The illiquidity discount is applied to valuations computed with the DCF methods to take into account the difficulty in selling (liquidating) the shares of a private company.
When a decision to exchange an asset for money is made, it might take time to execute it. This amount of time depends on the availability of a buyer as well as the technical difficulties in the transfer. The longer the process takes, the more likely it is that the investor becomes exposed to unwanted and unremunerated risks; thus leaving them in an undesirable situation.
Public company shares can be traded on stock exchanges almost instantly through standardized contracts - so the effect of illiquidity is negligible.The illiquidity discount therefore captures the above described disadvantages experienced when investing in private company shares.
Many different models exist in literature to estimate this discount. Equidam applies the results of the empirical research of William L. Silber and further studies of Prof. Aswath Damodaran. Accordingly, the illiquidity discount depends on current profitability and projected last year revenues – both associated with higher buyers’ interest in a company.