One plus one equals two, right?

If we can agree on this, we can also say that the sum of the parts equals the whole.

But, as logical as this theory may seem, it may not hold true when determining the value of a shareholder’s minority interest in a business.

To illustrate this, let’s assume that you own 250 shares of a business that has 1,000 shares of stock outstanding. Let’s further assume that your partner owns the other 750 shares and that the business is worth $100,000 as a whole.

If we were attempting to determine the value of one share of your stock, we would start by dividing $100,000 by the 1,000 shares outstanding and arrive at $100 per share. However, do your shares have the same value per share as your partner’s? Probably not.

Minority interest discount

If you tried to market your 25 percent interest in the company, you would probably have a difficult time finding a buyer willing to pay you the pro rata value of $25,000.

This difficulty arises because you hold a minority interest in the company and thus lack the ability to exercise control over the company’s management. Because you own less than 50 percent of the company’s voting stock, you lack the power to set corporate policy, appoint management, pay dividends, determine management compensation or choose the direction of the company or those with whom it should do business.

This lack of control makes your interest less valuable per share than the 75 percent interest your partner owns. This difference in value is commonly known as a minority interest discount. It is the reason that the value of your shares added to the value of your partner’s shares might not equal the total value of the company.

How is the minority discount calculated?

The most common way to determine the value of a minority interest begins with determining the value of the company as a whole. Once this is done, the shareholder’s pro rata interest value is calculated.

In the example above, this value would be $25,000. The discount is then applied as a percentage subtracted from the pro rata value.

So, how is the amount of the discount calculated?

The percentage is generally estimated by professional business appraisers from control premiums that are paid in the securities market for the ability to control a company. The theory used here is that the minority interest discount should bear an adjusted inverse relationship to the premium that one would pay to gain control of a company.

A premium may be paid to acquire stock in a company for many reasons. It’s possible that the acquirer feels the company is undervalued or that there is a synergy to be realized by adding the target’s product or service to the company’s existing business. But, the acquirer’s control of the company after acquiring a majority interest is the overriding reason that companies pay premiums for control interests.

Several studies have measured the price per share paid by companies merging or taking over other publicly traded companies. These studies show that acquiring companies generally pay more per share to acquire a company than the value of the target’s shares traded on the open market just prior to the merger or acquisition.

The minority discounts implied from the control premiums paid by these companies range approximately from 20 percent to 30 percent.

Lack of marketability discount

But that’s not the end. An additional discount for lack of marketability needs to be considered. That discount is generally based on the particular business and economic factors regarding it. That range could be from 15 to 25 percent.

What does this mean to you? If you are negotiating to purchase a minority discount in a company, be aware that the price you pay for such interest should be discounted by 53 percent to 68 percent of its pro rata value.

Conversely, if, as in the example, you are attempting to sell your pro rata $25,000 minority interest in a company, you may want to be prepared to accept a lesser value, to recognize the discounted value of your minority ownership interest’s lack of control of the company.

There’s no doubt – when it comes to valuing interests in a company, it pays to be in control and have a marketable interest.