The Illiquidity and Marketability Discount
An illiquidity or discount for lack of marketability (DLOM) is a reduction applied to the value of an asset that cannot be sold quickly at low cost. A stake in a private company or a restricted block of shares is worth less than an otherwise identical, freely traded holding, because the owner may have to wait, accept a lower price or pay high transaction costs to exit. Private equity and venture stakes are deeply illiquid, which is one reason their required returns are so high. The discount grows with the expected holding period, the uncertainty of the asset and how thin the market for it is.
Why it matters
Liquidity is the freedom to turn an asset into cash on short notice without moving the price against yourself. A listed share has it, a stake in a private restaurant chain does not. Two businesses with identical cash flows are not worth the same if one can be sold tomorrow and the other locks your capital in for years. Investors pay less for the trapped one, and that gap is the illiquidity discount. The deeper the stake is buried, the longer the wait to exit and the thinner the pool of buyers, the larger the discount grows.
Formulas
Worked examples
An analyst values a minority stake in a private firm at US$10 million on a marketable basis, as if it could trade freely. Comparable restricted-stock studies suggest a discount for lack of marketability of about 25 percent for a holding of this kind. What is the stake worth after the discount?
Apply the discount to the marketable value. US$10 million times gives US$7.5 million. The US$2.5 million reduction is the price of being unable to sell the stake quickly and cheaply. The size of the discount would widen if the expected holding period were longer, the firm riskier, or the pool of potential buyers smaller, and would narrow as a liquidity event such as an IPO approached.
Common mistakes
- ✗Illiquidity affects only how easily an asset trades, not its value. The difficulty of exiting reduces value directly. Buyers pay less for an asset they cannot sell quickly without a price concession.
- ✗The illiquidity discount is a fixed percentage. It varies with the expected holding period, the asset’s risk and the depth of its market, so a single number rarely fits every stake.
- ✗The control premium and the illiquidity discount cancel out. They are distinct adjustments. A controlling stake in a private firm can carry both a premium for control and a discount for illiquidity.
- ✗Listed and private stakes with the same cash flows are worth the same. The private stake is worth less, because the inability to trade it freely imposes a real cost the discount captures.
Revision bullets
- •An illiquidity discount lowers the value of assets that cannot be sold quickly
- •It is also called the discount for lack of marketability (DLOM)
- •Private and restricted stakes are worth less than freely traded equivalents
- •The discount grows with the holding period, risk and market thinness
- •Deep illiquidity is one reason PE and VC demand high returns
- •It is a separate adjustment from the control premium
Quick check
A discount for lack of marketability is applied because an asset
The illiquidity discount on a private stake will generally be larger when
Connected topics
Sources
- Titman & MartinTitman, S. & Martin, J. D. Valuation: The Art and Science of Corporate Investment Decisions. Pearson.Chapter material on valuing illiquid private stakes. The discount for lack of marketability and its link to high PE/VC required returns follow this text.
- Damodaran (2005)Damodaran, A. "Marketability and Value: Measuring the Illiquidity Discount." NYU Stern Working Paper, 2005.Reviews restricted-stock and pre-IPO evidence on the size of the illiquidity discount and what drives it.