When would a marketability discount be understated as oppose to overstated? For example:
Q13) When quantifying the lack of marketability discount [DLOM: discount for lack of marketability], which of the following types of data would result in a marketability discount that is understated?
A) Restricted stock grants (answer)
B) IPOs
C) Put Options
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I understand that “restricted stock grants” will enjoy marketability in the near term, while there is no such guarantee for private company shares. DLOM is “an amount of % deducted from the value of an ownership interest to reflect the relative absence of marketability.”
Since a company with restricted stock grants will be more marketable the discounts should be less, correct? However, what does this have to do with “understating” or "overstating’ discounts?
A restricted stock (grant) would be discounted versus the market value of the traded shares. There is no market for the restricted share, so they must be worth less.
An IPO wouldn’t discount the shares, it would appreciate the value of them. In effect it’s doing the opposite of DLOM
Say the discount is at 10% becuase of lack if liquidity. Does understating mean it should be 8% lets say, meaning it is actually more liquid than it is?
Consider a private company stock that you’re saying has a freely traded value (no DLOM) of $100. After your research, you feel an appropriate DLOM is 20%. Thus, the fair market value is $80 (this is ignoring any minority interest discounts).
If that particular share of stock had an impending IPO, that share would be more marketable because the company is about to go public and quite a few more investors will gain access to it.
If that share had put options attached to it, it would be more marketable because it provides the holder with some downside protection (beyond the strike price).
If that share was a restricted one, it would be less marketable - for obvious reasons.
Now, if none of 1., 2., or 3. were taken into consideration when you originally calculated your 20% DLOM, then:
An impending IPO would mean your 20% is overstated (it’s clearly more marketable) - maybe use 10%? Your FMV jumps from $80 to $90. Makes sense for a stock thats more marketable than you originally thought.
A put right would mean your 20% is overstated (the holder now enjoys some downside protection), so reducing your DLOM will increase your FMV. Again, makes sense for a stock that’s “safer,” and as a result, more marketable.
Restrictions on transfers or sale of the stock would mean your 20% is understated because restrictions are just plain less desirable. So here, you’d increase your DLOM - maybe 25%, 30%? The reduced FMV of $70-75 makes sense here.