Valuing a minority interest

A minority investor in a privately held company, brings to my mind being stuck in the mud! It is likely to be a slow process finding a buyer and there is probably little they can do to influence cash flows.

Coincidentally, valuing a minority interest in a privately held company can also feel like being stuck in the mud! The valuation path is not clear. The conflicting minority interest valuation literature can bog you down.

The old story

The control premium story changed over thirty years ago, and with it the traditional path to valuing minority interests became a little muddied!

The minority interest valuation story use to go something like this...

• Research shows that in the acquisition of publicly listed companies, investors are observed paying price premiums above the pre-bid share price. The inference from this is that investors are paying a premium to take control.?
• Consequently, when valuing a minority interest a discount for lack of control needs to be deducted from a control value. The minority interest discount simply being the inverse of the control premium. Easy!

The new (ish) story

However, in Eric Nath's 1990 article Control Premiums and Minority Discounts in Private Companies, Mr Nath stated that these observed price premiums reflect either an:

• undervalued target;
• strategic value; or
• an overpayment.[1]

In other words, observed acquisition premiums in the public market appear to measure very little in the way of control.[2]

As Chris Mercer states, control is not what matters, it’s what you do with it. It's whether you can increase cash flows or reduce risk that impacts value.[3]

Mercer argues for a disappearing minority interest discount. Because minority investors in public companies have elements of control, they control when they buy and sell, they receive prorated dividends and they can expect to receive the benefits of reinvested earnings.[4]

Nath goes further and states that shareholders in public companies have full control over their investments. The control premium is a myth and so with it the minority interest discount for a shareholder in a public company.[5]

Minority interest in privately held companies

However, the similarity between a minority interest and control in a public company does not hold for a minority interest and control in a private company.

Control in a private company provides the controlling shareholder liquidity through the ability to take the business to market. The minority investor in a private company has no such option. ?

Income approach for valuing minority interests

Eric Nath advocates an income approach to value minority interests in private companies, not least because it provides a focus on the probability of future events rather than a hypothetical discount.[6]

The American Society of Appraisers Procedural Guidelines on partial ownership, set out that the income approach should include an assessment of the expected holding period, expected interim dividends and the expected terminal cash flow. The Society highlights factors to consider in relation to[7]

• cash flow - the history of dividends, expected future dividend policy, preferential claims, and possible future transactions for the business.
• required rate of return - the expected holding period, the difficulty in marketing the interest and the required rates of return on similar investments.

Factors impacting minority interests

According to Nath, in a private company the issues of control and liquidity are intertwined. Factors that impact minority interests include:

• patterns of historical liquidity in the stock;
• if there is a controlling owner how benevolent that owner is to other shareholders; and
• in the absence of a controlling owner how is control exercised.[8]

As the Procedural Guidelines highlight the level of ownership does not always indicate the degree of control. Governance documents, preference shares and other factors may confer control even if the interest is less than 50%.[9]

A 2% ownership position may be in a position of limited control if there are two other owners of 49% each and at odds with each other. The same 2% owner would be in a very different position if the other owner held 98% or if 49 owners each held 2%.[9]

Summary

Inferring minority discounts from logically flawed control premiums maybe a muddy track to navigate.

Alternatively, a simple income approach involving modelling cash flows and rates of return for the minority shareholder may provide a safer and cleaner route.

Simon Cook

Simon specialises in valuing private businesses and quantifying damages. He is a Chartered Accountant Business Valuation Specialist and Forensic Accounting Specialist with Chartered Accountants Australia and New Zealand (CA ANZ). He chairs the CA ANZ Business Valuation group for Queensland, is a member of the CA ANZ Trans-Tasman Business Valuation Committee and likes running long distances in the muddy hills!?

[1] Nath, E, Control Premiums and Minority Interest Discounts in Private Companies, Business Valuation Review, (June 1990), page 40.

[2] Nath, E, How Public Guideline Companies Represent "Control" Value for a Private Company, Business Valuation Review, (December 1997), page 169.

[3] Mercer, Z. Christopher, and Travis W. Harms. Business Valuation: An Integrated Theory, John Wiley & Sons, Incorporated 2020. Page 253.

[4] Mercer, Z. Christopher, and Travis W. Harms. Business Valuation: An Integrated Theory, John Wiley & Sons, Incorporated 2020. Page 266.

[5] Nath, E, Best practices regarding control premiums, Chartered Business Valuators, Journal of

Business Valuation, 2011, pages 27 and 28

[6] Nath, E, Directly Valuing Private Minority Interest using the Income Approach, FVLE Issue 55, July 2015.

[7] American Society of Appraisers, Procedural Guidelines, PG2 Valuation of Partial Ownership Interests, 2009, page 46.

[8] Nath, E, Control Premiums and Minority Interest Discounts in Private Companies, Business Valuation Review, (June 1990), page 45.

[9] American Society of Appraisers, Procedural Guidelines, PG2 Valuation of Partial Ownership Interests, 2009, page 44.