Determining the fair market value of a private company’s common stock involves more than estimating enterprise value. One of the most critical adjustments in a 409A valuation is the Discount for Lack of Marketability (DLOM). Since shares of private companies cannot be bought or sold as easily as publicly traded stocks, their value is typically adjusted downward to reflect reduced liquidity.

For startups and growing businesses, understanding how DLOM works is essential because it directly influences stock option pricing, tax compliance, and audit readiness. As valuation standards continue to evolve, auditors and regulators increasingly expect companies to support every assumption with sound analysis rather than relying on standardized discounts.

This article explores advanced DLOM models, the assumptions behind them, and the audit considerations companies should keep in mind when preparing a defensible 409A valuation report.

What Is a DLOM?

The Discount for Lack of Marketability (DLOM) measures the reduction in value resulting from an asset’s inability to be readily sold in an open market.

Public company shares enjoy high liquidity, allowing investors to buy and sell them almost instantly. Private company shares, however, often require board approvals, legal restrictions, or lengthy transactions before ownership can change hands. Because of these limitations, investors generally pay less for illiquid securities.

In a 409A valuation, DLOM is applied after determining the company’s enterprise value and allocating value among different equity classes. The resulting adjustment helps estimate the fair market value of common shares used for employee stock option grants.

 

Why DLOM Matters in 409A Valuations

DLOM significantly affects the final value assigned to common stock. Even a modest change in the discount percentage can substantially alter the exercise price of stock options.

Applying an appropriate DLOM helps companies:

  • Reflect the economic reality of illiquid shares.
  • Support IRS Safe Harbor requirements.
  • Improve consistency in financial reporting.
  • Strengthen audit documentation.
  • Reduce valuation disputes with investors and auditors.

An unsupported or overly aggressive discount can raise concerns during financial audits or tax reviews, making careful analysis essential.

Common DLOM Models Used Today

Selecting the right DLOM model depends on the company’s stage, available data, expected liquidity timeline, and valuation objectives. Modern 409A valuation methodology often incorporates one or more of the following approaches.

1. Option-Based Method

The Option Pricing Method estimates DLOM by treating marketability as a financial option. It calculates the value of liquidity by considering factors such as expected volatility, holding period, and risk-free interest rates.

Because it incorporates market-based assumptions, OPM is widely accepted for venture-backed startups and companies with complex capital structures.

2. Protective Put Method

This approach estimates the cost of purchasing a hypothetical protective put option that would shield an investor from price declines during the expected holding period.

The cost of that protection serves as a proxy for the marketability discount. Although conceptually sound, the method requires reliable market inputs and may not be appropriate for every private company.

3. Longstaff Model

The Longstaff Model assumes investors have perfect knowledge of future stock prices and measures the opportunity cost of being unable to sell at the optimal time.

While it often produces higher discounts, valuation professionals generally apply it carefully because its assumptions can be difficult to justify in practice.

4. Restricted Stock Studies

Historically, analysts compared prices of publicly traded shares with restricted shares that could not immediately enter the market.

Although still referenced, this approach has become less influential as company-specific valuation techniques have gained broader acceptance.

Key Assumptions Behind DLOM

Regardless of the selected model, every DLOM calculation depends on several important assumptions.

Expected Time to Liquidity

One of the most significant inputs is the estimated period before shareholders can sell their stock through an IPO, acquisition, or secondary transaction.

Longer holding periods generally result in larger marketability discounts.

Stock Price Volatility

Companies with greater uncertainty typically experience higher volatility.

Higher volatility increases investment risk, which may influence certain option-based DLOM calculations.

Market Conditions

Economic conditions, capital market activity, and investor sentiment all affect liquidity expectations.

Periods of slower fundraising or reduced acquisition activity may support higher discounts than more active markets.

Company-Specific Factors

Auditors increasingly expect valuation professionals to consider:

  • Financial performance
  • Revenue growth
  • Industry outlook
  • Capital structure
  • Customer concentration
  • Competitive position

Rather than relying solely on historical averages, modern 409A valuation methodology emphasizes company-specific analysis supported by current market evidence.

Audit Considerations for DLOM

Auditors pay close attention to DLOM because it directly impacts the reported fair market value of common stock.

Several areas typically receive detailed review.

Documentation Quality

Every assumption should be supported with evidence rather than generalized statements.

Supporting documentation may include:

  • Financial forecasts
  • Comparable company analysis
  • Market research
  • Industry reports
  • Board-approved business plans

A well-prepared 409A valuation report clearly explains why each assumption was selected and how it affects the final conclusion.

Consistency Across Valuations

Frequent changes in DLOM percentages without clear business justification may trigger additional audit questions.

If assumptions change due to new financing, operational improvements, or changing market conditions, companies should fully document those reasons.

Independent Professional Judgment

Auditors generally place greater confidence in valuations prepared by experienced independent firms.

Professional business valuation services provide objective analysis supported by recognized valuation standards, helping reduce the likelihood of audit adjustments.

Best Practices for Companies

Companies can strengthen their DLOM analysis by following several practical guidelines.

  • Update financial projections regularly.
  • Document every significant valuation assumption.
  • Monitor major business events between valuation dates.
  • Maintain consistency across reporting periods.
  • Work with experienced valuation professionals familiar with IRS and audit expectations.
  • Retain supporting market data used during the valuation process.

These practices not only improve compliance but also make future valuations more efficient.

Why Choose Sharp 409A for Independent Valuation Expertise?

At Sharp 409A, we help startups, venture-backed companies, and private businesses navigate complex valuation requirements with confidence. Our experienced valuation professionals prepare IRS Safe Harbor-compliant reports using recognized methodologies, company-specific analysis, and thorough documentation designed to withstand audit scrutiny. Whether you need an initial 409A valuation, annual refresh, ASC 718 support, cap table analysis, or valuations following financing rounds and other significant corporate events, we deliver accurate reports, transparent pricing, and fast turnaround times. We focus on providing practical guidance throughout the process, ensuring your equity decisions are supported by reliable, defensible valuations tailored to your company’s unique circumstances.

FAQs

  1. What is DLOM in a 409A valuation?

DLOM adjusts private company share value to reflect limited marketability, helping determine fair market value for compliant stock option pricing.

  1. Which DLOM model is commonly used for private companies?

The Option Pricing Method is widely used because it incorporates volatility, liquidity, timing, and other market-based valuation assumptions effectively.

  1. Why do auditors review DLOM assumptions carefully?

Auditors assess whether DLOM assumptions are reasonable, well-documented, and consistently applied to support accurate, defensible valuation conclusions.

  1. Can DLOM percentages change between valuation reports?

Yes. Significant business events, market conditions, financing rounds, or updated financial projections may justify changes in DLOM percentages.

  1. Why should companies hire independent valuation professionals?

Independent valuation experts provide objective analyses, strengthen audit readiness, support IRS compliance, and deliver reliable, well-documented valuation reports.

Sharp 409A

Founded in 2014, Sharp 409A began with a mission to simplify 409A valuations for global startups. With 15+ years of experience, a presence in 13+ countries, and over 1,000 valuations covering assets worth 200B+ USD, we deliver independent, IRS-compliant, audit-ready fair-market value reports that companies can confidently rely on.