Beware The Closely Held Minority Interest

Wednesday, January 25, 2006

Orville Lefko, Business Law Today, http://

Beware The Closely Held Minority Interest
Abstracted from: Is A Piece Of The Pie Ever Enough?
By: Orville Lefko Lefko Group, Troy, MI
Business Law Today - Vol. 15, No. 2, Pgs. 28-31

It's the runt of the litter.
Although a minority interest in a closely held company usually has little or no real value, the currently accepted method for appraising one is to apply two discounts to its pro rata share of the company's total fair market value: the minority discount, which reflects the absence of control, and the illiquidity discount, which reflects the inability to sell. The long judicial opinions (concerning, for example, divorces, estate and gift taxes, and clashes among shareholders), countless articles, and numerous books that try to calculate these discounts are largely wasted efforts. Their chief benefit is to counter appraisals that mistakenly assigned significant values to a minority interest. According to CPA and financial analyst Orville Lefko, the important question to ask is this: Why would anyone willingly purchase a minority share?

These dogs won't hunt.
Every answer to this question is refutable, the author argues. Perhaps a purchaser seek dividends; but a closely held company rarely declares them, and then only when the controlling shareholders decide to do so. Perhaps the purchaser seeks stock appreciation, but that can be realized only by selling stock ­for which no active market exists. A lawsuit brought to force controlling shareholders to purchase the stock, by alleging that they operate the company for their own benefit, seldom succeeds. Perhaps a company employee buys a minority interest to ensure continued employment or a higher salary, or a buyer hopes to steer the company's business in a self-interested direction; however, a minority holder lacks the power to bring about the desired results. Power over company policy would come only if no single holder already had control (for example, if two other feuding holders each had a 40% interest), and the power would be only that of a swing voter.

Don't count your chickens.
In certain instances, a minority interest might have real value. A buy/sell agreement with the company or the controlling shareholders could specify that, upon retirement or death, the minority holder is bought out based upon a multiple of earnings, a percentage of sales, or the holder's pro rata share of book value as calculated by the outside accountant. Nevertheless, a buy/sell agreement is no panacea, since a price that is fair at signing could be unfairly low at buyout time. The agreement might anticipate this problem by providing for each side to retain an independent appraiser, but if the result is two widely differing valuations, a third appraiser might have to resolve the dispute, after which the dissatisfied minority holder could still sue for a higher price. An impending IPO could also make a minority holding valuable, the author suggests, although market conditions might necessitate canceling or indefinitely postponing the offering. As an insider, the minority holder could suffer a loss even after a completed IPO. Insiders must usually keep their shares for at least one year, during which the price could fall below the minority holder's cost.

Abstracted from Business Law Today, published by American Bar Association,
Section of Business Law, 321 N. Clark Street, Chicago, IL 60610.

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