Let’s say that you represent a 40% shareholder in a corporation. You are reviewing a shareholder’s agreement which says that in certain circumstances (death, disability, termination of employment) your client is required to sell his or her shares at fair market value. So far, so good.
The stipulated event happens. The valuator determines that the fair market value of all of the shares of the corporation is $1,000,000.
Your client expects a cheque for $400,000. The cheque that he or she receives is for $300,000. The client says, “sue them.” You look into things and figure out that the valuator correctly applied a ‘minority discount’ of 25%. Could have been 20%. Or 30%. But let’s not quibble about that.
So your client cannot sue the other side. They cannot sue the valuator. But hey, all is not lost. They can sue you, because when you reviewed the draft agreement, you did not understand that this could happen and did not tell them.
So, what is a ‘minority discount’, anyway?
It is a discount applied by valuators to the value of the shares held by a minority shareholder to reflect that shares which do not carry with them the right to control the corporation are less valuable than shares which do. The flip side of that is the application of a ‘premium for control’ when the shares of the majority shareholder are being valued.
As for the exact amount of the discount which will be applied, good luck getting a straight answer to that question from a business valuator. It is an art, not a science.
When I represented the majority shareholder drafting a valuation provision in a shareholder’s agreement, I used to give the client three choices:
- Just say fair market value without specifying whether or not there will be a minority discount. The valuator will likely apply one. You win. However, if the minority shareholder hires a decent lawyer, they will probably catch it and you may look like you were trying to get something by them.
- Provide for fair market value and specify that there will be a minority discount. At least you are being transparent. If the other side does not object, you win. If they do, you are in for a negotiation.
- Or, you could specify fair market value with no minority discount. You lose on the numbers but win on transparency and being seen as trying to be reasonable.
Lawyers drafting shareholders agreements should know this. Or increase their liability coverage.