For business owners placing a high value on their entity, let’s discuss how marketability affects the overall value of the business. A certified valuation analyst will determine the Discount for Lack of Marketability (DLOM), if applicable to the business. DLOM also catches the attention of the IRS and other agencies hovering over the valuation analyst, which means this is not taken lightly.
A quick description of DLOM is can be found in the International Glossary of Business Valuation Terms as “an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of the ability to convert property to cash at minimal cost”
Here’s an example: Amazon stock has a higher price than a lesser known public company on the same stock exchange. Investors know they can buy Amazon stock and convert back to cash rapidly without the risk of not finding a buyer. In a different example, we buy stock of a lesser known public company and we find it cannot be quickly sold and converted to cash. This becomes a concern driving a price reduction and the uncertainty of completing the sale makes it possible that the final sale price declines in value. A prudent investor would need to understand this discount when buying shares to protect against lost value in a future sale scenario.
Since you have grasped the concept of DLOM so quickly we can introduce another term, Discount for Lack of Liquidity (DLOL). Liquidity is the ability to readily convert property to cash quickly without significant loss of principal. This is only a technical distinction. We’re bringing in the big guns now! Marketability indicates salability while liquidity indicates how fast the sale can occur at the current price. If it’s liquid then it’s marketable and if it’s non-marketable then it’s illiquid. But being illiquid doesn’t mean non-marketable- it is still sellable but not without the loss of value (now say that 10 times fast).
Let’s put all this into how it relates to you, the savvy investor/future business owner. When you look at a business venture you’ll look at the barrier of entry, the cost to invest and lastly, the return on your investment. For example, say your friend wants you to invest together in a new business. You will, at some point, look at the the marketability and liquidity (DLOM and the DLOL) of said investment when deciding to invest. Why? Because if, at some point, you wish to pull out your profit, and/or any cash, then you need to know that you can do so readily and without loss of value. We all know the economy is stabilized on the backbone of small businesses. You could certainly impress your peers if you introduce them to these concepts when they mention investments. Planning long term for investments and the ultimate exit is always a good idea.
Darrin Maddox MBA, CPA, CVA