The concept of "Degree of Marketability" is a crucial element in business valuation that plays a significant role in determining the worth of a company. Marketability refers to the ability of an asset to be sold or purchased quickly and easily without incurring significant transaction costs and with a high degree of certainty of realizing the anticipated valuation proceeds. In the context of business valuation, it refers to the ease with which an ownership interest in a company can be sold or transferred.
The degree of marketability impacts the valuation of a business because an investor's ability to sell their ownership interest in a company affects their willingness to purchase the interest in the first place. A lack of marketability can result in a lower price for the ownership interest, which ultimately reduces the overall value of the business.
For instance, a minority shareholder in a private company may be unable to sell their shares quickly and may incur substantial costs in doing so. This situation can significantly reduce the value of their ownership interest compared to a shareholder in a publicly-traded company who can easily sell their shares on an exchange.
Therefore, it is crucial to consider the degree of marketability when valuing a business. Business valuation professionals often use empirical evidence and market data to estimate the degree of marketability of a company's ownership interests.
One way to measure the degree of marketability is through discounts for lack of marketability (DLOM). DLOM is a reduction in the value of an ownership interest due to its illiquid nature. The discount can vary widely and depends on various factors, including the size of the ownership interest, the financial performance of the business, and the industry in which it operates.
In case of unlisted stocks, DLOM is more significant due to the lack of a public market for trading the ownership interest. According to a study by the University of Chicago, the median DLOM for unlisted stocks is approximately 30%, while for listed stocks, it is around 5% to 10%. The study was based on an analysis of 5,000 restricted stock transactions and involved estimating the DLOM for each transaction. The researchers used a variety of models and methodologies to calculate the discounts, including the restricted stock studies, pre-IPO studies, and option pricing models.
The study provides valuable insights into the impact of marketability on business valuation and underscores the importance of considering marketability when estimating the value of a business. The findings are consistent with industry practices, which typically apply a higher DLOM for unlisted stocks compared to listed stocks.
A real-world example of the impact of DLOM can be seen in the 2013 appraisal of the Facebook stock. In the appraisal, the court applied a 35% DLOM, resulting in a $6.8 billion valuation, significantly lower than the $11.5 billion value sought by the plaintiffs. The case involved a dispute over the value of Facebook's shares, with the plaintiffs arguing that the company's shares were worth more than the price paid by Facebook for the shares. The court relied on expert testimony to determine the fair value of the shares and ultimately applied a DLOM of 35% based on the illiquid nature of the shares.
The outcome of the appraisal underscores the impact of marketability on business valuation and highlights the importance of considering DLOM when estimating the value of a business. It also highlights the need for companies to take steps to enhance their marketability, such as improving financial performance, increasing transparency, and enhancing corporate governance.
However, listed company shares can also attract marketability discounts, albeit to a lesser extent than unlisted stocks. The marketability of listed company shares depends on factors such as the liquidity of the stock, the trading volume, and the bid-ask spread.
In the case of shareholders agreements, the terms of the agreement, such as the right of first refusal and the transfer restrictions can impact degree of marketability. For example, if the shares of a company are highly illiquid and will have a high DLOM. It may be difficult for a shareholder to sell or transfer their shares. Other way, this can also make it difficult for the other shareholders to exercise their right of first refusal, as they may not be able to find a buyer for the shares. In this case, the shareholders agreement may need to be revised to reflect the marketability of the shares and to ensure that the transfer restrictions are reasonable.
Similarly, ESOPs are also subject to the degree of marketability of the underlying shares. ESOP participants may be subject to restrictions on the sale or transfer of their shares, and the marketability of the shares can impact their ability to exercise their options or sell their shares. If the shares are highly illiquid and have a high DLOM, it may be difficult for ESOP participants to sell or transfer their shares, which can impact their ability to realize the value of their shares.
It is essential for business owners and investors to understand the impact of marketability on business valuation. To increase the degree of marketability, owners can take steps such as improving the financial performance of the business, increasing transparency, and enhancing corporate governance.
In conclusion, the degree of marketability is a critical factor in business valuation. Business owners, investors, and valuation professionals should consider it when estimating the worth of a company. Discounts for lack of marketability play a significant role in case of unlisted stocks, while listed company shares can also attract marketability discounts, albeit to a lesser extent. Understanding the concept of marketability and taking steps to enhance it can help business owners increase the value of their business.