DLOM and DLOC in Brazilian Shareholder Disputes

Context

Every valuation of a minority interest in a Brazilian closely held company coexists with two inevitable premises: the interest has no active secondary market, and the minority holder does not control the company's decisions. These two economic facts materialize in valuation as discount adjustments to the value proportional to economic equity: the Discount for Lack of Marketability (DLOM) and the Discount for Lack of Control (DLOC).

In shareholder disputes: partner exclusion, exercise of withdrawal rights, apportionment of equity in partial dissolution, tag-along and drag-along exercise: these discounts can shift quantification by an order of magnitude. The methodological choice is rarely trivial and almost always judicially contested.

The two discounts defined

The adjustments operate at different levels of Pratt's value hierarchy:

• DLOC (Discount for Lack of Control): downward adjustment applied when the valued interest does not hold control rights: capacity to elect management, define distribution policy, deliberate on material operations. Moves value from "controlling marketable" to "minority marketable".
• DLOM (Discount for Lack of Marketability): downward adjustment applied when the interest lacks a liquid secondary market for its disposal. Moves value from "minority marketable" to "minority non-marketable": frequently the most relevant level in typical Brazilian closely held companies.

The two discounts are additive in economic function but multiplicative in mathematical application. A typical minority interest in a closely held company accumulates both.

The Mandelbaum framework

The U.S. Tax Court decision in Mandelbaum v. Commissioner (1995) established the framework of ten qualitative factors for DLOM justification. Although originating in U.S. tax context, its adoption by international valuation practice has made it a reference also in Brazil: implicitly incorporated in arbitral reports and CVM opinions.

The ten Mandelbaum factors:

1. Prior sales history of the valued interest
2. Dividend distribution policy
3. Nature of the company, its history and position in the industry
4. Economic outlook of the company and the sector
5. Quality of management
6. Total outstanding shares or quotas and their relative size
7. Cost and probability of an eventual IPO
8. Contractual restrictions on transfer
9. Preferential rights and protections established in articles of incorporation
10. Existence of redemption rights or put options

The factors function as a justification checklist: each one increases or reduces the applicable DLOM. They are not numerical weights, but qualitative anchoring for the final range.

The Finnerty model

Purely qualitative Mandelbaum reasoning coexists with quantitative models based on option pricing. The Finnerty model (2002 and subsequent updates) is the most widely accepted in professional valuation practice. It models DLOM as the price of a put option at the arithmetic average price: economically replicating the cost of being unable to sell the interest at any time during the restriction period.

The model has three critical inputs:

• Volatility of the underlying asset: proxy via publicly traded comparables
• Expected restriction period: reasonable time until the interest can be disposed of
• Risk-free rate: equivalent-term NTN-B in the Brazilian context

Practical limitation: the Finnerty model produces a maximum DLOM of ~32.3% regardless of volatility. For very high-volatility situations: startups, distressed companies: other models (Longstaff, Chaffee) or empirical restricted stock studies are more appropriate.

Brazilian practice

Application in Brazil faces three peculiarities:

1. Limited local empirical base: the main restricted stock studies (Stout, Pluris, FMV) are American. There is no Brazilian equivalent with comparable statistical mass. Practice resorts to analogical calibration: defensible but contestable.
2. CVM position and jurisprudence: the CVM has not issued specific regulation on DLOM/DLOC. In reports for tender offers (CVM Resolution 85), usual practice avoids significant discounts, positioning value closer to "controlling marketable." In private disputes in arbitration, there is greater room for rigorous application.
3. Brazilian Corporations Law and withdrawal rights (art. 45): apportionment of equity at economic value does not require explicit DLOM, but the underlying DCF methodology may incorporate it implicitly via discount rate. Recurring methodological discussion in shareholder arbitrations.

Methodological recommendation

In valuation mandates for shareholder disputes, the defensible approach combines three layers: (i) qualitative justification by the ten Mandelbaum factors, with case-by-case evaluation of each factor in the company's context; (ii) quantitative anchoring by Finnerty or equivalent model, with volatility calibrated by market comparables and realistic restriction period; and (iii) explicit sensitivity of results to reasonable DLOM and DLOC ranges.

Methodological transparency is the primary defense asset in cross-examination: the arbitrator or judge needs to understand why the chosen number is reasonable. Black-box models or numbers without open justification do not survive contradictory proceedings.