The benefits of possessing the controlling ownership in a business are undeniable. Decisions afforded to controlling ownership include, but are not limited to:
- Decide on levels of Officer Compensation;
- Decide with whom to do business;
- Decide whether to pay dividends;
- Make acquisitions;
- Liquidate assets;
- Determine capital expenditures;
- Change the capital structure;
- Amend articles of incorporation or bylaws;
- Sell a controlling interest;
- Select directors, officers, and employees;
- Determine company policies; and,
- Block any of the above
Quantifying the Value of a Minority Interest
When requested to ascribe a value to a minority interest the appraiser is tasked with quantifying the value for the interest’s lack of control. As typical when discussing methodologies surrounding business valuation, appraisers disagree on the most appropriate method to accomplish this.
There are two methods available to appraisers for quantifying the value of a minority ownership interest’s lack of control:
- Applying a discount for lack of control (Option A) – This method applies a numerical discount to values reached within all three approaches (Asset, Income, and Market). To reach a value under the Income and Market approach the appraiser uses “normalized” cash flows. Normalized adjustments aim to adjust cash flows to an optimal basis under the Standard of Value required. For example, one of the most common adjustments is to normalize Officer’s Compensation. The appraiser performs market research as to the fair salary an Officer should receive for their contributions to the business.
- No adjustments to cash flows (Option B) – Unlike the approach described above, an appraiser would not use “normalized” cash flows. Instead, the appraiser would make no adjustments to the cash flows under the assumption a minority interest could not influence this level of change.
The following table illustrates both approaches:
Table I:
| Option A | Option B | |
| Actual Cash Flows | $ 300,000 | $ 300,000 |
| Normalization Adjustments | 100,000 | n/a |
| Cash Flows Used | 400,000 | 300,000 |
| Times: (1 + Long-Term Growth Rate) | 103% | 103% |
| Long-Term Cash Flow | 412,000 | 309,000 |
| Capitalization Rate | 20% | 20% |
| Implied Value | 2,060,000 | 1,545,000 |
| Discount for Lack of Control | 25% | n/a |
| Non-Control Value | 1,545,000 | 1,545,000 |
| 1% Ownership Interest | 1% | 1% |
| 1% Non-Control Value | 15,450 | 15,450 |
The results illustrate both methods, under specific circumstances, could lead to the same value. Option A assumes the Officer of the company is overcompensating himself by $100,000. However, from a real-world perspective, could a minority owner force the Officer to take a salary reduction of $100,000? Although both produce the same result, the economic realities are likely that Option B is more consistent with the actual cash flows available for distribution.
The following example assumes the Officer of the company is overcompensating themselves by $200,000.
Table II:
| Option A | Option B | |
| Actual Cash Flows | $ 300,000 | $ 300,000 |
| Normalization Adjustments | 200,000 | n/a |
| Cash Flows Used | 500,000 | 300,000 |
| Times: (1 + Long-Term Growth Rate) | 103% | 103% |
| Long-Term Cash Flow | 515,000 | 309,000 |
| Capitalization Rate | 20% | 20% |
| Implied Value | 2,575,000 | 1,545,000 |
| Discount for Lack of Control | 25% | n/a |
| Non-Control Value | 1,931,250 | 1,545,000 |
| 1% Ownership Interest | 1% | 1% |
| 1% Non-Control Value | 19,313 | 15,450 |
As we see in Table II, by making normalization adjustments (Option A) that a minority owner could possibly not implement in reality, we may have overstated the minority owner’s value.
It is up to the Appraiser’s professional judgment to conclude as to which method provides a more reliable, and defensible, indication of value. Consideration should be given to the real world economic benefits the minority shareholder is expected to receive in the future. Regardless of the choice, it is important to not double count the lack of control. For example, using minority cash flows within an income approach, and applying a discount for lack of control. In our next article, we will discuss the sources of data used in estimating a discount for lack of control, and some of the issues with this data. The most appropriate method depends on the circumstances and the appraiser for your specific engagement.