What is Illiquidity Discount?
Illiquidity describes assets that cannot be readily sold in the open market — which usually warrants a discount to be attached to the valuation due to the absence of marketability.
Illiquidity Discount Definition: Private Company Valuation
The illiquidity discount is the discount applied to the valuation of an asset, as compensation for the reduced marketability.
In other words, upon purchasing the investment, there is an immediate risk of value loss where the asset cannot be sold again – i.e. the cost of buyer’s remorse in which it is difficult to reverse the purchase.
The illiquidity discount stems from liquidity risk, which is the incurred loss in asset value from the inability to easily liquidate the position.
The opposite of illiquidity is the concept of liquidity, which is the ability of an asset to be:
- Sold and Converted into Cash Quickly
- Sold Without Incurring a Significant Reduction in Value
In short, liquidity measures of how quickly an asset can be sold in the open market without requiring a significant discount
But for an illiquid asset, liquidating the position could be challenging due to:
- Legal Restrictions from Selling (i.e. Contractual Clauses)
- Lack of Buyer Demand in the Market
In the second scenario, to exit the position, the seller must often offer steep discounts compared to the purchase price in order to sell the illiquid asset — resulting in greater capital loss.
Determinants of the Illiquidity Discount
The illiquidity discount is a function of the required compensation demanded by the investor in order to invest in an illiquid asset, which takes into consideration the:
- Opportunity Cost of Potentially Missed Future Opportunities
- Loss of Optionality in Timing the Exit
- Expected Holding Period
- Employee Stock Compensation (e.g. Restricted Stock Units, or “RSUs”)
The more illiquid an asset is, the greater the discount expected by investors for the incremental risk of purchasing an investment with limited flexibility of selling in the future.
For example, early-stage investors (e.g. venture capital) require illiquidity discounts because of the long-term holding period for when their capital contribution is locked up.
The size of the illiquidity discount is contingent on the opportunity cost of tying up the capital to the investment as compared to investing in assets with lower risk (i.e. assets that could be sold even if the valuation were to decline).
Learn More → The Cost of Illiquidity (Source: Damodaran)
Discount For Lack of Marketability (DLOM)
All else being equal, illiquidity results in a negative impact on the valuation of an asset, which is why investors expect more compensation for the added risk.
Conversely, a liquidity premium can be added to the valuation of an asset that can easily be sold/exited.
In practice, the value of the asset is first calculated ignoring the fact that it is illiquid, and then at the end of the valuation process, a downward adjustment is made (i.e. the illiquidity discount).
The size of the illiquidity discount is largely up for debate, but for most private companies, the discount tends to range between 20-30% of the estimated value as a general rule of thumb.
However, the illiquidity discount is a subjective adjustment for the buyer and a function of the particular company’s financial profile and capitalization.
Thus, depending on the circumstances, the illiquidity discount can be as low as 2% to 5%, or as high as 50%.