Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 22

Handling Discounts for Lack of Marketability and Liquidity for Minority Interests in Operating Businesses¹

Introduction

Discrete Percentage Discount for Lack of Marketability

Minority Ownership Interests

Controlling Ownership Interests

Using Options to Estimate the Discount for Lack of Marketability

Chaffee Model

Longstaff Model

Finnerty Model

Shout Option

Perpetual Exchange Option

Long-term Equity Anticipation Securities (LEAPS) Studies

Comparison of Theoretical Models to Empirical Data

Building the Discount for Lack of Marketability into the Discount Rate

Venture Capitalists' Required Rates of Return

Quantifying the Marketability Factor in the Discount Rate

Measuring Blockage (Illiquidity) Discounts for Public Companies

Summary

INTRODUCTION

While there is no universal definition, the authors consider marketability to be defined as the ability to sell the interest, and liquidity as the ease or difficulty of receiving the proceeds. Thus, marketability encompasses liquidity. Data typically used for estimating rates of return are prices for traded shares in highly marketable and liquid public stock markets. Investors desire liquidity. Thus, those who invest in shares of companies without liquid markets will require a discount for lack of marketability (DLOM) and a discount for lack of liquidity compared to what they would pay for shares of high-volume publicly traded companies.

Having estimated required rates of return from market data for publicly traded stocks, there ...