Is a piece of the pie ever enough?
Forget about a minority interest in a closely held company
By Orville B. Lefko
Having a minority interest sounds like a disadvantage from the start. It
Whenever the fair market value of less than a 50 percent ownership interest
in a closely held business must be determined, the question of how much to
discount that interest from its pro-rata value arises. Innumerable articles
in professional publications, various court opinions and entire books deal
with that question. They fail to answer the more relevant question which
is, "Why would anyone any hypothetical or actual willing
buyer buy a minority interest in a closely held company?"
The truth is that most minority interests have little or no value.
Appraising a minority interest is really a problem of determining whether
it has any value at all rather than one of calculating how close to its
pro-rata value its worth might be. Nevertheless, the current procedure for
appraising a minority interest in a business is to value 100 percent of the
business and then to apply discounts to the pro-rata value of the interest
in order to arrive at its fair market value.
An appraiser of a minority interest in a closely held business will
generally apply two different discounts to that interest's pro-rata value.
They are the so-called minority discount that accounts for the lack of
control related to owning a minority interest, and the illiquidity discount
that accounts for the interest's lack of marketability.
In the past, most court decisions involving valuations of minority stock in
closely held companies have reflected lack of marketability and the
disadvantages of lack of control in one all-encompassing discount.
In Estate of Woodbury G. Andrews, 79 T,C, 938 (1982), the tax court
stated that "... two conceptually distinct discounts are involved
here, one for lack of marketability and the other for lack of control. The
minority shareholder discount is designed to reflect the decreased value of
shares that do not convey control of a closely held corporation. The lack
of marketability discount, on the other hand, is designed to reflect the
fact that there is no ready market for shares in a closely held
corporation." Even in this case, as in most earlier cases, the court
did not identify the amount of each of the two discounts.
Later court opinions that deal with minority and illiquidity discounts,
epitomized by that of the tax court in Bernard Mandelbaum et al v.
Commissioner, Tax Court Memo 1995-255, have put forth technical
procedures and check lists that business appraisers cannot ignore if they
expect their value opinions to have credibility in litigated matters. Most
recent decisions do distinguish between the minority and illiquidity
discounts. At least one book, Z. Christopher Mercer, Quantifying
Marketability Discounts (1997), is totally devoted to the subject of
discounts for lack of marketability.
Shannon Pratt, Business Valuation Discounts and Premiums (2001)
provides a detailed look at the two subjects in the book's title.
Innumerable articles that take various positions on how to calculate lack
of marketability and minority discounts have appeared in professional
publications. Annual surveys are made covering implicit discounts in the
pricing of restricted stock.
In large part, the books, the articles, the surveys and the lengthy court
decisions represent wasted effort. Their main benefit is as a source of
arguments useful in opposing appraisals that have assigned substantial
undeserved value to minority interests in businesses. These erroneous
appraisals can often be found in divorce actions, estate and gift tax cases
and stockholder disputes as well as in other litigated matters.
As stated above, the relevant question is, "Why would anyone
any hypothetical or actual willing buyer buy a minority interest
in a closely held company? Theoretical answers to that question are
1. To receive dividends but only a very small
percentage of closely held companies pay dividends, and, it is the
controlling shareholders who decide whether or not to pay a dividend and
they determine the amount if one is paid. That is true even in the
case of a so-called subchapter "S" corporation or a limited
liability company where a stockholder must include his pro-rata share of
the corporation's earnings on his personal income tax return even though he
may not have received any cash income from the corporation.
2. To benefit from the growth in value of the stock but
to realize his profit would require him to sell his interest and, by
definition, there is no active market for the stock. And, a minority
stockholder cannot force a sale or liquidation of his interest unless he
sues and succeeds in showing that the controlling shareholders are
operating the company in such a way as to benefit themselves at his
expense. Such a suit is not easily won.
He can, of course, go along for the ride with a growing company and hope to
benefit from an initial public offering (discussed below) or a sale or
merger. This requires a lot of patience and willingness to forego the
opportunity cost of whatever money he has sunk into his minority holding.
He should also be aware that the farther out into the future he must wait
to realize his gain, the less that gain is worth today. As an example, $1,
10 years hence discounted to present value at 6 percent
is worth only 56 cents today.
3. As an employee, to insure that he will continue to be employed
by the company or, as a shareholder, to arrange to hire a relative
but a minority interest's voting power cannot determine
anyone's employment status.
4. As an employee, to be paid a higher salary than a nonstockholder
employee but the holder of a minority interest does
not have the power to set salaries.
5. To be able to direct purchases, and perhaps to channel business to
another company in which he has an interest but a
minority shareholder cannot take either of these actions without the
controlling shareholders' concurrence.
6. To vote on corporate policy matters but
a holder of less than a 50 percent interest usually cannot count on
being able to influence corporate policy decisions except in those
instances where the corporate bylaws call for a 2/3 vote or more to take
certain actions. If a 2/3 vote is required, a 33.4 percent interest would
have the ability to block or prevent an action, but not to initiate one.
And, why would anyone buy the stock just for the possibility of
blocking some future action? It should, however, be noted that it is
possible for the holder of an interest of 50 percent or even less to exert
effective control over a company provided that the remaining ownership
interests are widely dispersed in smaller blocks.
7. To have the right to receive fair treatment as a minority
stockholder but she may have to resort to litigation
in which she attempts to show that she has been mistreated by the
controlling shareholder(s). This can be costly and time consuming and there
would be no assurance that she would prevail in court.
8. To gain swing vote power but this can be
done only when the company's stock ownership is distributed in a way that
makes that possible, for example, 40 percent, 40 percent and 20 percent
(the swing vote). And, even then, the shareholders holding a total
of the majority of the voting stock would have control. Only if they
disagree does the swing vote have any influence. Why would anyone look
forward to that contingency as a reason for buying the minority
To summarize, minority interests in most closely held companies have very
little fair market value. Some minority blocks of stock may have nominal
value in special circumstances but, to appraise them, normal business
valuation techniques are either inapplicable or of limited usefulness.
There should, therefore, be little need to discuss whether either a
minority discount or a lack of marketability discount should be applied to
the pro-rata value of minority stock (except, as mentioned above, when
someone such as an IRS agent or the nonearning spouse's appraiser
in a divorce action has erroneously attributed significant value
to the stock).
Common sense should dictate against the purchase of a minority interest at
any meaningful price. Some possible exceptions to this rule are discussed
below. Keep in mind, however, that the exceptions either involve linking
the minority interest to an agreement that may give it some value, or a
special situation involving the purchase or holding of the
It is possible that a binding agreement between the minority shareholders
and either the corporation itself or the controlling shareholders can
temper or eliminate some of the inherent drawbacks of minority stock. The
stock per se, however, retains its disadvantages unless the agreement is
assignable to a purchaser or transferee of the stock. It is the stock
plus the agreement that may have value, not the stock alone.
An example of an agreement that may give a minority block of stock
some value is a buy-sell agreement. A buy-sell describes the
procedure for determining the price that a shareholder, or his estate, will
be paid for his stock when one of various triggering events such as his
retirement or his death occurs. The price may be based on a multiple of
earnings, on a percentage of sales or on other figures. Often it is
specified to be the pro-rata portion of book value as determined by the
company's outside accountant.
However, regardless of the methodology selected, a price that the parties
agree is fair when they enter into the agreement may prove to be
unrealistic when a transaction is triggered. To avoid this problem, the
buy-sell may provide for a business appraiser to value the stock annually
or when a transaction occurs.
Going a step farther, it may provide for each party to have her own
appraisal performed. That can raise a new problem since two
"independent" appraisers seldom arrive at the same value for a
business interest. In fact, their values may differ widely. If that
happens, a third appraiser may be appointed to reconcile the two differing
opinions or, in effect, to arbitrate the matter.
Even after the final appraisal has been done (at no little cost for the
three appraisals), it is not uncommon for one party to feel that she cannot
live with the value result. She then brings suit to get a "fair"
buyout price. Thus it can be seen that a buy-sell agreement is not a
cure-all for the disadvantages of minority stock. Of course, absent a
buy-sell or other agreement giving the stock some value, it may be
There is one unique situation when minority stock may have considerable
value. That is when an initial public offering (IPO) seems to be imminent
and the stock's price reflects that possibility. However, making money on
an IPO is far from being a sure thing. IPOs may be withdrawn or delayed
indefinitely because of market conditions. If the IPO is not completed, the
investor may have no way of recovering his investment. He is a minority
stockholder with all of the disadvantages that are discussed above.
Even after the IPO is completed, both the "lucky" insiders and
those who buy at the market may lose money. The stock that insiders receive
is usually restricted from resale for at least a year. During that time,
the stock's price may decline to below its original offering price or even
below its cost to the insiders.
According to statistics compiled by Professor Jay R. Ritter at the
University of Florida, in Table 10 of his working paper, Some Factoids
About the 2004 IPO Market (2005), 3,490 or 56 percent of the 6,221 IPOs
that reached the market between 1980 and 2002 had lower average three-year
buy-and-hold returns than the comparable return on a CRSP (Center for
Research in Security Prices) index of Amex, Nasdaq and NYSE firms. In fact,
the average three-year buy-and-hold return for all 6,221 of the IPOs was
21.5 percent lower than the return on the CRSP index stocks.
On average, therefore, even insiders would have a difficult time beating
the market with an IPO. This is so in spite of the fact that, according to
Ritter, every category of the IPOs, classified by pre-issue sales volume,
had sizable average first-day returns.
A 50 percent or even a somewhat smaller interest may possess most of the
characteristics usually associated with a controlling interest. As
mentioned above, that occurs when the remaining ownership interests are
widely dispersed. However, that is begging the question. The fact is that a
50 percent or smaller interest needs help somebody else's vote
in order to control an enterprise. Where there are two 50 percent
interests, neither controls although each can veto proposed actions by the
other. Except for this veto power, each suffers from all of the
disadvantages of minority stock. Neither can accomplish anything without
the active cooperation or the passive compliance of the other.
An investor would be well-advised to avoid this potentially disastrous
situation. A 50 percent interest is more like a minority interest than a
controlling interest and it should be valued as such. That means that its
value is minimal to anyone except the other 50 percent interest holder or
to someone acceptable to him as a successor to the original holder.
Some readers may say that they know of a fairly large, seemingly profitable
closely held business in their geographical area to which they would gladly
pay a considerable sum for a 50 percent or even for a small minority
interest. They should examine their motives for the investment and try to
satisfy themselves that those goals are likely to be reached. Alternative
investments should be considered. The risk/reward ratio for an investment
in a minority interest can be favorable only if there is an accompanying,
legally enforceable agreement that operates to mitigate the interest's
The large volume of material available on the subject of valuing a minority
interest is misguided. It concentrates on how to determine the appropriate
discount from an interest's pro-rata value. Instead, the question that
should be addressed is whether a minority interest has any value at all.
Lefko is of counsel to The Lefko Group in Troy, Mich. His e-mail is