Imagine owning 20% of a profitable private company. You cannot call a broker and sell your shares by lunch. There is no public market, buyers are scarce, and any sale will take time, cost money, and come with restrictions. That reality is why the discount for lack of marketability (DLOM) exists, and why it is often one of the largest and most contested adjustments in a business valuation.
This guide explains what a DLOM is, how it differs from a discount for lack of control, how appraisers measure it, and what it takes to defend it before the IRS or a court.
Key Takeaways
- A DLOM reflects the absence of a ready market for a private ownership interest; a DLOC reflects the lack of control.
- Appraisers support DLOM with restricted stock and pre-IPO studies, option models, and cash flow analysis, not rules of thumb.
- The Mandelbaum factors, such as distributions, transfer restrictions, and holding period, explain why discounts differ.
- Statutory fair value cases, including Massachusetts appraisal-rights cases, often exclude these discounts entirely.
What Is a Discount for Lack of Marketability?
A DLOM is a reduction in value that reflects the absence of a ready market for an ownership interest. Investors pay more for assets they can quickly convert to cash at a known price. An interest in a closely held company lacks that liquidity, so a hypothetical buyer would pay less for it than for an otherwise identical publicly traded interest.
Marketability discounts apply most often to:
- Gifts and estate transfers of closely held stock or LLC interests
- Family limited partnership valuations
- Stock option and 409A valuations of common stock
- Some shareholder and buy-sell valuations, depending on the standard of value
DLOM vs. Discount for Lack of Control
These two discounts are often confused, but they address different problems.
| Feature | Discount for lack of control (DLOC) | Discount for lack of marketability (DLOM) |
|---|---|---|
| What it reflects | Inability to direct the business, set distributions, or force a sale | Inability to sell the interest quickly at a known price |
| Applies to | Minority interests | Both minority and, to a lesser degree, controlling interests |
| Typical evidence | Control premium studies, comparison of public minority prices | Restricted stock studies, pre-IPO studies, option models |
| Order of application | Usually applied first | Usually applied after the DLOC |
A minority owner may suffer both: she cannot force a dividend or sale, and she cannot easily sell her shares. The discounts are applied in sequence, not added together.
How Appraisers Measure DLOM
There is no single formula. Credible appraisers rely on several types of evidence and explain how each applies to the specific interest.
Restricted Stock Studies
These studies compare the price of restricted shares of public companies, which could not be resold for a period under SEC rules, to the freely traded price of the same company’s stock. Because the companies are identical, the difference isolates the effect of illiquidity. Historical studies frequently reported average discounts in the range of roughly 20% to 35%, although results vary widely and depend on the holding period in effect when the data was collected.
Pre-IPO Studies
These compare prices in private transactions before an initial public offering to the IPO price. They often show larger discounts, but they also capture other risks, such as the chance the IPO never happens, so they must be used carefully.
Option Pricing Models
Models such as the Chaffe, Finnerty, and Longstaff approaches estimate the cost of a put option that would protect the holder from price declines during the expected holding period. They are especially common in 409A valuations and for interests with expected liquidity events.
Quantitative Cash Flow Models
Some appraisers model expected distributions, holding period, and required return to estimate how much less a buyer would pay for the illiquid interest.
The Mandelbaum Factors
In Mandelbaum v. Commissioner (1995), the Tax Court listed factors that affect the size of a marketability discount. They remain a useful checklist:
- Financial statement analysis and the company’s performance
- Dividend policy and history of distributions
- Nature of the company, its history, and its position in the industry
- Strength of management
- Amount of control in the transferred shares
- Restrictions on transferability
- Expected holding period
- Redemption policy
- Costs associated with a public offering
An interest in a company that pays steady distributions, has a buy-back history, and imposes few transfer restrictions deserves a smaller discount than one in a company that never distributes cash and requires board approval for every transfer.
How the IRS Looks at DLOM
The IRS published a DLOM job aid for its own engineers and appraisers. It emphasizes that the discount must be supported by facts about the specific interest, not by a rule of thumb or an average from a study. In audits and litigation, the IRS frequently challenges discounts that:
- Cite study averages without explaining why they fit the subject company
- Ignore distributions or a short expected holding period
- Double count risk already reflected in the discount rate
- Apply both discounts at aggressive levels without support
Defensibility checklist: Explain which evidence you relied on and why, tie the discount to the interest’s actual rights and restrictions, cite the governing documents, and reconcile multiple methods rather than relying on one.
When DLOM Does Not Apply
The standard of value matters. Under fair market value, a DLOM is usually appropriate for a minority interest. But in statutory fair value proceedings, such as dissenting shareholder appraisal actions in many states, courts often reject marketability and minority discounts. Massachusetts’ appraisal-rights statute, for example, defines fair value without discounting for lack of marketability or minority status. Our guide to shareholder disputes and fair value in Massachusetts explains this in more detail.
In divorce cases, courts differ by state on whether marketability discounts apply to an owner who will keep the business.
A Simple Example
Suppose a company’s equity is worth $10 million on a controlling, marketable basis. A 25% interest would be worth $2.5 million pro rata. If the appraiser supports a 15% discount for lack of control and a 25% discount for lack of marketability, the calculation is:
- $2.5 million × (1 − 15%) = $2.125 million
- $2.125 million × (1 − 25%) = $1.59 million (rounded)
The combined effect is about a 36% reduction, not 40%, because the discounts are applied in sequence. This example is illustrative only; actual discounts depend entirely on the facts.
Illustrative Example: Two 20% Interests, Two Different Discounts
Assume two hypothetical family companies are each worth $15 million on a controlling, marketable basis, and a parent gifts a 20% interest in each to a child.
Company A is a real estate holding LLC that distributes most of its cash flow every quarter, has a history of redeeming members who want out, and allows transfers to family members without consent. Company B is an operating manufacturer that has never paid a distribution, requires unanimous consent for any transfer, and has no plan for a sale in the foreseeable future.
Both interests lack control and marketability, but they are not equally illiquid. The holder of Company A’s interest receives regular cash and has a realistic path to liquidity, so the evidence supports a smaller marketability discount. The holder of Company B’s interest may wait many years with no cash return while still bearing risk, so a larger discount is supportable.
Applying the same percentage to both, as some informal appraisals do, would understate one value and overstate the other. More importantly, it would be hard to defend in an IRS audit, because the IRS expects each discount to be tied to the specific rights, restrictions, and economics of the interest. That is why credible gift tax reports read the operating agreement line by line before choosing a discount.
Frequently Asked Questions
No. Courts and the IRS reject one-size-fits-all discounts. The discount must be supported by evidence tied to the specific interest.
Sometimes, but it is usually smaller. Even a controlling owner faces time and cost to sell a private company.
If a gift is adequately disclosed on a timely filed return, the IRS generally has three years to challenge the value. Without adequate disclosure, the statute of limitations may never start. A qualified appraisal is a key part of adequate disclosure.
Yes. Transfer restrictions, rights of first refusal, and put rights all affect marketability and should be analyzed.
Defensible Discounts Start With the Facts
Foxboro Consulting Group, Inc. prepares gift, estate, and minority interest valuations with discounts supported by current research and tied to the governing documents. Our credentialed professionals have testified on valuation matters and understand what the IRS and courts expect to see.
Planning a gift or estate transfer of a business interest? Contact Foxboro Consulting Group for a valuation that can withstand scrutiny.
