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The value of a minority interest in a business.

THE VALUE OF A MINORITY INTEREST IN A BUSINESS

According to the 1990 Statistical Abstract of the United States, approximately 17 million businesses exist in the U.S. They are comprised of over 3.4 million corporations, 1.7 million partnerships, and more than 12 million sole proprietorships. Furthermore, the United Shareholders Association, a group formed in 1986 to represent minority shareholders in public corporations, reports that there are approximately 47 million minority shareholders in approximately 10,000 U.S. public companies. It is logical that millions of minority shareholders also exist in closely held companies - that is, non-publicly traded companies.

What Is a Minority Interest?

A minority interest is an interest which has no meaningful control over the day-to-day operations of a business, as in the case of a minority shareholder who owns less than 51 percent of a corporation and has no input as to management's salaries or other corporate matters, including the payment of dividends. In a public corporation, the minority shareholder with free-trading stock can simply sell his stock through the appropriate exchange and receive cash for his stock based on the bid price minus commissions.

Simply put, the minority shareholder, while not having "control," does have "marketability." In a closely held situation, however, the minority shareholder often has little, if any, opportunity to attract a buyer to assume his position, which has neither control nor liquidity.

The following schematic (see table) illustrates the three basic levels of value which every businessperson should understand before investing in business. The example assumes a corporate structure with stock; this valuation principle, however, applies to other business entities such as partnerships. The schematic is an excellent tool for visualizing the relationship of minority interests to other corporate interests. Three basic levels are illustrated:

* Top level - corporate control and marketable (liquid)

* Middle level - lack of control but marketable (liquid)

* Bottom level - lack of control and lack of marketability (not liquid)

Determining Minority Interest Value

As can be seen on the "Levels of Value" table, the non-marketable minority interest (bottom level) is worth much less than the total marketable enterprise level (top level) because of control and marketability differences. To determine the proper value for the minority interest, the higher levels of value must be discounted. Since we are examining the issue of a minority interest in a closely held corporation, the first discount to be taken is the "lack of control discount." Accordingly, the second discount, known as "lack of marketability," would be taken from the already reduced value. If a controlling interest is being valued that lacks a public market, then only the "lack of marketability" discount would be applied.

For example, assume a control value of $1 million (top level) is determined for a business. Next, a lack of control (middle level) discount would be taken for valuation of a minority interest (for example, assume a 30-percent minority interest discount), reducing the value to $700,000, which is equivalent to a freely trading minority interest. Then a lack of marketability discount (bottom level) is applied (assume 40 percent), resulting in a net valuation of $420,000 ($700,000 less 40 percent). As can be seen in this example, a total discount of $580,000 ($300,000 plus $280,000), or 58 percent of the control-level value, has been applied in valuing a minority interest with no ready market.

What This Means to the Minority Investor

The minority investor who is told that he or she should invest $100,000 for a 10 percent interest in a business with a total enterprise value of $1 million should now be able to correctly negotiate from knowledge when he or she responds, "No, my investment is worth a much higher percentage of the company, since I am disadvantaged compared to the control interest because I lack control. Additionally, I also lack liquidity, and unless you can somehow remedy these missing elements of value, I must have a higher percentage of the deal."

Conversely, the unfortunate investor who invested $100,000 for 10 percent of the business in the prior example, based on a pro-rata portion of the $1 million total enterprise value, theoretically, lost a substantial portion of the investment immediately because he or she did not understand the above valuation principle.

It should be noted, however, that each situation differs, requiring detailed analysis by a valuation expert to determine the appropriate discount levels. An investor should think twice before becoming a minority shareholder (or partner) with no control or liquidity. One way to deal with this potential concern is to structure the deal to provide meaningful control and liquidity to the minority investor. This subject, however, is an entire article in itself. Remember, it is easy to get into a deal; the difficult part is getting out with your investment and a fair rate of return.

Richard Houlihan, CPA, ASA, is a principal with Houlihan Dorton Jones Nicolatus & Stuart, Inc., a member of Houlihan Valuation Advisors and a subsidiary of OTRA Securities Group.

PHOTO : Control vs. Minority Interest Value
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Houlihan, Richard
Publication:Utah Business
Date:Sep 1, 1991
Words:839
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