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Owner gets a wake-up call on bringing in minority investor

“Can anybody remember when the times were not hard and money not scarce?”                  

— Ralph Waldo Emerson

John Wilson, CEO of Ace Business Stuff, has been working diligently with his controller, Tom Sampson, to assess his debt requirements as well as his potential equity needs, but he suspects that his controller is right that bank financing may be insufficient.

“Hi Lary,” John said when he got Lary Columnist on the phone. “We’re almost finished with our forecast, but it still looks like we’ll need some equity. I’d like to explore what you said about strategic buyers and financial buyers and see the diagram you mentioned.”

“John, this diagram is only meant as a general overview of some key valuation concepts,” I said when I visited with John at his office a few days later. “It should help you better understand certain key concepts that underlie the valuation of an ownership interest in your company. (This diagram is available on the valuation page of my Web site at www.exkalibur.com/?cat=37.)

“At the top is the strategic buyer. In short, he’s looking for more than a simple financial return. He or she is looking to share a distribution network, like Newscorp’s purchase of MySpace for example, or to expand an existing product line, like Mars buying Wrigley’s. These acquisitions are often about the ‘white space,’ filling in gaps in the acquirer’s product line as we’ve seen happening in the wine industry recently, say with the sale of Rosenblum Cellars to Diageo. The expectation is that the strategic buyer will pay a special premium to obtain certain strategic advantages.

“Contrarily, the financial buyer is looking solely for a return on investment. That buyer is usually unwilling to pay a premium beyond his target rate of return. In the second horizontal bar, you’ll note the term ‘control value.’ Keep in mind that when most people talk about valuation, they’re talking about value for the whole company, or at least a controlling interest of 51 percent.”

“But that’s not what I’m looking for,” John said. “I have no intention of selling my company. I’m just looking for a minority investor.”

“I understand, John, and that’s why I think these concepts are valuable. Since you’re considering a sale of a minority interest in your company, the valuation is not the same as if you were selling a controlling interest.”

“I don’t see why not. They’re getting a piece of the same company I own, and it should be worth to them what it’s worth to me.”

“From a valuation perspective, John, it’s going to be worth more to you because you have a controlling interest. You’re the boss, you can elect a majority of your board of directors and you call the shots. Your potential partner has limited courses of action if he doesn’t like the direction in which the company is going.”

“Then he shouldn’t invest, Lary. It’s really that simple, isn’t it?”

“Absolutely, he must believe in the company as well as your leadership, but that doesn’t mean he has much influence over things if they don’t go well. So, let’s review the two primary discounts that occur from the valuation of a controlling interest in a company.

“First, there is a control premium, or a minority discount because, as I’ve said, the minority shareholders must depend on the majority shareholders to make wise decisions. Since they don’t control the company, their ownership piece is worth less, and therefore, they’ll expect to pay less to buy it.”

“What you’re saying, Lary, is that if my company is worth, say $2 million, and I need to raise $400,000, I’m going to have to give up more than the 20 percent that I would get by multiplying $2 million by 20 percent. Is that right?”

“In theory, yes, John. But in a negotiated situation like you’re thinking about, it might play out differently. If an investor agrees that the company is worth $2 million, he might conclude that it’s a fair proposition and pay $400,000 for a 20 percent interest.”

“What kind of discount are we talking about, Lary? How big is that so-called minority discount?”

“I know you’ll love this answer, John, but it depends on a number of factors that a qualified valuation specialist will assess. Why don’t we get into those details another time?”

“OK, but I don’t like the direction this is going, Lary. The value of the minority interest I’m selling keeps going lower.”

“I understand your point, John, but there is yet another, bigger factor to consider – a lack-of-marketability discount. A minority investment in a private company is also an illiquid investment, and the lack of liquidity makes it less desirable, say, than a comparable investment in a public company. The minority investor in a private company is not usually able to cash out until you do.”

“So, Lary, what are we up to, in total discounts I mean? Is there anything left for me?”

“First, John, these discounts don’t get added together. The Marketable Minority Interest Value you see on the diagram gets calculated first by applying the minority discount. That’s roughly equivalent to a share of stock of a publicly traded company; you’ve probably noticed that public company shareholders almost always receive a control premium when the entire company is purchased. Then on the remaining net number, the lack-of-marketability discount is applied to arrive at the Non-Marketable Minority Interest Value, which is at the bottom of the diagram. This generally represents the minority investment in a private company. All in? It wouldn’t be unusual for those discounts to equal a 30 percent to 45 percent discount from the value of a controlling interest in the same corporation.”

“So, in my little $2 million example, the value of my company to a minority investor might be more like $1.1 million to $1.4 million or so. That’s a big difference.”

“Yes it is, John. Remember, though, that in your case, this is a negotiated process, and the potential investor won’t know all of this. I want you to be aware of these concepts, though, because minority investors are not easy to find for these two key reasons – they don’t have much control, and they can’t get their money back easily. All the more reason you need to carefully prepare your forecast and be certain you’ve captured all of the unique attributes and capabilities of your company so you can justify a fulsome value and only raise the equity capital that you absolutely need.

“Let’s get together again next week when you have the forecast finished, and we’ll talk further about this process.”

•••

Lary Kirchenbauer is the president of Exkalibur Advisors Inc., providing practical business strategies for family and other privately owned businesses in the middle market. He works closely with senior executives and their businesses to accelerate their growth and improve personal and professional performance. Visit his Web site at www.exkalibur.com, or go to The Daily Blog at www.exkalibur.com/?page_id=22 for current information and to offer your comments or questions.