What it means
When you own shares in a major listed company, you can sell them instantly on a stock exchange during trading hours. Private company shares, however, do not have this luxury.
If you own a stake in a local bakery or a private tech startup, finding a willing buyer takes time, legal work, and negotiation. Because of this delay and difficulty, financial experts apply a marketability discount to lower the estimated value of the private shares.
This concept matters immensely during business valuations for tax purposes, estate planning, divorces, or when bringing in outside investors. If an appraiser values a private manufacturing business at $10 million overall, your 20% stake is not automatically worth $2 million.
A discount for lack of marketability is usually subtracted to reflect the trapped nature of your capital. In practice, business valuators determine this discount by studying restricted stock studies or pre-initial public offering transactions.
They compare private company share sales to similar public company shares to see how much investors demand as a price penalty for illiquidity. The resulting percentage lowers the final valuation figure.
Non-finance managers need to grasp this because company valuations are rarely straightforward. When reviewing financial reports, estate plans, or equity purchase offers, recognising this discount helps you understand why private equity is valued differently from public shares, ensuring realistic financial expectations.
Imagine two identical houses. One is in a busy suburb with buyers lined up outside.
The other is on a remote island where boats arrive once a month. You must lower the price of the island house just to attract a rare buyer willing to wait.
In practice
Real-world examples
Example 1
You own a 15% stake in a private software firm valued at $1 million. Because the shares are hard to sell, a 25% marketability discount is applied, making your actual stake worth $112,500 instead of $150,000. The $37,500 difference is the price of not being able to sell quickly.
Example 2
A family-run manufacturing business is valued at $4 million for inheritance tax. The accountant applies a 30% marketability discount to the shares passing to the children, reflecting the months it would take to find a buyer. The taxable value falls from $4,000,000 to $2,800,000, though the tax authority may challenge a discount that looks too large.
Example 3
An angel investor is negotiating to buy a 10% share of a private logistics company. The founders use a marketability discount to lower the purchase price, arguing the investor cannot cash out quickly if the market drops. If the company is worth $5 million, the proportional share is $500,000, and a 20% discount would bring the price to $400,000.
Think of it
Imagine two identical houses. One is in a busy suburb with buyers lined up outside. The other is on a remote island where boats arrive once a month. You must lower the price of the island house just to attract a rare buyer willing to wait.
Formula
Calculation
Base Value x (1 - Discount Percentage) = Final Marketable Value. For example, if a private business interest is valued at $500,000 before discounts, and the appraiser applies a 20% marketability discount, the calculation is 500,000 x (1 - 0.20) = $400,000.
The discount is applied to the value of the stake, not the whole company. If the business is worth $10 million and you own 20%, your proportional share is $10,000,000 x 20% = $2,000,000. With a 25% marketability discount, the stake is worth $2,000,000 x (1 - 0.25) = $1,500,000, so the discount takes away $500,000. If a minority discount of 10% also applied, it would be taken from the already reduced figure, leaving $1,500,000 x 0.90 = $1,350,000.Case study
Seen in the real world
This is a fictional, illustrative scenario. GreenField Logistics, a mid-sized regional transport company, prepared for a shareholder buyout when one of the founders decided to retire. The firm hired an independent valuation expert to determine the fair market value of the retiring founder's 30 percent equity stake. The expert initially calculated the total company value at 5 million pounds, suggesting the 30 percent stake was worth 1.5 million pounds.
However, because GreenField Logistics was a private company with tight ownership restrictions that required board approval for any share transfer, the expert applied a 25 percent marketability discount. This reduced the valuation of the retiring founder's shares to $1,125,000. The remaining owners used this discounted figure to negotiate the buyout successfully. This case shows how illiquidity directly impacts cash payouts in private business transactions.
Watch out
Common mistakes
- Confusing marketability discounts with minority discounts, which relate to a lack of control rather than a lack of liquidity.
- Applying a generic percentage discount without researching industry-specific restricted stock studies or private transaction data.
- Assuming private company shares are worth their exact proportional fraction of the total business value without adjustments.
Questions
People also ask
Why do private shares need a discount?
Private shares cannot be sold instantly on an exchange. The discount compensates buyers for the time, cost, and risk of finding a buyer.
Who decides the size of the discount?
Certified business valuators determine the percentage using empirical data, market studies, and specific characteristics of the company.
Is a marketability discount always used?
Not always. If the company is actively preparing for a public stock market launch or has a guaranteed buyer agreement, the discount may be lower or zero.