Revisiting the Illiquidity Discount for Private Companies: A New (and 'Skeptical') Restricted‐Stock Study

Data from restricted‐stock studies are routinely used by business‐valuation analysts and small‐business appraisers to estimate discounts for lack of marketability, or DLOMs, which are then applied in the valuation of private companies. The rationale for the use of such DLOMs is that, even after an investor is compensated for the risk associated with holding an asset, an asset held unwillingly (due to illiquidity) must be worth less than if the asset were held by choice. But the same rationale can also be applied to the DLOM on riskless assets (such as Treasuries), and the evidence is consistent with a DLOM on such assets of only about 2.5%. This in turn suggests that any DLOM larger than 2.5% amounts to a second round of discounting for risk (where the first round occurs in a DCF or similar core valuation). Discounting with conventionally measured DLOMs is likely to be redundant because liquidity or marketability is highly correlated with company size, and size is already an important determinant of discount rates. Existing evidence suggests that, before DLOMs are applied, real‐world valuations of small businesses typically include discounts of as much as 50% for lack of size. And given that restricted‐stock studies are routinely used to support DLOMs of 20% to 40%, the valuation discounts resulting from this procedure are likely to be much too large. In contrast to industry practice, the author's study of a large sample of private placements of equity produces evidence consistent with use of a DLOM no greater than 5% or 6%.