How do you determine a "lack of marketability" discount for a private tech company?

A "discount for lack of marketability" or DLOM is needed in a private tech company valuation because most of the valuation approaches which are used to estimate value utilize data which assume marketability.

For example, the value of a company may calculated using a multiple derived from comparable publicly traded companies (e.g. Company A projects revenue of $5 million over the next 12 months and the revenue multiple for a group of comparable public companies is 3.0x producing an estimated enterprise value of Company A of $15 million -- if Company A was publicly traded). This "as if marketable" value must be adjusted to an "as if non-marketable" value to be appropriate for a private company.

After adding cash to and subtracting debt from the enterprise value to arrive at equity value (e.g. the $15 million enterprise value of Company A would be increased $5 million for cash and decreased $2 million for debt to reach an equity value of $18 million). The equity value is put into an allocation model, typically a Black-Scholes option pricing model, to calculate the value per share (e.g. after considering the liquidation preferences of preferred stock and the dilution effect of that preferred stock, plus common stock, warrants, and earlier stock options, the resulting value of common stock for Company A might be $0.20 per share -- "as if marketable").

The resulting "as if marketable" value per share is reduced by a DLOM to make it "as if non-marketable." The appropriate DLOM for a particular valuation report is selected by looking at the results of a couple of analytical techniques and tempering those with professional judgment.

The most common analytical techniques are: (a) to examine transactions in the shares of comparable companies just before and just after those companies complete initial public offerings of their stock; and (b) to calculate the cost of a put option for the stock of a private company for an extended period (i.e. several years to an expected IPO or sale). The former technique assumes that investors will require a discount to an eventual IPO price if they are buying shares of stock before the IPO; the latter technique assumes that investors will demand a higher rate of return for holding shares of a private company than they will require for a comparable public company.

The numerical results of these two techniques are calculated and compared, both to each other and to other companies at a similar stage in life. The final DLOM is selected using the appraiser's professional judgment (e.g. if the "as if marketable" value of common stock for Company A is $0.20 per share and the DLOM is 30%, then the "as if non-marketable" value of common stock for Company of is $0.14 per share).

Although the numerical results of the DLOM analysis for an early stage company may be quite high -- sometimes more than 50% -- there has been considerable resistance from the SEC (directly on this issue) and the IRS (in connection with valuation reports for different purposes) to very high DLOMs, so audit firms and appraisers tend to be somewhat more conservative and cap DLOMs at lower levels -- often 30% to 40%. Companies within a year or two of an IPO can expect even smaller DLOMs -- perhaps 10% to 20%.

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