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Buying a Brother Out - Why 20% of a Company is Worth Less than 20%

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After working together for years at Rockford Pest Control, Mark and Tim decided it was time to part ways. Tim asked his brother Mark to buy out his 20% share in the family business, which was left to the brothers when their father died.

After bickering with Mark over valuation for months, Tim decided it was time to get help. Tim’s first stop was the family accountant, who provided the brothers some rules of thumb for valuing the business. The accountant said that he was not qualified to appraise the business for a buy-out and that the brothers should seek the advice of an expert. Without further guidance from the accountant, Tim decided to call one of the business brokers who advertises in the classified section of a pest control industry magazine and commissioned an appraisal.

The business broker, having no formal training in business appraisal practice, law, or finance, charged the brothers a few thousand dollars to issue an appraisal. The appraisal was based on comparable acquisition statistics, such as sales and cash flow multiples, and ultimately valued the common equity of the business at $4.8 million. In order to determine the value of each brother’s share, the appraiser simply multiplied their percentage of ownership by his estimated value of the business. For example, Mark, the president of the company, owned 80% of the business so his shares were worth $3.84 million (i.e., 80% x $4.8 million) and Tim owned 20%, so his shares were worth $960,000 (i.e., 20% x $4.8 million).

Upon receiving the valuation, Tim was content with the numbers and was ready for Mark to cash him out for a cool million. Mark, however, had some serious reservations. First, he didn’t have a million bucks lying around to pay off his brother. Second, Tim hadn’t lifted a finger for the sake of the business for years, and now Mark was being forced to come up with almost a million dollars to pay him off. Finally, while he was delighted at the prospect of owning a business worth almost $5 million, he had no idea as to whether or not the broker knew what he was doing. Was this valuation accurate? Would an acquirer pay that for the business? If an acquirer wouldn’t pay him $4.8 million for the business why should he pay his brother almost a million dollars for his equity stake? Although Mark wasn’t sure what the right answers were, he instinctively felt something wasn’t quite right with the valuation and that is when he called me to review the appraisal.

Mark’s suspicions were justified and he was correct to question the business broker who had prepared the valuation. There are two primary issues appraisers are confronted with when valuing minority interests in private companies, and after two minutes with the appraisal in hand, I realized that both had entirely eluded the business broker and caused him to arrive at drastically erroneous conclusions.

The business broker did not take into consideration that minority interests in privately held businesses are: 1) worth less per share than control interests due to lack of control, and 2) a minority owner in a private business has no liquid market in which to sell his interest, which significantly depresses value. Both concepts are elementary to business appraisal practice and have been recognized by the courts for decades. For example, a widely quoted statement from the 1935 stock valuation case, Cravens vs. Welch, depicts the essence of a minority stockholder’s situation: “Minority stock interests in a ‘closed’ corporation are usually worth much less than the proportionate share of assets to which they attach.”

Discounts for Lack of Control (“DLOC” or “Minority Interest Discount”)
Minority shareholders have very little, if any, financial and operational control over the business and therefore have relatively little control over the return on their investment. The American Society of Appraisers defines a minority interest discount as “the reduction, from a pro rata share of the enterprise value of the entire business, to reflect the absence of the power of control.” Minority shareholders are oftentimes held hostage by the control shareholders who have the power to:

  • Lease a building to the corporation at above-market rates
  • Borrow funds from the corporation interest-free
  • Take actions to force the minority shareholder out of the corporation
  • Cause the corporation to invest in opportunities for personal benefit
  • Control the board of directors, hire / fire management, and set compensation
  • Determine whether or not to pay dividends
  • Liquidate, sell or recapitalize the company, and acquire or sell assets
  • It is not uncommon to see minority interest discounts of 25% to 50% for closely held pest control companies. In this case, the business broker failed to discount Tim’s shares by 25% to 50% due to lack of control.

    Discounts for Lack of Marketable (“DLOM”)
    It takes many months to sell a privately held company, and not only is the eventual sale price uncertain, the eventual sale itself is far from guaranteed. Couple that with legal, accounting and transaction fees, even owners who own 100% of the equity find their liquidity impaired by transaction delays and costs. For shareholders who own a minority interest in a closely-held business, the effects are magnified and their stock is much less marketable, and therefore substantially less valuable. Valuation experts tend to agree that lack of marketability discounts for controlling interests range from 0 to 20%. For minority interests (an ownership interest of 1% to 50% of the equity) I often see lack of marketability discounts of 30% to 50%.

    Let’s assume for a second that the business broker came to a reasonable conclusion of value for a strategic sale - $4.8 million (which I disagreed with, but that’s not the point here). Certainly if an acquirer purchased 100 percent of the brothers’ equity for $4.8 million, the proceeds would be distributed pro-rata to Mark and Tim according to their ownership. But who in his right mind would buy Tim’s 20% interest in the business by itself? A 20% owner has no control over the business and there is no ready market to resell the shares, therefore the only existing buyer for Tim’s interest in the business is Mark.

    After reviewing the original appraisal, I determined that Tim’s interest was worth closer to $400,000 than $960,000. In response, Tim hired a another credentialed business valuation expert to critique my review of the initial appraisal. He agreed with me, and in the end, we all agreed on $450,000, saving Mark from overpaying $500,000 based on a business broker’s erroneous and ill-founded conclusions.

    The pest control industry, like many industries has given rise to niche, industry consultants who provide advice on valuation without the requisite credentials. They lack the training and knowledge of how a valuation should be conducted for a given situation. A word of advice to pest control operators: industry expertise and valuation expertise are not synonymous.

    The author is a credentialed business valuation expert qualified to practice in state and federal court and before the IRS. Names of individuals, companies, and facts have been changed in order to protect identities.

    Interested in learning more about valuation and mergers & acquisitions in the pest control industry? Subscribe to Potomac Company commentary and research on the Pest Control Industry.

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