Researching the Effect of COVID-19 on the DLOM
Business valuation experts often apply a discount for lack of marketability (DLOM) when valuing a private business interest. This adjustment reflects the relative difficulty of converting the interest into cash, quickly and at minimal cost, compared to publicly traded stocks. The discount is typically stated as a percentage of the interest’s value.
The DLOM is derived from various empirical studies and then it’s adjusted based on the characteristics of the subject company, the size of the business interest, and current market conditions. During the COVID-19 pandemic, market conditions changed swiftly and dramatically. Here’s an overview of how the DLOM has been affected.
Empirical Discount Studies
Common sources of empirical data used to quantify a DLOM include:
Restricted stock studies. Restricted stock is identical to freely traded stock, except that it’s subject to a minimum one-year holding period. A restricted stock study compares restricted stock prices to freely traded stock prices on the same day to estimate the discount for lack of marketability.
Pre-initial public offering (pre-IPO) studies. The Securities and Exchange Commission requires companies to disclose all stock transactions (including stock options and convertible preferred stock) within three years of going public. A pre-IPO study compares these private transactions to the company’s IPO price.
Stock option studies. These studies derive discounts from puts and/or calls on publicly traded stock options known as long-term equity anticipation securities (LEAPs). Put options give the holders the right to sell the stock at a certain price in the future; they are typically issued at or below the current market value. Call options give the holders the right to buy the stocks at a certain price in the future; they allow the holders to “call” away shares at a higher price in the future.
A discount based on LEAP puts and calls reflects what the universe of buyers and sellers have agreed upon as a price that they would relinquish or acquire shares for in the future compared to the current stock price. Discounts also reflect factors such as time, volatility, and dividend yield.
COVID-19 has had adverse effects on many sectors of the economy. It has caused significant market volatility and uncertainty since the economy was temporarily shut down in March 2020. Has the pandemic affected the marketability of business interests?
LEAP stock option discount data released by MergerShark, a proprietary source of M&A and business valuation data, may provide an answer. The 2020 data indicates that the COVID-19 pandemic has increased discounts, which means companies are less marketable. The database includes LEAP put and call options from a sample group of 30 large publicly traded U.S. companies, such as Nike, Starbucks, and Microsoft. This diverse sample group provides a reliable, market-based proxy for valuation discounts.
The data shows a large spike in discounts from January to March across the 6-, 12- and 24-month periods, reflecting the stock market’s significant decline as well as the uncertainty surrounding the future. Although the stock option-based discounts remained elevated in November from the start of the year, discounts have fallen due to the market’s apprehension as reflected in the March stock market lows. The MergerShark 2020 averages are roughly 15% higher than the historic averages for such monthly discounts over the past five years.
When quantifying a DLOM for a privately held business, it’s important to factor in current market conditions, including the effects of the COVID-19 crisis. Each company is unique. Contact a valuation advisor to understand what’s right for the case at hand.