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Volume 15, Number 2 November/December 2005
Is a piece of the pie ever enough?
Forget about a minority interest in a closely held company
By Orville B. Lefko
Having a minority interest sounds like a disadvantage from the start. It is.
Whenever the fair market value of less than a 50 percent ownership interest in a
closely held business must be determined, the question of how much to discount
that interest from its pro-rata value arises. Innumerable articles in professional
publications, various court opinions and entire books deal with that question. They
fail to answer the more relevant question which is, "Why would anyone — any
hypothetical or actual willing buyer — buy a minority interest in a closely held
company?"
The truth is that most minority interests have little or no value. Appraising a
minority interest is really a problem of determining whether it has any value at all
rather than one of calculating how close to its pro-rata value its worth might be.
Nevertheless, the current procedure for appraising a minority interest in a
business is to value 100 percent of the business and then to apply discounts to
the pro-rata value of the interest in order to arrive at its fair market value.
An appraiser of a minority interest in a closely held business will generally apply
two different discounts to that interest's pro-rata value. They are the so-called
minority discount that accounts for the lack of control related to owning a
minority interest, and the illiquidity discount that accounts for the interest's lack
of marketability.
In the past, most court decisions involving valuations of minority stock in closely
held companies have reflected lack of marketability and the disadvantages of lack
CALENDAR
of control in one all-encompassing discount.
In Estate of Woodbury G. Andrews, 79 T,C, 938 (1982), the tax court stated that
"... two conceptually distinct discounts are involved here, one for lack of
marketability and the other for lack of control. The minority shareholder discount
is designed to reflect the decreased value of shares that do not convey control of
a closely held corporation. The lack of marketability discount, on the other hand,
is designed to reflect the fact that there is no ready market for shares in a closely
held corporation." Even in this case, as in most earlier cases, the court did not
identify the amount of each of the two discounts.
Later court opinions that deal with minority and illiquidity discounts, epitomized
by that of the tax court in Bernard Mandelbaum et al v. Commissioner, Tax Court
Memo 1995-255, have put forth technical procedures and check lists that business
appraisers cannot ignore if they expect their value opinions to have credibility in
litigated matters. Most recent decisions do distinguish between the minority and
illiquidity discounts. At least one book, Z. Christopher Mercer, Quantifying
Marketability Discounts (1997), is totally devoted to the subject of discounts for
lack of marketability.
Shannon Pratt, Business Valuation Discounts and Premiums (2001) provides a
detailed look at the two subjects in the book's title. Innumerable articles that take
various positions on how to calculate lack of marketability and minority discounts
have appeared in professional publications. Annual surveys are made covering
implicit discounts in the pricing of restricted stock.
In large part, the books, the articles, the surveys and the lengthy court decisions
represent wasted effort. Their main benefit is as a source of arguments useful in
opposing appraisals that have assigned substantial undeserved value to minority
interests in businesses. These erroneous appraisals can often be found in divorce
actions, estate and gift tax cases and stockholder disputes as well as in other
litigated matters.
As stated above, the relevant question is, "Why would anyone — any hypothetical
or actual willing buyer — buy a minority interest in a closely held company?
Theoretical answers to that question are discussed below.
1. To receive dividends —but — only a very small percentage of closely held
companies pay dividends, and, it is the controlling shareholders who decide
whether or not to pay a dividend and they determine the amount if one is paid.
That is true even in the case of a so-called subchapter "S" corporation or a limited
liability company where a stockholder must include his pro-rata share of the
corporation's earnings on his personal income tax return even though he may not
have received any cash income from the corporation.
2. To benefit from the growth in value of the stock — but — to realize his profit
would require him to sell his interest and, by definition, there is no active market
for the stock. And, a minority stockholder cannot force a sale or liquidation of his
interest unless he sues and succeeds in showing that the controlling shareholders
are operating the company in such a way as to benefit themselves at his expense.
Such a suit is not easily won.
He can, of course, go along for the ride with a growing company and hope to
benefit from an initial public offering (discussed below) or a sale or merger. This
requires a lot of patience and willingness to forego the opportunity cost of
whatever money he has sunk into his minority holding. He should also be aware
that the farther out into the future he must wait to realize his gain, the less that
gain is worth today. As an example, $1, 10 years hence — discounted to present
value at 6 percent — is worth only 56 cents today.
3. As an employee, to insure that he will continue to be employed by the company
or, as a shareholder, to arrange to hire a relative — but — a minority interest's
voting power cannot determine anyone's employment status.
4. As an employee, to be paid a higher salary than a nonstockholder employee —
but — the holder of a minority interest does not have the power to set salaries.
5. To be able to direct purchases, and perhaps to channel business to another
company in which he has an interest — but — a minority shareholder cannot take
either of these actions without the controlling shareholders' concurrence.
6. To vote on corporate policy matters — but — a holder of less than a 50 percent
interest usually cannot count on being able to influence corporate policy decisions
except in those instances where the corporate bylaws call for a 2/3 vote or more
to take certain actions. If a 2/3 vote is required, a 33.4 percent interest would
have the ability to block or prevent an action, but not to initiate one. And, why
would anyone buy the stock just for the possibility of blocking some future action?
It should, however, be noted that it is possible for the holder of an interest of 50
percent or even less to exert effective control over a company provided that the
remaining ownership interests are widely dispersed in smaller blocks.
7. To have the right to receive fair treatment as a minority stockholder — but —
she may have to resort to litigation in which she attempts to show that she has
been mistreated by the controlling shareholder(s). This can be costly and time
consuming and there would be no assurance that she would prevail in court.
8. To gain swing vote power — but — this can be done only when the company's
stock ownership is distributed in a way that makes that possible, for example, 40
percent, 40 percent and 20 percent (the swing vote). And, even then, the
shareholders holding a total of the majority of the voting stock would have
control. Only if they disagree does the swing vote have any influence. Why would
anyone look forward to that contingency as a reason for buying the minority
stock?
To summarize, minority interests in most closely held companies have very little
fair market value. Some minority blocks of stock may have nominal value in
special circumstances but, to appraise them, normal business valuation
techniques are either inapplicable or of limited usefulness. There should,
therefore, be little need to discuss whether either a minority discount or a lack of
marketability discount should be applied to the pro-rata value of minority stock
(except, as mentioned above, when someone — such as an IRS agent or the
nonearning spouse's appraiser in a divorce action — has erroneously attributed
significant value to the stock).
Common sense should dictate against the purchase of a minority interest at any
meaningful price. Some possible exceptions to this rule are discussed below. Keep
in mind, however, that the exceptions either involve linking the minority interest
to an agreement that may give it some value, or a special situation involving the
purchase or holding of the interest.
It is possible that a binding agreement between the minority shareholders and
either the corporation itself or the controlling shareholders can temper or
eliminate some of the inherent drawbacks of minority stock. The stock per se,
however, retains its disadvantages unless the agreement is assignable to a
purchaser or transferee of the stock. It is the stock plus the agreement that may
have value, not the stock alone.
An example of an agreement that may give a minority block of stock some value
is a buy-sell agreement. A buy-sell describes the procedure for determining the
price that a shareholder, or his estate, will be paid for his stock when one of
various triggering events such as his retirement or his death occurs. The price
may be based on a multiple of earnings, on a percentage of sales or on other
figures. Often it is specified to be the pro-rata portion of book value as
determined by the company's outside accountant.
However, regardless of the methodology selected, a price that the parties agree is
fair when they enter into the agreement may prove to be unrealistic when a
transaction is triggered. To avoid this problem, the buy-sell may provide for a
business appraiser to value the stock annually or when a transaction occurs.
Going a step farther, it may provide for each party to have her own appraisal
performed. That can raise a new problem since two "independent" appraisers
seldom arrive at the same value for a business interest. In fact, their values may
differ widely. If that happens, a third appraiser may be appointed to reconcile the
two differing opinions or, in effect, to arbitrate the matter.
Even after the final appraisal has been done (at no little cost for the three
appraisals), it is not uncommon for one party to feel that she cannot live with the
value result. She then brings suit to get a "fair" buyout price. Thus it can be seen
that a buy-sell agreement is not a cure-all for the disadvantages of minority
stock. Of course, absent a buy-sell or other agreement giving the stock some
value, it may be virtually worthless.
There is one unique situation when minority stock may have considerable value.
That is when an initial public offering (IPO) seems to be imminent and the stock's
price reflects that possibility. However, making money on an IPO is far from being
a sure thing. IPOs may be withdrawn or delayed indefinitely because of market
conditions. If the IPO is not completed, the investor may have no way of
recovering his investment. He is a minority stockholder with all of the
disadvantages that are discussed above.
Even after the IPO is completed, both the "lucky" insiders and those who buy at
the market may lose money. The stock that insiders receive is usually restricted
from resale for at least a year. During that time, the stock's price may decline to
below its original offering price or even below its cost to the insiders.
According to statistics compiled by Professor Jay R. Ritter at the University of
Florida, in Table 10 of his working paper, Some Factoids About the 2004 IPO
Market (2005), 3,490 or 56 percent of the 6,221 IPOs that reached the market
between 1980 and 2002 had lower average three-year buy-and-hold returns than
the comparable return on a CRSP (Center for Research in Security Prices) index of
Amex, Nasdaq and NYSE firms. In fact, the average three-year buy-and-hold
return for all 6,221 of the IPOs was 21.5 percent lower than the return on the
CRSP index stocks.
On average, therefore, even insiders would have a difficult time beating the
market with an IPO. This is so in spite of the fact that, according to Ritter, every
category of the IPOs, classified by pre-issue sales volume, had sizable average
first-day returns.
A 50 percent or even a somewhat smaller interest may possess most of the
characteristics usually associated with a controlling interest. As mentioned above,
that occurs when the remaining ownership interests are widely dispersed.
However, that is begging the question. The fact is that a 50 percent or smaller
interest needs help — somebody else's vote — in order to control an enterprise.
Where there are two 50 percent interests, neither controls although each can veto
proposed actions by the other. Except for this veto power, each suffers from all of
the disadvantages of minority stock. Neither can accomplish anything without the
active cooperation or the passive compliance of the other.
An investor would be well-advised to avoid this potentially disastrous situation. A
50 percent interest is more like a minority interest than a controlling interest and
it should be valued as such. That means that its value is minimal to anyone
except the other 50 percent interest holder or to someone acceptable to him as a
successor to the original holder.
Some readers may say that they know of a fairly large, seemingly profitable
closely held business in their geographical area to which they would gladly pay a
considerable sum for a 50 percent or even for a small minority interest. They
should examine their motives for the investment and try to satisfy themselves
that those goals are likely to be reached. Alternative investments should be
considered. The risk/reward ratio for an investment in a minority interest can be
favorable only if there is an accompanying, legally enforceable agreement that
operates to mitigate the interest's inherent disadvantages.
The large volume of material available on the subject of valuing a minority
interest is misguided. It concentrates on how to determine the appropriate
discount from an interest's pro-rata value. Instead, the question that should be
addressed is whether a minority interest has any value at all.
Lefko is of counsel to The Lefko Group in Troy, Mich. His e-mail is
[email protected].
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