, that a buyer is willing to pay to acquire a controlling interest in a business. The premium reflects value that is only accessible to a controlling holder — the ability to redirect strategy, replace management, extract synergies, alter the capital structure, or control the timing and amount of distributions. Control premiums are commonly observed and measured in precedent M&A transactions and are the conceptual inverse of a minority discount.
Equity Value
Equity value is the value of a company attributable specifically to its equity holders, as distinct from enterprise value, which represents the value of the whole operating business attributable to all capital providers combined. Equity value is derived from enterprise value by deducting net debt, minority interests, and preferred stock, and adding back non-operating assets. Equity value divided by diluted shares outstanding produces value per share, the figure most directly comparable to a company's quoted share price.
Enterprise Value (EV)
Enterprise value (EV) is the total value of a company's core operating business, independent of its capital structure — it represents what the business as a whole is worth to all capital providers combined, before distinguishing between debt and equity claims. Enterprise value is the direct output of discounting unlevered free cash flow (FCFF) at WACC. To move from enterprise value to the value attributable to equity holders specifically, net debt, minority interests, and other non-operating adjustments must be deducted — the enterprise-to-equity bridge.