The Basics You Should Know About Valuing Minority Interest
In this article, we will be discussing the factors that should be considered when talking about Minority Interest stakes.
Minority Interest Limitations
Having non-controlling interest, the minority investor is typically restricted in terms of making critical business decisions due to the lack of voting rights. Some areas of limitation include the following:
- The election of company directors and the appointment of its officers;
- The declaration and distribution of dividends;
- Customers’ and suppliers’ contractual relationships;
- Raising debt or equity capital for the firm;
- Employing key personnel;
- The divestment of the company or sale of assets;
- The approval of strategy plans, mergers, acquisitions, or capital expenditures.
As such, the value of any partial ownership in a firm is likely to be worth less than its prorated shares. For example, 25% interest may be worth less than 25% of the entire business value.
Valuing Minority Interest
The broad approaches related to valuing minority interest include:
- Using similar past transactions that involve the transfer of similar minority interest stakes or other market comparables;
- Using the discounted cash flow method, valuing the future stream of expected economic benefits that are received from owning the minority stake in the firm. These can include dividends taken over time and the share of proceeds if the business is sold.
- A proportional percentage of the total business value with a determined discount applied to it.
Determining the Discount
When estimating the value of a minority shareholder’s interest, it is typically acknowledged that a discount needs to be applied to their shares (due to the limitations stated above such as the lack of voting power and management influences). This is called the discount for lack of control (DLOC).
While estimating the value for a proportional share of a business is clear-cut, establishing the discount can be subjective. Some factors to consider include the size of the minority stake, the spread of the shareholdings, whether the shares are locked in, historical and expected dividend payout policies, and the ability to impact key business decisions or the appointment of key officers and personnel.
A discount for lack of marketability (DLOM) may also be applied if the firm is a private company. This discount will account for the lack of liquidity when selling the investment. While this discount can be applied to both controlling and noncontrolling interests, the discount for a minority investment is typically higher than the discount applied for controlling ownership interests, as there may be higher risks or difficulties when selling the investment.
It is not uncommon for the value of a minority investment in a private company to amount to 50% or 80% of the value of a stake in a firm that has control and that is fully marketable. Consequently, understanding the discounts for the lack of control and marketability in the business valuation is essential, especially so when it comes to valuing minority interests in a private firm.
The following paragraph will talk about Adjustment to Earnings
So, here we will be discussing the differences between EBITDA, Adjusted EBITDA, and Seller’s Discretionary Earnings (SDE) which are common earnings that are used in the valuation.
Differences between EBITDA, Adjusted EBITDA, and SDE
A crucial step in preparing a valuation is to first determine the earnings that you will use as the basis for the valuation.
You may come across some of the following terms: EBITDA, Adjusted EBITDA, or Seller’s Discretionary Earnings (SDE) among some of them.
What is EBITDA?
EBITDA is essentially adjusting the reported net profit for interest, taxes, depreciation and amortisation. EBITDA reflects the company’s operating profitability prior to non-cash and non-operating line items. EBITDA can be used when comparing operating the performance across the industry sector.
What is Adjusted EBITDA?
Adjusted EBITDA takes a further step by adjusting EBITDA for non-recurring, non-operating, or unusual revenue or expense items. This is to better reflect the business’s operating earning ability on a day-to-day basis. Some of the adjustments may include:
- Raising or decreasing rental expenses of office spaces that are owned by the owner according to the current market rate;
- Considering any related party transactions and adjusting them to the market rate;
Making adjustments for one-off non-recurring expenses such as the disposal of assets, lawsuits, or start-up expenses.
- Including any potential cost synergies post-integration.
What does the term “Seller’s Discretionary Earnings” mean?
Seller’s Discretionary Earnings are typically used for small firms that are actively managed by their owner(s). It adds back on the owner’s salaries, benefits, and other incentives to EBITDA, after adjusting the total compensation of all owners to the market value. Some examples include personal club memberships, entertainment expenses, personal insurance plans, donations, vehicle-related expenses, etc.
After concluding which earnings to use, we can move on to next step of the business valuation process. Please visit our past posts in our Valuation Series of articles to find out more.
Of course, if you are unsure about the specificities of valuing your company and the most appropriate method to go for, contact AM Corporate Services today. Our experts can advise and guide you accordingly.