While valuing partial interests in a private company, the standard of value that is adopted will have an impact on the value of the minority interest.
By Douglas Craig, Financial Consultant
The value of a partial interest in a private company requires special attention. Take for example a company that has 2 owners. The first owner holds 80% of the company and the second owner holds 20%.
The first owner has legal control of the company and in valuation terms has a ‘controlling’ interest. The second owner’s 20% interest does not have legal control and is referred to as a ‘minority’ interest.
If this hypothetical company had an overall value of $1 million, the controlling shareholder with the 80% interest would have a value of $800,000 based on the proportionate or ‘pro rata’ value. There can be rare cases where the controlling shareholder’s value could be greater or less than pro rata value but in most cases a pro rata allocation of total value for the controlling shareholder is appropriate.
Standard of Valuing Partial Interests in a Private Company
For family law purposes, the definition or standard of value that is adopted will have an impact on the value of the minority interest. The Family Law Act in Ontario does not specify a definition of value for use in business valuations. ‘Fair market value’ is most commonly used in business valuations in the family law context since fair market value has been accepted by Canadian Courts.
If ‘fair market value’ is adopted as the definition of value, the fair market value of the minority interest may be less than the pro rata value calculation. In the above example, the fair market value of the minority interest may be less than $200,000 (which is the 20% pro rata share applicable to the 20% minority interest). This is generally due to the fact that the minority shareholder does not have the same rights as the controlling shareholder in governing the direction of the company and in realizing a return on investment.
The fair market value of the minority interest is dependent on the facts of the situation and other guidelines including:
- By the way, control is determined for the subject company. Corporate legislation governing the company, the company’s incorporating articles and bylaws, and voting agreements can all specify how control is determined.
- By the size and makeup of the shareholdings. In the situation where there are three shareholders each holding a 1/3 interest in the company, each shareholder has a minority interest. However, if two of these shareholders are related, these two shareholders would be assumed to hold family control. Even if two shareholders are not related, together they could outvote the third shareholder. This is referred to as ‘group control’.
- If a shareholders’ agreement is in place. A shareholders’ agreement can specify (a) how control of the company is determined, (b) the sale of the company, (c) transfers of shares by existing shareholders or to outsiders, and (d) how value is determined for certain triggering events such as the death or disability of a shareholder.
- Whether a shareholding has a ‘nuisance value’. A shareholder with a small shareholding relative to the other shareholders could create difficulties in the company by disagreeing with corporate planning or by initiating a legal action against the company or its controlling shareholder. Also, a minority shareholder could attempt to block a takeover bid by a purchaser that was looking to acquire 100% of the company.
- Whether there is a market for minority shareholdings. It is usually rare, though, for an organized market to exist for private company shares.
Discount from Pro Rata Value to Determine Fair Market Value
If a particular shareholding is a minority interest, a discount from pro rata value is usually applied in determining its fair market value (the ‘minority discount’). The quantum of the minority discount typically reflects the severity of the restrictions and/or limitations affecting the minority interest.
The minority discount, especially in Canada, typically includes the lack of marketability (or ‘liquidity’) for the shares of a minority shareholder. In the US, valuators often provide a separate discount for both the lack of control by a minority interest and for the lack of marketability. Although it’s not entirely clear, the difference in approach may be due to the available research and studies undertaken on marketability discounts in the US.
The selection of the minority discount is very subjective and will depend on the facts of the particular situation and the professional judgment of the valuator. If the valuation is for litigation purposes, the valuators will make recommendations in their reports regarding the application of a minority discount. Ultimately, though, the court will decide on the applicability and quantum of the minority discount.
The minority discount can range from 5% to as much as 50%. Based on the above example, if a hypothetical minority discount of 25% is applied to the pro rata share applied to the minority shareholder’s 20% interest of $200,000, the fair market value of the minority interest would be $150,000.
With the increasing use of mediation, arbitration and collaborative approaches to family law matters, in my view, consideration should be given to a standard of value that provides the fairest and most equitable value to the shareholder in the particular set of circumstances. In these situations, ‘fair market value’ may or may not be the fairest or most equitable standard of value to apply to a minority interest. Other standards of value, such as ‘fair value’, could be considered if the omission of a minority discount provides a fairer settlement.
Douglas Craig, CPA, CA, CBV, is the founder and President of Equity Trends Inc, a business valuation and financial consulting services firm in Toronto.