If you’re thinking about selling stock in your advisory business to one or more employees (or a son or daughter), you need to know about minority discounts.
A minority discount is only relevant when valuing shares in a closely held or privately owned company. The use of a minority discount can help move more ownership, or shares, into the hands of a son, a daughter, or employee, faster and with fewer tax consequences, if applied correctly.
A minority interest is non-controlling ownership, usually defined as less than 50% of a company's voting shares. A minority discount is a reduction in the price of stock from its fair market value because the minority interest owner(s) cannot direct or control the business operations, and because of lack of marketability of the stock.
The dynamics of the internal transition process in most financial service business models is one in which the owner(s) feels compelled, or at least in their interests, to facilitate the financing for the buyers, in one way or another. The company or the selling shareholder cannot gift shares of stock to a non-family member without tax consequences equal to ordinary income. You can increase the employee’s salary, or give them a bonus, only to see them pay taxes at ordinary income rates and turn around and buy stock from a majority owner, creating long term capital gains rates for the seller. Most sellers don’t like that sequence of tax events. A minority discount sometimes makes more economic sense and can help advance the prospects of both parties, especially on the equity management issues of continuity planning and business growth.
In terms of minority discounts, the applicable range is between approximately 0% and 40% percent (I have seen 50%, but that’s pushing the envelope in my opinion). It is imperative that every owner and investor confer with their CPA first as to what is reasonable and appropriate in each situation. Note that it is appropriate to calculate separate discounts for lack of control and for lack of liquidity. A discount, if offered, should be applied fairly and evenly. For example, if a 10% interest in the company is being sold to two investors at or about the same time, the same valuation method and the same level of discounting should apply to each sale.
Owners and employees, including sons and daughters in family-run businesses, agree in most cases to what is fair and reasonable after consultation with their tax counsel and after considering all the circumstances – there is no clear answer as to precisely what level of discount is appropriate.
Interestingly, in most cases, at least in the financial services industry at this value level ($4,000,000 to $5,000,000), the parties agree that the minority discount will be zero, but with some important considerations. Minority discounts are not always “packaged” as a discount in value; rather, such discounts or benefits are often embedded in the lending terms.
Consider that, in most internal sales, the owner or seller of the stock almost always provides very generous financing terms, enabling the purchase of the minority shares, perhaps even providing the funding through a salary increase or bonus or payment of dividends. Also consider that, in the majority of cases, the minority owners may have a direct path to majority ownership upon the owner’s death, disability or retirement, usually through a written continuity or succession plan (i.e., a Buy-Sell or Shareholders’ agreement, or a Right of First Opportunity), which also, again, is usually accompanied by very generous, long-term financing terms from the owner or the company (or the company itself in a redemption situation).
The reality of minority discounts lies in the answer to this question: how do you sell or transfer the equity in a financial services business, worth, say, $500,000, to an employee, son or daughter, who has little or no investible assets? The answer is, as an owner, you find a way to legally reduce the price per share. In order to do this, it is often necessary to sell the stock incrementally. Every share an employee, son or daughter buys, as long as they own less than 50%, is arguably subject to a minority discount for lack of control and for lack of liquidity.