16 Aug The Minority Shareholder
I receive a steady stream of calls from minority shareholders who are dealing with one or more of the many struggles inherent in such positions. I also talk regularly with people about the valuation, purchase and sale of minority interests. It’s a very important and interesting topic. So, I’ve written the basic overview that I provide, and it goes like this.
The actual rights and powers of the minority shareholder are described in the documents that govern the particular organization–such as the bylaws, shareholder agreement or operating agreement. But in most cases, a majority of shares will win votes and, thereby, control the company. The controlling shareholder or shareholders have the power, then, to appoint who manages the business, and dictate how it is managed and how much the managers and employees are paid. The controlling shareholder has broad freedom to set his or her own salary and perquisites, and whether and when to distribute profits. When this is paired with the understanding that the value of an ownership interest in a business is a function of the certainty with which income will be received, the lack of control as to whether profits or cash will be returned to owners has a significant dampening affect on the value of minority interests. For this reason, minority interests in private companies typically trade at a significant discount to control positions. In fact, discounts of 40 percent to well over 50 percent are common. The discount that’s appropriate for any particular share holding depends on the particulars. Characteristics that enhance the value of minority positions include:
Dispersion of Ownership Interests: If a single shareholder owns a controlling stake, the lack of control discount placed on the minority interest will be large. If, on the other hand, there are many shareholders and none with control, any shareholder could — by aligning with other minority shareholder —garner some (or swing) control. This could be cause for a more mild minority discount.
Shareholder Agreements or Operating Agreements: If the governing documents of the organization provide meaningful rights and protections to the minority shareholder, lower discounts may be merited.
Put Options: If the company has an obligation to buy back shares under certain circumstances, this could reduce the minority discount, depending on the terms and the likelihood of occurrence.
Historical Treatment of Minority Shareholders: If shareholders historically have been treated fairly and have been paid fair value for their interests by controlling shareholders or the company, lower discounts could be merited.
Laws: Some states have stronger protections for minority shareholders. If the company is organized in a state with such protections, discounts will be lower.
Let’s say the fair market value of TMZ Company is $1,000,000 and there are 100 shares outstanding. What are 25 shares worth?
It’s a loaded question. The answer is, it depends.
If a single owner owns all 100 and wishes to sell 25, it’s unlikely a buyer could be found at any price. Not without significant protections.
But say the ownership breakdown is 35, 40 and 25, and the owner of the 25 shares wishes to sell. In most cases, the only viable buyers would be the two other shareholders. And one could argue convincingly that this 25% could be worth nearly $1,000,000. That’s right — the value of the entire company. This is because, assuming the governing docs call for majority rule, whichever current shareholder gains ownership of the additional 25% will control the company. That means, hire and fire whomever they choose and pay compensation to whomever they choose in amounts and at the time of his choosing. The shares owned by the losing bidder could be rendered nearly worthless.
In a final illustration of minority interest valuation dynamics, let’s say TMZ has 76 shareholders: 75 that own 1 share each and one that owns 25. Again, 100% ownership is worth $1,000,000. What are 25 shares worth? This case is a bit similar to the one we just discussed above, but not as extreme. Barring some very unique shareholder dynamics, one could reasonably surmise that whomever owns the 25 units could persuade an additional 26 to vote with him and they would together control the business. That puts a lot of power in the hands of the 25 unit block. Yes, but the 25 block cannot control the business on his own. He must persuade another 26 shareholders. To do so, he will need to make some promises to the 26, if not 75. So a significant amount of the value of the business would likely rest with the owner of the 25 block, but not anywhere near the “approaching $1,000,000” as in the earlier example.
To be sure, most of the value of the typical private company is in the first 50.01 percent interest, assuming the governing documents call for majority rule. To the extent a minority interest can expect to receive income in the future, the anticipated future income can be valued as described in this publication.
If you are a minority shareholder, don’t feel helpless. You do have rights. Investigate the laws in your state and your rights under the documents that govern the management of your company. Know your rights and exercise them to garner the most for your ownership.