IPO · 2025-12-19

Liquidity Discount in Pre-IPO Valuation: Quantifying the Lack of Marketability

The Hong Kong Stock Exchange (HKEX) recorded 71 new listings in 2025, raising a combined HKD 87.6 billion, a 62% increase in funds raised year-on-year, per HKEX data published in its December 2025 Market Statistics report. This surge in primary market activity, driven largely by a pipeline of A-share companies seeking H-share listings and a recovery in GEM IPOs, has intensified a perennial valuation dispute between issuers and pre-IPO investors: the quantification of the liquidity discount. For CFOs pricing a pre-IPO round or family offices underwriting a cornerstone investment, the lack of marketability discount (DLOM) is no longer a theoretical accounting footnote. The SFC’s 2024 revised Code of Conduct for sponsors explicitly requires sponsors to justify valuation assumptions in listing applications, including the discount applied for illiquidity. With a growing number of pre-IPO transactions structured via convertible bonds (CBs) and private placements in BVI or Cayman holding vehicles, a defensible, data-driven DLOM methodology is now a prerequisite for both regulatory approval and fair pricing. This article dissects the quantitative frameworks used by Hong Kong market practitioners—from restricted stock studies to IPO discount analysis—to isolate the pure illiquidity penalty from other valuation factors.

The Regulatory Imperative for Quantified Discounts

The SFC’s heightened scrutiny of sponsor work has made the DLOM a critical line item in listing due diligence. Under paragraph 17 of the SFC’s Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (2024 edition), sponsors must ensure that all material assumptions in a valuation report are reasonable and adequately supported. This directly applies to the DLOM applied in pre-IPO valuations, where a blanket 20-30% discount is no longer acceptable without empirical backing.

The sponsor’s obligation extends to verifying the basis of any discount applied to a pre-IPO transaction price. In practice, the HKEX Listing Division has issued comment letters requesting detailed breakdowns of how a DLOM was derived, particularly when the pre-IPO valuation differs materially from the implied IPO price range. For instance, a 2025 listing application for a biotech company on the Main Board was required to provide a restricted stock study (RSS) of comparable US-listed Hong Kong biotech firms to justify its 25% DLOM, rather than relying on a generic industry average. This regulatory pressure has shifted the burden of proof from the valuer to the sponsor, who must now document the methodology in the sponsor’s due diligence report.

The 2024 Code of Conduct Amendments

The 2024 amendments to the SFC Code of Conduct introduced a new requirement under paragraph 16.3, mandating that sponsors disclose the key assumptions used in any valuation model commissioned for the listing. For pre-IPO rounds, this includes the discount for lack of marketability. Failure to provide a robust quantitative analysis—such as a benchmarked average of DLOMs from recent comparable transactions—can result in the SFC requesting a supplementary valuation report, delaying the listing timetable by 6-8 weeks. Market participants report that the average time for SFC to clear valuation-related queries increased from 14 days in 2023 to 22 days in 2025 for applications involving significant illiquidity discounts.

Quantitative Methodologies for DLOM Estimation

Three primary methodologies dominate Hong Kong market practice for quantifying the DLOM in pre-IPO valuations: the Restricted Stock Study (RSS), the IPO Discount Study, and the Option Pricing Model (OPM) approach. Each yields a different range depending on the company’s size, sector, and the specific terms of the pre-IPO instrument (common equity vs. CB vs. preference shares).

Restricted Stock Study (RSS)

The RSS compares the price of privately placed restricted stock to the publicly traded price of the same issuer’s common stock, isolating the illiquidity penalty. For Hong Kong-listed companies, a 2025 analysis of 28 restricted stock placements on the Main Board between 2020 and 2024 showed a median discount of 18.3% (range: 12.1% to 31.7%), per data compiled from HKEX filings. This study, conducted by a Big Four valuation firm for a recent pre-IPO engagement, controlled for factors such as dividend yield, volatility, and lock-up periods. The key limitation for pre-IPO valuation is that the target company is not yet public, so the RSS must use a proxy sample of comparable listed firms with similar market capitalisation (HKD 500 million to HKD 5 billion) and industry exposure (e.g., healthcare, technology). For a pre-IPO company in the TMT sector, the median discount from the RSS was 21.4%, reflecting higher volatility and lower dividend yields.

IPO Discount Study

The IPO Discount Study measures the difference between the pre-IPO transaction price and the IPO offer price for the same company, adjusted for market movements and time decay. A 2025 study of 42 Hong Kong IPOs on the Main Board that had a pre-IPO round within 12 months of listing found an average discount of 15.7% (median: 14.2%). However, this figure is contaminated by non-liquidity factors, including the IPO discount (the intentional underpricing to ensure a successful float) and the time value of money. When isolating the pure illiquidity component—by subtracting the average IPO first-day pop of 8.2% (HKEX 2025 data) and the risk-free rate over the holding period—the implied DLOM narrows to 7.5% to 11.0%. This methodology is most defensible when the pre-IPO round and the IPO occur within 6 months, minimising time-value distortions. For example, a 2025 listing of a consumer goods company saw its pre-IPO CB conversion price set at a 12.3% discount to the IPO price, of which 4.8% was attributable to the CB’s conversion premium, leaving a net DLOM of 7.5%.

Option Pricing Model (OPM) Approach

The OPM approach treats illiquidity as an option to delay sale, using the Black-Scholes or binomial framework to estimate the cost of being unable to trade. The model inputs include the stock’s volatility (often proxied by the volatility of comparable listed firms), the expected time to liquidity (the estimated time to IPO or a liquidity event), and the risk-free rate. For a typical pre-IPO company targeting a listing within 18 months, with a volatility of 45% (common for healthcare firms), the OPM yields a DLOM of 22% to 28%. This is higher than the RSS or IPO study because it assumes the investor cannot hedge the position. The OPM is preferred by family offices and hedge funds structuring pre-IPO investments because it allows sensitivity analysis: a 6-month delay in the IPO timeline increases the DLOM by 3-4 percentage points, directly impacting the negotiated conversion price of a CB.

Sector-Specific DLOM Benchmarks in the 2025 Market

The DLOM is not uniform across sectors. Data from 2025 pre-IPO rounds in Hong Kong shows significant variation based on industry, company size, and the type of security issued.

Technology and Biotech: Higher Volatility, Higher Discount

Pre-IPO rounds for biotech and technology firms under Chapter 18C of the HKEX Listing Rules (specialist technology companies) command a higher DLOM due to their negative cash flows and binary outcomes. A 2025 analysis of 15 pre-IPO rounds for 18C companies showed a median DLOM of 27.5% (range: 22.0% to 34.0%), using a combination of RSS and OPM methodologies. The higher discount reflects the longer expected time to profitability and the greater uncertainty around regulatory approval for biotech products. For example, a pre-IPO CB issued by a gene therapy company in Q1 2025 carried a conversion discount of 30% to the anticipated IPO price, of which 26% was attributed to illiquidity and 4% to the CB’s structural subordination.

Consumer and Industrial: Lower Discounts

For traditional consumer goods and industrial companies with positive EBITDA and a clear path to listing, the DLOM is lower. A 2025 study of 12 pre-IPO placements for Main Board applicants in these sectors found a median DLOM of 13.5% (range: 10.0% to 18.0%). These companies often have lower volatility (30-35%) and shorter expected listing timelines (9-12 months), reducing the OPM-derived discount. The IPO Discount Study for this group showed an average DLOM of 10.2%, after controlling for first-day pop. This data is critical for CFOs negotiating with cornerstone investors: a 13.5% DLOM versus a 27.5% DLOM changes the implied pre-money valuation by 14-20 percentage points.

Practical Application in Pre-IPO Deal Structuring

The quantification of DLOM directly informs the pricing of pre-IPO instruments, particularly convertible bonds and preference shares. The discount applied must be defensible to both the investor and the regulator.

Structuring Convertible Bonds (CBs)

In a typical pre-IPO CB issued by a Cayman-incorporated holding company for a Hong Kong listing, the conversion price is set at a discount to the IPO offer price. The discount comprises two components: the DLOM and the conversion premium (the investor’s compensation for converting equity risk into debt-like risk). A 2025 deal for a fintech company set the conversion price at a 20% discount to the expected IPO price. The DLOM was quantified at 14% using the OPM approach (18-month horizon, 50% volatility), and the remaining 6% was the conversion premium. The CB’s prospectus for the HKEX listing included a detailed valuation report explaining this breakdown, satisfying the SFC’s requirement under paragraph 16.3 of the Code of Conduct.

For pre-IPO preference shares with mandatory conversion upon listing, the DLOM is a key input to the liquidation preference calculation. A 2025 GEM listing saw a Series B preference round priced at a 22% discount to the IPO price, with a 17% DLOM derived from an RSS of comparable GEM-listed firms. The remaining 5% was attributed to the preference shares’ seniority in liquidation. The SFC’s review of the valuation report focused on the comparability of the RSS sample, requiring the sponsor to demonstrate that the selected firms had similar trading volumes and bid-ask spreads to the expected liquidity profile of the target company.

Actionable Takeaways for Pre-IPO Practitioners

Adopt a multi-method approach: Use at least two of the three primary methodologies (RSS, IPO Discount Study, OPM) to triangulate the DLOM, as a single method can be challenged by the SFC under the 2024 Code of Conduct.
Benchmark against sector-specific data: Reference the 2025 HKEX data showing a 13.5% median DLOM for consumer/industrial and 27.5% for biotech/18C companies to anchor negotiations with pre-IPO investors.
Document the sponsor’s justification explicitly: Ensure the sponsor’s due diligence report includes a dedicated section on the DLOM, citing the specific methodology, sample size, and adjustments made, to avoid SFC comment letters that delay the listing timetable.
Sensitivity-test the IPO timeline: For CB structures, model the DLOM impact of a 3-month, 6-month, and 12-month delay in the IPO, as a 6-month delay increases the OPM-derived discount by 3-4 percentage points.
Differentiate DLOM from other discounts: Clearly separate the illiquidity discount from the conversion premium in CBs or the liquidation preference in preference shares, as the SFC will require a line-by-line breakdown of all valuation assumptions.