50-50 = equal? Not!

In the Estate of Betty Able, Betty's husband founded a highly successful and profitable manufacturing business 40 years ago. Twenty years later he sold half (50 percent) of the shares in the business to his manager of operations who has managed the business ever since.

Upon the transfer of those shares the two owners executed a typical buy/sell Agreement that provided for fair market value buyouts under certain conditions, including death and retirement. What the buy/well agreement failed to do is to define "fair market value" and how it is to be determined. Most states have defined fair market value in their statutes and in most cases the definitions are similar:

"The price at which a property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the later is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts."

Business falls to estate

Five years ago Mr. Able died. His widow, who has never taken an active part in the business, inherited his shares. Last year Betty passed away and her children, who have no interest in ownership or operations of the business, are wanting money and are seeking to be bought out by the 50 percent partner. In their opinion the business is worth $1 million and their interest is worth $500,000, or 50 percent of the whole. The question is this: "Is the value of their shares equal to 50 percent of the whole?" The answer is "Probably not!"

A shareholder in a public company is usually a minority shareholder who has no control over the decision-making in the company, but has highly marketable shares. In contrast, a majority shareholder, partner, or member in a closely held, private company may have total control but finds that his/her interests have limited marketability. A minority shareholder, partner, or member in a private closely held company can be in the even more limited position of not only lacking in control but also lacking in marketability for the shares.

In the absence of any separate agreement to the contrary, a 50 percent interest is not considered to be a controlling interest and could therefore be subject to discounts. The criteria for determining the degree of control that an owner (shareholder, partner, or member) has is determined by whether that person has the ability to:

* Appoint management

* Determine management compensation and perquisites

* Set policy and change the course of the business

* Acquire or liquidate assets

* Select people with whom to do business and award contracts

* Make acquisitions

* Liquidate, dissolve, sell out, or re-capitalize the company

* Sell or acquire Treasury shares

* Declare or pay dividends

* Change the articles of incorporation, bylaws, partnership agreement, or operating agreement

* Block any of these actions

Value of minority interest

Without the ability to control, a minority interest is worth less money to a "willing buyer" than is a control interest.

It is therefore reasonable to apply a discount for lack of control to the 50 percent interest being acquired by the partner.

Of course, the next question will probably be "How much of a discount"?

Numerous studies have been conducted to quantify discounts for lack of control and the general consensus is that there are approximately 30-35 factors that should be considered when arriving at the percentage of discount, including:

* Are voting rights proportionate?

* Is control ownership concentrated?

* Is a change of control likely?

* Are there undue management restrictions?

* Can the entity agreement (articles of incorporation, partnership agreement, operating agreement) be easily changed?

* Can management be changed easily?

* Is there control over accounting?

* Are distributions proportionate?

* Can management compensation be controlled?

* Does the interest have swing value?

* Are there discretionary expenses?

* Is business or financial risk high?

* Is management dependent on key people?

* Are owners deeply involved in the business?

Liquidity, or marketability, is the ability to convert an investment into cash quickly. Shares in public companies are highly marketable and can be converted into cash within a matter of days. Interests in private, closely held companies (shares, partnerships, or memberships) are less marketable and require time and effort in order to convert equity into cash. It is not unusual for it to take a year or more to sell a majority (controlling) interest in such a company, let alone a minority interest.

Investors love liquidity and are willing to pay for it. When it comes to investing in minority interests in private, closely held companies, investors are few and far between, and those who are around typically require significant discounts for lack of marketability.

In an attempt to quantify the amount of a discount for lack of marketability, numerous studies have been conducted over a number of years. Among the many factors to be considered when estimating the amount are:

* Is the business risk high?

* Is the financial risk high?

* Are there rights to liquidation?

* Are there rights to withdrawal / return of capital?

* Are there possibilities for a cash call?

* Are capital calls mandatory and probable?

* Have there been sales of interests?

* Are there transfer restrictions?

* Is there a right of first refusal?

* Is the holding period long?

* Is there a bankruptcy risk?

* Are there outside financing sources?

* Is cash flow strong and stable?

* Are owners harmonious?

Appraisal value

Utilizing discount studies, business appraisers will typically establish a base for discounts for lack of control and discounts for lack of marketability and then make adjustments up or down using the applicable criteria. The heirs of Betty Able might be looking at something like this:

100 percent enterprise value $1,000,000

50 percent proportionate interest $ 500,000

Discount for lack of control (33 percent) $ 165,000

Total $ 335,000

Discount for lack of marketability (27 percent) $ 90,450

Fair market value of 50 percent interest $244,550

This type of situation is more common than what one might think and might have been avoided had more thought been put into the buy/sell agreement.

Jerry F. Golanty of Reno is a master certified business appraiser accredited in litigation. Contact him at 332-4881.