Minority Discount Explained
In their regular corporate finance column, Les Nemethy and Sergey Glekov look at the flipside of control premium, the subject of their last article.
Our last article was on control premiums. Minority discount is basically the flipside of control premium: in the same way that a premium applies when you purchase 51% of shares that make 100% of the decisions, so too a discount applies when you purchase 49% of shares that make few or no decisions as related to the corporate governance of a company.
The fewer the rights associated with the minority stake, the higher the discount. Here we will examine some of the factors that might affect the extent of the discount.
Firstly, statutes, articles of incorporation, shareholders’ agreements or bylaws may require a supermajority to approve certain actions. For instance, in some jurisdictions, an approval of specific corporate actions such as sale of assets or liquidation of the company may require a two-thirds majority instead of a simple majority.
As a result, a shareholder with a one-third ownership interest in the company may block such actions (and hence have more value than without blocking rights, the discount depending on extent of blocking rights).
Secondly, the distribution of equity ownership has an important bearing on the relative rights of shareholders. For example, if a company is owned by three shareholders holding equity interest of 33.33% each, no one has absolute control, and no one is in a relatively inferior position to the other two.
(Neither of the three shareholders may have a control premium in such a case; if there is a pattern of two shareholders voting together, the shares of the third shareholder may, nevertheless, have a discount.)
Thirdly, variation in minority discounts may result from “differences in the extent to which the minority stockholders are economically disadvantaged”, as Philip Saunders Jr. says in “Control Premiums, Minority Discounts, and Marketability Discounts”. Basically, if a company is well run, and all shareholders receive the same pro rata returns to capital, then the minority discount will be less.
The concept of minority discount is consistent with the concepts of marketability and lack of marketability. However, it is important to distinguish between a discount for lack of ownership control (minority discount) and a discount for lack of marketability.
The concept of marketability deals with liquidity of the subject ownership interest; that is, how quickly and certainly it can be converted to cash at the owner’s discretion, as outlined by Shannon Pratt, Robert Reilly and Robert Schweihs in “Value a Business”.
A discount for a lack of marketability may be even applied to a 100% ownership interest in a closely held enterprise, as it may take months and require significant expenses and efforts to prepare and sell a 100% ownership interest.
The following chart illustrates the relationship between controlling and non-controlling ownership interest value, and marketability and lack of marketability.
The types and amounts of appropriate discounts often cause significant disputes and controversies during valuations. It would be an error to apply the above discounts too rigidly: every situation requires careful analysis of facts and considerable judgment.
Les Nemethy is CEO of Euro-Phoenix (www.europhoenix.com), a Central European corporate finance firm, author of Business Exit Planning (www.businessexitplanningbook.com) and a former president of the American Chamber of Commerce in Hungary.
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