7 basic principles of business valuation : Principle 7Jean-Claude Desnoyers
Principle nº 7: Absent a shareholders’ or other ownership agreement, or legislation or adjudicated legislative intent that dictates otherwise, the value of a controlling interest in a business may have a greater value per share than does a minority interest in that same business when each is viewed in isolation.
The first 6 basic principles explained in the previous articles allowed the Chartered Business Valuator (CBV) to determine the total value of a business. The 7th principle, instead, revolves around the value of an individual shareholding: can the value per share be different for one shareholder or another? The answer is yes: being a majority or minority shareholder will influence the value of your shares.
The role of the CBV is also to give you information on the value of a shareholding.
Controlling interest and minority interest
We must first understand what a minority shareholding is: it is present as soon as a business belongs to two or more owners. For example, if one of the shareholders holds 60% of the shares of a business, it will be said that he has a controlling interest. The one who owns 40% will have a minority interest since he has an ownership percentage of less than 50%. As a result, his rights will be limited concerning some business-related decisions that will be listed below, resulting in a minority interest could be worth less than a majority interest.
Please note: even if a business is run by two shareholders with 50% of the shares each, their interest can be considered as a minority shareholding, since neither shareholding confers control. To determine the value of a minority interest, the CBV will take into account various parameters that will also be presented in this article. This step will allow him to calculate the minority discount, which is a downward adjustment of the value of the shares.
Things a controlling owner may be able to do that a minority cannot
There are some disadvantages to being a minority owner since majority ownership provides greater control in the business. It usually makes it possible to take a good part of the decisions, such as:
- Decide the levels of compensation for officers, directors and employees
- Decide with whom to do business and enter into binding contracts, including contracts with related parties
- Decide whether to pay dividends and, if so, how much and to whom
- Redeem outstanding stock or issue new shares
- Make acquisitions or divest subsidiaries or divisions
- Buy, sell, or mortgage any or all company assets
- Determine capital expenditures
- Sell a controlling interest in the company with or without participation by minority shareholders
- Select directors, officers and employees
- Block any of the above
Calculate the minority discount
Due to the lack of control that has just been explained, the value of a minority interest could be adjusted downward by the CBV. Here are some of the factors he will observe during his evaluation:
- Size of all the block of shares and the number of shareholders
- Family control
- Shareholders’ agreement
- Articles of incorporation and bylaws
- Shareholders’ relationships, including the intent of the various shareholders with respect to their dealings with one another vis-a-vis their shareholdings
- Agreement with Lenders
- The implication of the shareholders in the business
- Contractual arrangements
After evaluating the “en” block value of the business and observing some factors, the CBV will calculate the per-share value and then the minority discount. For example, if, as a minority shareholder, you own 40% of a business, the business has a value of $ 100,000 and the CBV judges a 20% minority discount is appropriate for your situation, it will make the following calculation: $ 100,000 x 40% = $ 40,000 x 80% (100% of the value minus 20% discount) = $ 32,000. The lower your ownership of all issued shares is in percentage, the higher the discount percentage.
Rest assured: some solutions can help avoid some of the disadvantages as a minority shareholder. The importance of having a good shareholders’ agreement, among others, should not be overlooked. Above all, this agreement can give you certain rights and prevent the controlling interest from having a monopoly on all major decisions in the business.
At the end of the day, it’s this notion of control that you need to keep in mind. Are you the shareholder who manages the business? Have you put in place a shareholders’ agreement that rebalances your role in the business? This will allow you to protect the value of your shares.
One last tip: you can, in a shareholders’ agreement, add a clause determining the price of shares, which will specify not to apply a minority discount when it is time to evaluate the per-share value of a minority ownership block. In practice, this is often forgotten.
If you need to evaluate your stake in a business or you want to have any other advice, please do not hesitate to contact me!