Why Are Minority Interest Positions Discounted?

By Ray Pinard | January 25, 2018

Last month we discussed several key questions that an owner must consider when awarding or selling a minority interest in their business. Let’s assume you have agreed to move forward. You probably are wondering, “If the fair market value of 5% of my company is valued at $1,000,000, but I am receiving only a fraction of that in selling a minority position, where is the rest of my money?” This month we will discuss minority and marketability discounts and their impact on the fair market value of a minority interest.

Minority Interest (Control) Discount1

A minority interest discount is the appropriate amount to be deducted from the pro rata value of a 100% equity interest to reflect the absence of some or all of the prerogatives of control within the company. The following chart illustrates the effect the continuum of control has on the value of an enterprise:

– 100% equity ownership position
– Control interest with liquidation control
– 51% operating control
– Two equity holders, each with 50% ownership
– Minority interest, although the largest equity interest
– Minority interest with cumulative voting rights
– Pure minority interest – no control features

To determine an appropriate minority interest discount, a valuator reviews the control, or lack thereof, the minority interest has over the company’s operation. Some control factors considered include electing directors and appointing management, and the ability to set levels of management compensation and perquisites, determine cash payouts on common shares, set company policies or business course, choose investments and projects to undertake, and purchase or sell assets.

Lack of control as shown on the continuum shown above adversely affects the fair market value of the minority position. Historically, the range of discounts is 10% to 40%.

Lack of Marketability Discount

Free cash flow is the ultimate source of value to investors. If an investor owns a security that is not publicly traded and does not have a ready market for liquidity and/or the sale is restricted in any way, the security will be worth less to the investor because it most likely cannot be liquidated quickly without accepting a significant discount in price.

The chart below is useful in determining the degree of liquidity in a closely held security.

– No restrictions on sale:
– – Evidence of a market:
– – – Meaningful history of dividends
– – – No history of dividends
– – No evidence of a market:
– – – Meaningful history of dividends
– – – No history of dividends
– Restrictions on sale:
– – Evidence of a market:
– – – Meaningful history of dividends
– – – No history of dividends
– – No evidence of a market:
– – – Meaningful history of dividends
– – – No history of dividends

To determine the appropriate lack of marketability discount, certain factors of marketability, or lack thereof, are considered as to their impact on the value of the company’s stock. Some of the factors examined are:

  • Economic outlook
  • Prospect of IPO or sale of the company
  • Size, nature (voting v. non-voting) and swing value of share block
  • Entity size relative to the industry
  • Income history
  • Expectations for entity growth
  • Investor sentiment
  • Management quality/shareholder friendliness
  • Put rights/redemption policy

Numerical assessments are assigned to each factor of marketability. Discounts can range from 15 to 65%.

Example:

Value of 100% interest in the company $20,000,000
Pro-rata minority interest to be valued 5%
Pro-rata interest in dollars, before discounts 1,000,000
Minority interest (control) discount, 30% (300,000)
Sub-total 700,000
Lack of marketability (liquidity) discount, 35% (245,000)
Value of 5% interest with discount $455,000

In this instance, the party receiving the proceeds for the sale of a 5% interest will receive $455,000 pre-tax. Again, before committing to selling your stock to a minority player, or issuing new stock for purchase, you need to be fully informed of what you are getting into.

If you or someone you know is facing any of the challenges noted above and could benefit from guidance on navigating through the dreadful world of discounts, please give me a call at (603) 620-7500 or write to raypinard@monticellostrategies.com.

1 For purposes of this article, stock, membership interest, partner interest, etc. are used interchangeably. Be aware that different legal and tax rules apply for different forms of business structure.

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