Finnerty DLOM Model for 409A: Formula, Inputs & Worked Example

Every 409A valuation report you will ever see includes a discount for lack of marketability. It sits near the end of the calculation chain, after your appraiser has estimated enterprise value, allocated value to common stock using an option pricing model, and arrived at a preliminary per-share figure. Then the DLOM comes along and reduces that number -- sometimes significantly. For a seed-stage company, the discount can exceed 35%. For a late-stage company heading toward an IPO, it might be 12%. The difference matters enormously to the strike prices your employees receive on stock options.

Of the three quantitative models appraisers use to calculate DLOM in 409A valuations, the Finnerty model has become one of the most widely cited. This article explains exactly what it is, how the Finnerty DLOM formula works, what inputs it requires, and how to read and evaluate the DLOM figure your appraiser delivers.

What Is DLOM and Why It Matters in 409A Valuations

DLOM stands for discount for lack of marketability. It reflects the economic reality that owning stock in a private company is fundamentally different from owning stock in a publicly traded one. A public shareholder can sell their shares on any trading day at a known, observable price. A private company shareholder cannot. They are locked in until a liquidity event -- an acquisition, IPO, or secondary transaction -- and that event could be years away or might never come.

The discount for lack of marketability quantifies that illiquidity penalty. In a 409A valuation, DLOM 409a is applied to common stock specifically, because common sits at the bottom of the capital structure and typically faces additional restrictions on transfer compared to preferred stock held by institutional investors.

Understanding DLOM matters for founders for several reasons. First, it directly affects the fair market value conclusion for common stock -- the number that determines your employees' option strike prices under IRC Section 409A. Second, an aggressive (too low) DLOM increases the risk that the IRS challenges your valuation and concludes that options were granted in-the-money, triggering significant tax penalties for employees. Third, a conservative (too high) DLOM means you are granting options at artificially low strike prices, which may create accounting and legal exposure.

It is worth distinguishing DLOM from the discount for lack of control, or DLOC. DLOC reflects the premium an acquirer would pay for a controlling interest versus a minority interest. DLOM reflects illiquidity. Both may apply in the same valuation -- they are not the same adjustment and should not be conflated. In most 409A valuations, the OPM-based allocation already captures the minority nature of common stock, so DLOC may not be separately applied, but DLOM 409a almost always is.

The Three DLOM Methods Appraisers Use

Before getting to the Finnerty model specifically, it helps to understand the landscape of DLOM methodologies, because most competent appraisers use more than one and weight the results.

The first category is empirical studies. Researchers have examined the prices at which restricted shares of public companies trade compared to their freely tradable counterparts. Restricted stock studies -- including the Silber (1991) study and databases maintained by FMV Opinions and Pluris -- consistently find discounts in the 15-35% range. Pre-IPO studies from Willamette Management Associates document discounts of 20-45% by comparing the price of pre-IPO transactions to the eventual IPO price. These empirical approaches give appraisers a sanity-check range for the quantitative models.

The second category is quantitative option-pricing models. These treat illiquidity mathematically: the inability to sell a share is economically equivalent to the loss of a put option on that share. If you could always sell freely, you could always exit at the current market price. The inability to do so has economic value -- specifically, it is worth what a hypothetical put option protecting you against downside would cost over the restriction period. Three quantitative models dominate 409A practice: the Chaffe model (European put option), the Finnerty model (Asian put option), and the Longstaff model (theoretical upper bound).

The third consideration is the appraiser's judgment about which method is most appropriate given the company's stage, available data, and the defensibility needed for the report. In the broader context of 409A valuation methodology, DLOM selection is part of the overall documented approach that supports safe harbor protection.

What Is the Finnerty DLOM Model?

The Finnerty DLOM model was introduced by John D. Finnerty in his 2012 paper published in the Financial Analysts Journal. Finnerty's key contribution was recognizing that the average-strike Asian put option is a better conceptual fit for the discount for lack of marketability problem than the European put option used in the Chaffe model.

Here is the intuition. An investor who holds a restricted security cannot sell at the current market price today. But they are also not simply waiting to see where the price is at the end of the restriction period. They are experiencing the entire path of prices over the restriction window and are locked out of acting on any of them. Finnerty argued that an Asian put option -- which pays based on the average price over the option's life rather than the price at a single point in time -- more accurately captures this economic loss.

The Finnerty DLOM model formula 409a is also relevant because the AICPA Practice Aid on valuation of privately-held-company equity securities specifically addresses quantitative DLOM models including Finnerty's approach. When your appraiser cites the Finnerty model in a 409A report, they are working within a framework that the AICPA and the IRS are familiar with, which supports the defensibility of the methodology.

The Finnerty DLOM Formula: Complete Breakdown

The simplified Finnerty DLOM formula is:

The term σ × √T / 2 is the core of the calculation. It combines volatility and time into a single number representing the scaled uncertainty over the holding period. Higher volatility means the stock could move significantly in either direction during the lock-up, increasing the value of the forgone put option. Longer restriction periods have the same effect -- more time means more potential for adverse price movement during the illiquidity window.

N() is the standard normal CDF, the same function encountered in Black-Scholes. It maps any real number to a probability between 0 and 1. When volatility or time is very low, the DLOM calculation from the Finnerty model approaches zero. When both are high, the discount increases -- though it is bounded below 1 (a 100% discount would imply the stock is entirely worthless to a private holder, which is a theoretical maximum).

Inputs Required to Apply the Finnerty Model

The Finnerty DLOM model requires two primary inputs: volatility (σ) and the restriction period (T).

Volatility is the more complex input. For public companies, historical price volatility is directly observable. For private companies, it is not. Appraisers derive volatility by identifying comparable publicly traded companies in the same industry and at a similar stage, then calculating their historical volatility over a lookback period that matches the expected restriction period. This is the same peer volatility methodology used in the option pricing model that allocates equity value to common stock. If your appraiser is applying the Finnerty DLOM model formula 409a alongside a Black-Scholes OPM, they are likely using the same volatility assumption in both places. Typical volatility inputs range from 55% to 120% depending on industry and stage.

The restriction period T represents the expected holding period -- how long it will take for the common stockholder to achieve liquidity. In 409A practice, this is typically the expected time to the next liquidity event: an IPO, acquisition, or secondary transaction. Common assumptions range from 1.5 to 4 years depending on the company's stage, recent financing activity, and management's plans. For a Series A company with no near-term exit in sight, T = 3.0 to 3.5 years is reasonable. For a late-stage company actively pursuing an IPO, T = 1.0 to 1.5 years is more appropriate.

The interaction between σ and T is through the square root of T, so doubling the restriction period does not double the DLOM -- the sensitivity is dampened. A 4-year restriction period produces a σ × √T term that is twice as large as a 1-year period for the same volatility, but the final DLOM does not double because N() is a nonlinear function.

Worked Example: Calculating Finnerty DLOM for a Series A Startup

Let's walk through a complete Finnerty DLOM calculation for a representative Series A company: a SaaS business, 18 months post-Series A, $8M ARR, no near-term exit process underway.

Cross-checking against the Pluris and FMV Opinions restricted stock databases, which show discounts of 25-35% for companies at this stage, confirms that 28% is in a reasonable range. The $3.02 per share would be used as the exercise price for stock options granted around the valuation date. You can see how DLOM fits into the full valuation waterfall in our 409A valuation example.

How Finnerty Compares to Other DLOM Models

The Finnerty model does not exist in isolation. Appraisers typically consider multiple methods and apply judgment in weighting them. Understanding the differences helps you evaluate whether your appraiser's methodology is appropriate.

The Chaffe model uses a European put option rather than an Asian put option. Because European put options are more valuable than Asian put options with otherwise identical parameters, the Chaffe model generally produces higher DLOM estimates than the Finnerty model for the same inputs. Critics argue that the European put overstates the illiquidity discount because it prices the worst-case terminal outcome rather than the averaged experience of holding the security over the restriction window.

The Longstaff model derives a theoretical upper bound on the discount for lack of marketability. Longstaff DLOMs tend to be higher than Finnerty DLOMs and are sometimes used as a ceiling to bracket the range rather than as a point estimate.

The empirical restricted stock studies provide real-world transaction data rather than mathematical models. They are valuable as a sanity check but may not reflect the specific characteristics of the subject company or current market conditions.

In practice, the Finnerty DLOM model tends to produce discounts at the lower end of the defensible range, which is why many appraisers weight it alongside empirical methods to arrive at a final DLOM that reflects a balanced view. A final DLOM derived from a 50/50 weighting of Finnerty and the restricted stock study midpoint is common in 409A practice. How that DLOM then interacts with the preferred/common value split is discussed in why your 409A value is lower than preferred price.

DLOM Ranges by Funding Stage: What to Expect

Understanding what DLOM range is typical for your stage helps you evaluate whether your 409A report reflects reasonable assumptions. Our 409A valuation benchmarks by stage provides additional context on common stock as a percentage of preferred.

Late-stage and pre-IPO companies typically carry DLOMs in the 10-20% range. When an S-1 has been filed or an IPO timeline is explicit, some appraisers use a PWERM approach that probability-weights the IPO outcome separately, and the DLOM applicable to the IPO scenario can be very low (5-10%), reflecting only the lockup period between the valuation date and the expected liquidity date.

Common Mistakes in DLOM Calculation for 409A

Several errors appear repeatedly in DLOM analysis, some of which can make a 409A valuation indefensible under audit.

Using an implausibly low restriction period to produce a smaller DLOM is a common form of manipulation. If a Series A company assumes a 12-month time to exit with no specific basis for that assumption, the resulting Finnerty DLOM will be substantially lower than warranted. The IRS is aware of this technique. T assumptions must be supported by documented analysis of the company's stage, plans, and market conditions.

Applying DLOM before the allocation model rather than after is a sequencing error. The discount for lack of marketability is applied to the post-allocation common stock value -- that is, after the OPM or PWERM has been used to determine what fraction of total equity value accrues to common stockholders. Applying it to the enterprise value before allocation confuses two separate analytical steps.

Relying solely on the Finnerty DLOM model without cross-checking against empirical restricted stock data can produce DLOM conclusions that, while mathematically defensible, fall outside the range of market observations. The AICPA Practice Aid specifically encourages appraisers to consider multiple methods and document the basis for weighting.

Failing to document the methodology adequately is a compliance problem independent of whether the math is correct. Under Treasury Regulations Section 1.409A-1(b)(5)(iv), the choice of DLOM method, the specific inputs used, and the rationale for those inputs must all be documented in the written report. A DLOM figure without supporting methodology documentation does not meet the independent appraisal safe harbor standard.

Confusing DLOM with DLOC remains surprisingly common. A founder reviewing a draft 409A report should verify that the discount for lack of marketability and any discount for lack of control are being applied as separate adjustments where both are warranted -- not merged into a single combined discount that is lower than either should be on its own.