Valuation of Partial Interests

Influenced by a shareholders' agreement

A well drafted shareholders' agreement is a key document in private companies. It is a contractual agreement between the shareholders as to how they will conduct the affairs of the company and govern themselves in normal and abnormal times.

Value Tip: If you don't want the Courts to sort out your internal problems for you, make sure you have a sound, well drafted shareholders' agreement.

In particular, the shareholders' agreement should set out the ground rules in situations where shareholders want to or need to sell their shares. Corporate divorces can be as acrimonious and as unsettling as marital break-ups. A shareholder /employee dies or is terminated for fraudulent activities. What happens to the shares and at what price should be governed the shareholders' agreement making for a relatively cleaner and quicker settlement. Pricing of the shares is often done by formula, can be performed by a specified party or can be derived at regular intervals to apply for a set future period, by mutual written agreement.

James and Bob, the sales and finance managers respectively, each held 5% of the shares of a private company. Over the years the business prospered, due principally to their efforts and not those of the 90% shareholder.  Eventually Bob decided it was time to move on and pursuant to the shareholders' agreement put his shares to the 90% shareholder, with the "value" of his shareholding to be determined by the company's accountant. The "value" so determined was low following application of a large minority discount, which was large. In short Bob got screwed as the poorly drafted shareholders' agreement worked against him. He is still bitter 10 years later.

Value Tip: You should seek the appropriate professional advice before signing a shareholders' agreement and understand the mechanics for getting out of a partial interest investment before getting into it.

In the absence of a shareholders' agreement

It is generally recognised that the value of a non controlling interest in a private company may not be worth its pro-rata value. For instance, if a company is worth $1 million, a 12% shareholding may be worth less than $120,000. Why should that be? Well it comes down to two principal reasons, being lack of control and lack of marketability. Often these factors are combined and referred to as a minority discount. The extent of the minority discount will depend on the individual situation.

Lack of control

Control has value. It bestows upon the holder the ability to run the business their way, subject to not abusing the minority. Control blocks of shares in private companies are generally valued at their pro-rata values. Value tip: Even though you own 60% of the shares you will not have control of important matters, such as approval of a major transaction, that under the Companies Act 1993 require a special resolution of shareholders to pass, requiring 75% of the votes.

Shares, which are not part of the control block, generally are valued at a discount to pro-rata value because the minority shareholder (in the absence of an appropriate shareholder agreement) cannot, among other things, elect the majority of the Board, influence strategy, influence dividend policy and/or force the sale of the business. Value Tip: This is not a good place to be when trying to influence the value of and/or protect your investment.

Lack of marketability

Not only is being an unprotected minority not a good place for you to be but lots of other people don't wont to be there either, resulting in a lack of marketability. The two factors are not mutually exclusive. Value tip: Private companies can take extended periods to sell. A partial interest in a private company may not even be saleable unless there is a shareholders' agreement, which creates an internal market for the shares among existing shareholders.

Special situations

50/50 shareholdings

In the absence of a shareholders' agreement, in this situation neither party has control and may be the worst of all worlds because of resulting log jambs and nothing getting done. A discount to prorata value would likely be applied. I have seen a situation where a court has ordered the dissolution of a private company because the 50/50 shareholders could not agree on anything.

48/48/2 shareholdings

In the absence of a shareholders' agreement, the 2% shareholder holds the balance of power. It is possible that if the 2% shareholding was offered for sale and both 48% shareholders wanted control, the 2% shareholding could attract a premium, logically up to the amount of the discount that would otherwise apply to a 48% shareholding, which could be substantial.

Non-voting shares

Assume the non-voting shares are the same in all respects as the voting shares except this class of shares has no votes. A discount to pro-rata value would likely be applied to the non-voting shares.

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