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Divorce Valuation Update - Minority Discounts
2005 National Legal Research Group, Inc.

One of the most common points of dispute in valuing a small family business is the appropriateness of a minority discount. A minority discount is a percent reduction in the value of an interest that comprises only a minority of the corporation's stock. It is generally distinguished from a lack of marketability discount, a somewhat similar percent reduction to account for the fact that the corporation's stock is difficult to market. A lack of marketability discount applies equally to all stock in the corporation, regardless of the size of the owner's interest. E.g., In re Marriage of Tofte, 134 Or. App. 449, 895 P.2d 1387 (1995).

The purpose of a minority discount is to reflect the smaller value of a block of stock that does not control the corporation. The value is reduced because the owner of the block has reduced influence over corporate policy. There is a risk that the shareholders who control the corporation will not manage it wisely, and that the minority shareholder will watch helplessly as the value of the corporation drops. The presence of this risk reduces the amount that a reasonable buyer would pay for the stock.

Logically, the amount of the reduction in value depends upon the extent of the risk of mismanagement. The mere fact that a theoretical risk of mismanagement exists does not automatically require a reduction. If the shareholders get along amicably and successfully manage the corporation without significant dissent, the risk of mismanagement may be so small that little or no discount is warranted. Howell v. Howell, 31 Va. App. 332, 523 S.E.2d 514 (2000). Along similar lines, where the shareholders are all close family members, and there is no evidence of significant dissent on management issues, courts sometimes find that there is no real risk of majority mismanagement. E.g., Redding v. Redding, 372 N.W.2d 31, 36 (Minn. Ct. App. 1985); Fields v. Fields, 342 S.C. 182, 536 S.E.2d 684 (Ct. App. 2000).

In determining control over the corporation, it is important to remember that the court is valuing the interest held by the marital estate, not the interest held by each spouse individually. Thus, where the parties together own a majority interest, a minority discount is not appropriate. E.g., Eyler v. Eyler, 492 N.E.2d 1071 (Ind. 1986) (where parties together owned 90% of corporation, error to apply a minority discount to wife's portion of the 90%); Fisher v. Fisher, 568 N.W.2d 728 (N.D. 1997) (where husband owned majority interest and wife owned minority, refusing to apply minority discount).

Another factor to be considered is the relationship between the blocks of stock owned by the shareholders. Most cases applying the discount involve a minority interest in a business with a single dominant majority shareholder. Where the corporation has many minority shareholders and no majority shareholder, so that no one shareholder has unilateral control over the corporation, a discount may not be appropriate:

A minority discount takes into account the relationship between the interest being valued and the total enterprise. A primary factor in determining the value of a minority interest is the degree of control that the owner either does or does not have within the corporation. Obviously, the degree of control must be analyzed in the light of the number and size of the remaining shareholders' interests in the corporation. For instance, a 20 percent minority shareholder may have greater control relative to two 40 percent minority shareholders than he or she would have relative to an 80 percent shareholder. In the former situation, a greater degree of control might justify a smaller minority discount than would be imposed in the latter.

In re Marriage of Tofte,134 Or. App. 449, 456, 895 P.2d 1387, 1391 (1995). For example, in Howell v. Howell, 31 Va. App. 332, 523 S.E.2d 514 (2000), where the husband was one among many partners in a large law firm, and did not apparently suffer from any lack of influence over firm policy, the court held that a minority discount was not appropriate.

The same result can also be reached by noting that the sum of the value of the shareholders' interests must normally equal the value of the entire enterprise. If the value of the minority interests is reduced by a certain amount to account for the lack of control, the value of the majority interest should normally be increased by the same amount (a control premium) to account for the benefits of control. Where the business has no majority shareholder, however, there is no interest which receives a control premium. Given that the sum of the parts must equal the whole, there is no basis for applying a minority discount.

Control, of course, can come from factors other than the size of the owning spouse's interest. Where the interest is a minority, but the owner controls the corporation by serving as CEO, the cases generally do not apply a discount. E.g., In re Marriage of Davies, 266 Mont. 466, 880 P.2d 1368 (1994); see also In re Marriage of Harrington, 85 Wash. App. 613, 935 P.2d 1357 (1997) (husband had option to buy the shares he did not own; no discount). The same principle can be seen in businesses with many minority shareholders and no majority, where the presence of control through participation in a controlling block of minority shareholders can make a discount inappropriate. E.g., Howell.

Finally, the valuator must look at whether there are any particular provisions in the bylaws of the corporation, or perhaps in a buy-sell agreement signed by the shareholders, that give the minority shareholders particular protection from oppression. For example, in In re Marriage of Branscomb, 201 Or. App. 188, 117 P.3d 1051 (2005), the business was a partnership that owned and operated real estate. The partnership agreements provided:

A partner may leave the partnership by notifying the other * * * partners at least four (4) months in advance in order to give the remaining partners time to respond. The remaining partners have the option during this 4 month period to buy out the leaving partner's interest at a price for the land set by an appraiser mutually agreed upon by all partners. * * * A reply to the leaving partner, in the form of a letter stating the good faith intention of the remaining partners to sell or to make a buyout, will be made within 30 days of notification. In the event that no buyout is offered by the remaining partners within 4 months of the notification, the partnership shall be dissolved and the assets liquidated by sale and divided proportionally to the respective percentages of ownership.

201 Or. App. at 198, 117 P.3d at 1058. Thus, a withdrawing partner was guaranteed to receive either the price set by an appraiser to whom all partners consented, or the withdrawing partner's percentage share of the proceeds of an actual sale of the partnership assets. This provision, the court held, essentially eliminated the risk that a partner could be harmed by minority status:

Our task is to determine the value of husband's interest in the land. Ordinarily, we would determine the value of his share on the open market. Here, on the other hand, under the terms of the agreements, husband would never have to sell his share on the open market; he would either sell it to his partners or, if they do not want to buy it, the entire parcel would be sold, as a single parcel, and he would receive his proportional share. In either case, the factual basis for a minority discount would not exist: no buyer would ever be put in the position of owning a minority interest and assuming a minority risk. If the other partners buy husband out, they simply augment their majority status; they would then become sole owners, neither majority nor minority. If no buyout occurs and the land is sold as a single parcel, then, obviously, no partial interest is put on the market.

201 Or. App. at 198-99, 117 P.3d at 1058. The court reversed a trial court decision that had applied a minority discount.

Multiple Valuations

When the same business must be valued at both the beginning and the end of the marriage, normally for the purpose of determining its growth in value, it is important to use the same rules for computing the minority discount at both times. In Haentjens v. Haentjens, 2004 PA Super. 398, 860 A.2d 1056 (2004), the husband owned a minority interest in a premarital business that was sold during the marriage. The master valued the business on the date of the marriage, including a minority discount, and subtracted that value from the sale proceeds to obtain the increase in value. The trial court rejected the master's approach, holding that no minority discount should be applied, and the appellate court affirmed:

By simply subtracting this discounted figure from the amount Husband ultimately received nine years later, as a result of the arms-length sale of the Company, the Master determined that Husband's interest in the Company had appreciated by $1,149,611 over the period in question. The error in using this method of assessment is that it effectively compares apples to oranges: the initial valuation, assessed in the context of an estate administration, incorporated a substantial minority discount, while the ultimate "value" received certainly did not contain such a discount as the entire business was sold.

The trial court rejected this fundamentally flawed analysis, and instead utilized the pre-tax, undiscounted IRS valuation as the initial value of Husband's inherited interest as of 1987. By using a valuation which did not incorporate a minority discount, the trial court could more accurately compare the (undiscounted) pre-tax initial value of Husband's interest in the Company to the (undiscounted) pre-tax sale proceeds Husband ultimately received for his 44.47% interest. As a result, the trial court determined that Husband's interest in the Company had appreciated by $12,763 during the period in question. . . . We agree. Accordingly, we conclude that Wife's first argument is unavailing and we affirm the appreciation as calculated by the trial court.

Id. at 1061-62 (footnote omitted). Thus, even though normal principles of valuation would have required use of a minority discount to value the business on the date of the marriage, the trial court properly refused to apply the discount. The trial court was not required to value the company; it was required to determine the increase in value of the company during the marriage. The actual sale proceeds clearly could not be discounted. To measure the increase in value accurately, it was essential to apply the same undiscounted valuation method when valuing the business as of the date of the marriage. Stated differently, the nominal gain in value achieved by converting a minority interest in a business into the actual proceeds of a sale was not the sort of increase in value subject to classification as marital property. See also Rowe v. Rowe, 33 Va. App. 250, 267, 532 S.E.2d 908, 917 (2000) (where business was sold to premium buyer pending prior appeal, trial court must use the same "premium value" standard for all valuations of the business).

Current Trend

A number of states have moved in the past 10 years to limit the application of minority discounts in divorce cases. These states reason that the trial court's task in a divorce case is to value the business as it presently exists. Minority status can reduce the value of the owning spouse's interest if sold to a third party but in most situations, the owner has no intention of selling the stock in the immediate future. The reduction in value due to minority status is therefore really a cost of sale, just like capital gains taxes or broker's fees. See Fogel v. Fogel, 2002 WL 653318 (Conn. Super. Ct. 2002); Brown v. Brown, 348 N.J. Super. 466, 792 A.2d 463 (App. Div. 2002) (opinion corrected June 11, 2002); Head v. Head, 714 So. 2d 231 (La. Ct. App. 2d Cir. 1998); Howell v. Howell, 31 Va. App. 332, 523 S.E.2d 514 (2000); cf. Owens v. Owens, 41 Va. App. 844, 589 S.E.2d 488 (2003) (discount based on actual past oppression of minority, not theoretical risk of future oppression, is proper even when no sale is imminent).

This limited view of minority discounts has been expressly rejected by other decisions. See R.V.K. v. L.L.K., 103 S.W.3d 612, 618 (Tex. App. 2003); May v. May, 214 W. Va. 394, 589 S.E.2d 536 (2003). These decisions reason that the standard of value is transferable value the price in a hypothetical sale to a reasonable buyer. Since these states assume a hypothetical sale, they apply a minority discount even where no actual sale is imminent. Decisions requiring an imminent sale generally hold that the standard of value is intrinsic value the value of the asset in the hands of the present owner, without a sale, unless a sale is actually imminent.

There is also at least one decision in which the court tried to take a middle ground, holding that the propriety of the discount where no sale is pending is an issue for the trial court. "Whether or not it is fair or appropriate to apply a discount in a divorce case where no immediate sale is contemplated is for the trial court to determine based upon the evidence of the case." Fausch v. Fausch, 697 N.W.2d 748, 752 (S.D. 2005).

While the courts are understandably reluctant to second-guess expert valuation testimony, the application of minority discounts depends first and foremost upon the definition of "value" for purposes of divorce. If the intrinsic value standard applies, minority discounts should generally not be given where a sale is not immediate, unless actual oppression of the minority is proven. If the transferable value standard applies, however that is, if valuation is based upon an assumed sale rather than upon value in the hands of the present owner then a minority discount will be appropriate in a much larger number of cases.

The standard of value for purposes of divorce is not an issue of fact for an expert but, rather, an issue of law and policy for the court. It is therefore not good practice to treat the entire issue of minority discounts as a pure question of fact. The legislatures and courts must give the experts appropriate guidance by determining, as a matter of law, whether divorce value is the value in the hands of the present owner, or value in an assumed hypothetical sale. Once this threshold issue is determined, the application of the standard of value then becomes a discretionary issue of fact.

The dispute between intrinsic value and transferable value is one of the great policy debates in the law of valuing marital property. It influences not only the use of discounts in valuing businesses, but also a variety of other issues, such as the subtraction of capital gains taxes and the costs of sale in valuing real property, and the classification and valuation of the goodwill of a business.

Intrinsic value is the modern trend, and probably the better standard as well, because it is more consistent with the actual facts of most divorce cases. The transferable value cases expressly hold that a sale must be presumed even where the facts show that it will not occur, and therefore ultimately base the valuation upon a mistaken factual assumption. The transferable value cases might respond that a sale is bound to occur at some point, but this is not necessarily true. The owner's interest might be transferred by gift or inheritance, or the business might be discontinued when the owner retires. Even if a sale does occur, it will almost always occur many years in the future, at a time when conditions may be very different than conditions today.

The transferable value standard is closer to the standard of value used in some other contexts. For example, the standard of valuation under the law of eminent domain is necessarily transferable value, because the entire concept of eminent domain necessary requires a transfer (the taking of privately owned property by the government). Transferable value is also obviously the proper standard when experts value a business for purposes of an actual transfer on the open market. But the divorce situation is different, because most businesses will not be transferred at or near the time of valuation. Like tax value, divorce value is ordinarily the value of an ongoing enterprise. This is fundamentally why the current trend is to reject valuation based upon an assumed transfer. In the majority of situations, the assumed transfer simply will not occur.

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