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In determining the fair market value of an interest in a company, not all classes of shares are created equal, nor are all sizes of shareholdings in that company. Once you've arrived at an estimated fair market value of the company, there are many factors that may or may not affect what portion of that value is attributed to the shares held by you, or your client. We're often asked to explain the nature of what is perhaps the most widely recognized of these adjustments, the minority discount.
An example helps to illustrate the concept. Assume that two individuals own a company, Maggie owns 60%, while Leslie owns the remaining 40%. Also assume the company is worth $1,000,000. We refer to this amount, the fair market value of all of the issued and outstanding shares, considered together, as the En Bloc value of the Company. The pro-rata value of Maggie's interest is $600,000, and Leslie's is $400,000, which seems intuitive. However, while the fair market value of Maggie's shares are equal to their pro-rata value, the fair market value of Leslie shares are often worth something less then $400,000. The difference between the pro-rata value of Leslie's shares, and their fair market value, is the minority discount. It reflects the fact that, due to her minority position, Leslie is unable to elect a majority to the board of directors, to determine the nature, quantum and timing of the return on her investment (such as the declaration of a dividend), to meaningfully impact the direction of the company, and a host of other aspects that can be directed by a controlling shareholder.
In the public markets, the existence of a minority discount is demonstrated in most corporate take-over bids. In press releases announcing the offer, it is often said that the bid represents a xx% premium over the target company's closing price at an earlier date. This premium is arguably just a reversal of the minority discount that is inherent in the quoted stock price of all publicly traded enterprises, as these prices reflect minority positions.
There is considerable literature with respect to quantifying the minority discount, and there are established ranges which are often quoted when debating the matter. Many court cases have found the minority discount in a certain situation to fall within these ranges, and there are just as many that find it to be outside, on one side or the other. The right answer may different each time, and while these established ranges and precedents are important considerations, the right answer is primarily dependant on the facts that are specific to the circumstance. This of course leads to a wide range of interpretation, differing opinions, and can become a major hurdle in resolving disputes between shareholders.
Thankfully, in the world of private companies, many shareholder agreements already contain direction on how the issue is to be handled. Most commonly, the agreement will dictate that transactions between shareholders are to occur at fair market value, without giving consideration to (among other things) a minority discount. Called pro-rata value above, it is also referred to using the term fair value. Does your shareholders agreement contain a similar provision? Do you recommend that your clients put some verbiage around the matter when drafting an agreement for them?
It is worth noting that, under the Canada Business Corporations act, since all holders of the same class of shares are treated equally on the wind-up and dissolution of a company, a minority discount is generally not appropriate in those situations.
For more information please feel free to contact myself or your local MNP advisor.
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