By Andrew Pike, CFA, ASA, RV
This article is focused on minority stake valuations in privately held (unlisted) companies in the Netherlands. Valuations of listed securities is a separate topic that is outside of the scope of this paper.
There are various valuation techniques and valuation discounts that are suited for minority interests (also known as noncontrolling interests). Before we jump in, let us first define what a minority interest is.
A minority or noncontrolling interest is an equity stake where the equity holder does not have rights to enforce their will concerning decisions about the subject company. Such rights can typically be gained by having a majority of the voting rights. An equity holder could also have a minority stake in the voting shares, but have contractual rights to enforce their wishes. In some cases, having board seats can also afford certain decision making powers.
It is important to carefully examine the company’s shareholders agreements and statutes when assessing the extent of a shareholder’s decision making powers. A simple voting majority might not mean total decision making power. Certain events may require a supermajority or unanimous decision of all voting shares. Some companies have multiple share classes where certain rights may be reserved for specific share classes.
Majority vs minority stake is not a binary condition in business valuation. When considering an investor’s minority stake, we look at the severity of their minority position. Non-voting STAK or employees’ foundation certificates typically have no voting rights whatsoever. A 49% stake in common voting shares and a board seat can often mean a minority stake, but with substantial influence. A qualitative assessment is an important step.
Before discussing which valuation techniques are better suited for minority stakes, let us do a brief refresher on valuation techniques. As discussed in my article “The 4 Pillars of Business Valuation”, every valuation has 4 components – cash flow, growth, risk, and excess assets.
The 3 basic valuation approaches applied in business valuations are income approach, market approach and asset approach. The income approach allows the valuer to explicitly model each valuation component (cash flow, growth, risk and excess assets). The market approach combines growth and risk into a multiple, which is then multiplied by a cash flow measure (e.g. operating profit, net profit, shareholders equity, etc). Excess assets are then added to the product. The asset approach combines all 4 elements into one figure.
Some income approach techniques discount cash flows to enterprise value (value of the business to equity and debt holders), which must then be adjusted by measurement date net debt and excess assets to arrive at equity value. This is because debt payments are not modelled within the cash flows. Other income approach techniques discount to firm value (adjust this for excess assets to arrive at equity value), in which case a net debt adjustment is not required because debt payments were explicitly modelled within the discounted cash flows.
Enterprise value techniques assume that net debt (total debt minus cash) can be refinanced by the shareholder in question. A minority stake shareholder cannot refinance a company’s debt. As such, firm value techniques might be more appropriate for minority stake valuations than enterprise value techniques.
The same goes for market approach techniques. Applying certain levels of cash flows (e.g. EBITDA, gross profit, revenues) result in an enterprise value whereas other levels of cash flows (e.g. net profit, shareholders equity) result in firm value.
Asset approach valuations represent a controlling stake. These techniques model what a shareholder could achieve if they liquidate the company or rebuild it, neither of which can be realized by a minority stake investor.
In the case of minority stake valuations, business valuers typically look at two special valuation discounts – discount for lack of control (DLOC) and discount for lack of marketability (DLOM).
DLOC represents a minority stake discount to a controlling (or majority) stake valuation. Applying DLOC results in a non-controlling stake valuation, which would thereafter be adjusted for DLOM to arrive at a minority stake valuation.
DLOC is often based on the pricing of majority vs minority transactions observed in the market. It ignores the unique characteristics of the company being assessed. Certain transactions upon which it is based might have been due to distressed situations, which may be incomparable to the subject company.
Premiums paid in DLOC benchmark transactions depend on the negotiation dynamics of the transactions. Some transaction elements might not be directly visible in the transaction price (post-deal employment arrangements, synergies, transaction timing, strategic focus of the acquiror, etc) or may be on a delayed or contingent basis.
Rather than valuing a controlling stake and then applying DLOC, one could simply apply a valuation technique that is suited to minority stakes, in which case a DLOC is not required.
DLOM represents the time and effort required to sell a minority stake in a private company versus a majority stake. Generally speaking (but not in all cases), it can be more difficult to sell a minority stake in a private company than a majority stake. Acquirors typically like to have control and to enforce their financial decision-making preferences.
There are four general approaches to estimating DLOM: restricted stock studies, pre-IPO transaction studies, private company discount studies, and option models. These can be layered with qualitative assessments such as Mandelbaum (discussed further below) or van den Cruijce[1].
Restricted stock studies compare the prices that investors are willing to pay for two otherwise identical securities, where one is fully liquid and the other has liquidity-related restrictions.[2] These studies show that restricted stock (stock that cannot be immediately resold due to restrictions on re-sale) indeed sells at a discount to its otherwise identical publicly traded sister stock.
Pre-IPO transaction studies compare initial public offering (IPO) prices to transactions in those companies preceding the IPO. When a company issues an IPO, the securities and exchange commission (SEC) requires the company to disclose all transactions in its shares for a certain period of time preceding the IPO.
Private company discount studies (PCD) measure the difference between valuation multiples of private and public companies. Studies can be based on a comparison of: 1) valuation multiples between (non-acquired) publicly traded stocks and acquired non-listed companies; or 2) valuation multiples of acquired publicly traded stocks and acquired non-listed companies. There are also some studies that combine these approaches.
Option models assume that an option holder has the right to sell a given financial asset in the future at a pre-specified price. The price of the option is based on the asset’s price at measurement date, time to expiration of the option, expected dividends, and the probability of earning a profit on the sale of the asset (expressed either explicitly or by way of stock price volatility). John Finnerty wrote that a lack of liquidity is a form of DLOM that exists when an interest holder cannot dispose of the interest quickly unless the holder is willing to accept a significant reduction in value.[3]
Market conditions and company-specific factors can impact DLOM. The size of the purchase has a negative impact on DLOM – smaller purchases report a higher DLOM.[4] Johan van den Cruijce found that company size, size of the interest to be sold, and especially level of control can have a substantial impact on DLOM.[5] Boris Steffen lists the following factors to be considered when measuring marketability, “put rights, dividend payments, potential buyers, size of interest, a potential sale or IPO, availability of information, restrictive transfer provisions and firm characteristics.”[6] John E. Elmore, JD, CPA stated the following, “[option models] ignore other factors that may reduce the marketability for privately held securities (e.g., contractual transferability restrictions). The DLOM indicated by [an option model] is an appropriate starting point for a DLOM analysis.”[7]
In the United States case of Mandelbaum v. Commissioner[8], Judge David Laro developed a nine-factor adjustment process for evaluating DLOMs:
For a more detailed discussion on this topic, see my article, “DLOM estimation methods”.
This section is based on court cases involving minority stakes and the Dutch tax authorities (Belastingdienst). Cases involving other areas of law (for example, civil law) or not involving the Dutch tax authorities might imply different conclusions. Please also note that judges act in their own discretion and the following summaries do not apply to all cases. For more details about these cases, please see my article, “Jurisprudence in court cases versus the Dutch tax authorities”.
This ruling of the appellate judgement of the court of Amsterdam[9] between an anonymous corporation (plaintiff) and the inspector of the Belastingdienst (defendant) concerned a dispute over the amount of wages, in respect of the shares, should be included in the levy of wage taxes and social taxes. The parties disagreed about the value that should have been attributed to the shares and, in particular, on the question of a discount in value because of the fact that the shares were not freely tradable for a period of two years after grant date.[10] The defendant argued for a discount of 5% (2.5% per year for two years) on the basis of compromises in similar situations. The plaintiff argued for a discount of 23.2%. The court ruled that the discount should be set at 10%.
This ruling of the District Court of The Hague concerned a case between the tax inspector of the Belastingdienst (defendant) and a director of a company (Plaintiff) who received shares as compensation. The majority shareholder and his family owned 90% of the group’s shares, which were sold for NLG 266,577.84 per certificate. The 10% shares of Plaintiff were sold for NLG 193,416 per certificate. The minority shares were sold at a discount of 27.4% to the price of the majority share. The tax authorities argued that the gain from the sale of the shares was employment compensation and applied a 27.4% discount on the share price as the basis for that gain, even after knowing of the higher majority share price.
A minority stake valuation may be required when the shareholder of an equity stake in a private company lacks the rights to enforce their financial preferences for the subject company.
Income and market approach valuations leading to firm value (instead of enterprise value) may be the most appropriate for valuing a minority stake in a private company.
Discount for lack of marketability (DLOM) should usually be applied to the resulting equity value.
Dutch courts have recognized DLOM evidence from restricted stock studies and option models. The courts have accepted DLOMs in the range of 10% to 27.4%.
For a detailed discussion of approaches to DLOM estimation, see my article, “Discount for lack of marketability (DLOM) estimation methods.” For a detailed discussion around Dutch court rulings on DLOM in tax cases, see my article, “Minority Interest Valuations in Dutch Tax Court Cases.” For more information on the business valuation capabilities of AN Valuations, see our Company Valuation services page.
A minority or noncontrolling interest is an equity stake where the equity holder does not have rights to enforce their will concerning decisions about the subject company.
For a publicly traded company, the minority interest value is typically the share price. For an unlisted (private) company, apply valuation techniques that lead directly to firm value and then apply a discount for lack of marketability (DLOM). Avoid valuation techniques that lead to enterprise value, where possible. Those valuation techniques allow you to apply debt at market rates and capital structure, which should be avoided.
49% is technically a minority stake because the shareholder does not have unilateral rights to enforce financial decisions. Contractual rights could afford the shareholder financial decision-making rights. Such a high minority stake might carry more weight that a small minority interest. This could result in relatively limited valuation discounts due to the minority stake.
An EBITDA multiple is not preferred because market capital structure and interest rates are embedded into the multiple. It can be applied if you are sure that the company’s leverage and interest rates are similar to market rates. It would be more preferrable to use a valuation multiple that is after interest income and expenses such as P/E (price to earnings) or price / book value (price to shareholders equity).
DLOC (discount for lack of control) represents a minority stake discount to a controlling (or majority) stake valuation. DLOM (discount for lack of marketability) represents the time and effort required to sell a minority stake in a private company versus a majority stake. It is generally preferred not to apply DLOC in a minority stake valuation. Lack of control should instead be handled in the cash flow forecasts and apply valuation techniques that are more suitable for minority stake valuations. DLOM should typically be applied in a minority stake valuation.
[1] See my paper, “DLOM estimation methods”
[2] Aaron M. Stumpf, Robert L. Martinez, and Christopher T. Stallman; “The Stout Risius Ross Restricted Stock Study: A Recent Examination of Private Placement Transactions from September 2005 through May 2010”; Business Valuation Review Volume 30, No. 1, Spring 2011; pp. 7–19.
[3] John D. Finnerty, “Using Put Option-Based DLOM Models to Estimate Discounts for Lack of Marketability,” Business Valuation Review 31, no. 4 (Winter 2013): 166.
[4] Institutional Investor Study Report of the Securities and Exchange Commission, Volume 5; 92nd Congress, 1st session; House Document No. 92-64, Part 5; pgs 2445 – 2475.
[5] Van den Cruijce, Johan; “The impact of control on the discount for lack of marketability”; taxnotes federal, volume 175, number 4; April 25, 2022.
[6] Steffen, B; “The Evolution of the Discount for Lack of Marketability”; ABI Journal, March 2023; ©2023 American Bankruptcy Institute.
[7] Elmore, J; “Determining the Discount for Lack of Marketability with Put Option Pricing Models in View of the Section 2704 Proposed Regulations”; Valuation Practices and Procedures Insights, Winter 2017; Willamette Management Associates.
[8] Mandelbaum v. Commissioner; 69 T.C.M. (CCH) 2852; *36-37 (1995).
[9] ECLI:NL:GHAMS:2012:BW1517
[10] The parties did not disagree on the application of a discount for lack of marketability, but on the amount of the discount. “Tussen partijen is niet zozeer in geschil dát er sprake is van een waardedruk, maar zij verschillen van mening over de omvang ervan.”