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In part I of this series on ownership valuation, we discussed the premium that an appraiser might add for a controlling ownership interest. In this article, we discuss two of the main discounts – minority ownership interests and lack of marketability.
If given for the former, minority ownership, a valuation discount is given for reasons that are the opposite of the reasons a premium is paid for controlling ownership. While a minority shareholder or LLC member can participate in electing the board of directors or managers, without a controlling interest, the minority owner cannot elect the majority of directors/manages. As such, the minority owner cannot change the direction of the business, declare dividends, have himself or herself hired as Chief Executive Officer, etc. This is particularly problematic for closely held corporations and the discount ranges from 10% to 50% in typical valuations
The second discount, lack of marketability, also applies to closely-held corporations. Another term for “marketability” is “salability,” both of which are a function of demand. If there is a high demand for something — concert tickets, for example — the sellers can raise the price. A limited supply results in a higher price. With closely-held corporations, the demand for the stock is low. This directly creates lack of marketability. This problem is amplified when the owner is selling less than a controlling interest in the company. That is, minority ownership interests are even less salable.
There may be additional reasons for the lack of marketability various features in the articles of incorporation, bylaws and/or in any ownership agreement. Sometimes, the founders of a company actually want to prevent the marketability of their stock. Thus, they add clauses requiring a waiting periods, rights of first refusal, arbitration clauses, and other provisions which raise “red flags” for any potential third-party buyer. For these types of minority interest owners, the true “market” for their ownership interest is the other owners. As such, they often must await action by the controlling owners. Where the demand is artificially dampened in this manner, the discount is increased for both minority ownership and for lack of marketability.
In general, ownership appraisers will provide both discounts when valuing a minority-stake. Often, the discount is compounded. Thus, the minority discount — say 20% — is taken and, then, from that already-lowered value, a second discount — say 30% — is taken for the lack of marketability. For a quick example, assume the total value of the minority interest is $100,000 (based on the fair market value of the business times the percent owned by the minority shareholder). The appraiser would discount that total value by 20% — down to $80,000 — and then take an additional 30% off of that amount ($24,000) — ending up with a value of $56,000 based on having a minority interest and lack of marketability.
With respect to publicly-held corporation, every share sold/traded is considered a “minority” share so the lack of control is a non-factor. Further, since there is a ready market for the shares, there is no discount for lack of marketability.
Contact San Diego Corporate Law
For more information, contact attorney Michael Leonard of San Diego Corporate Law. Mr. Leonard was recently named as “Best of the Bar” by the San Diego Business Journal for 2018 and for the previous three years. Mr. Leonard provides a full array of legal services for San Diego businesses including contract review and drafting, mergers and acquisitions, corporate formations, private placement memorandums, and employment-related services like crafting employee handbooks. Mr. Leonard can be reached at (858) 483-9200 or via email.