If a store block is worth a million dollars, what is a 10% share in
it worth? Let’s say that ten sisters and brothers own equal
shares. What is each one’s share worth? The simple answer is 10%
of a million dollars. But the simple answer is not necessarily the
accurate answer. Because, if the question is, what would that 10%
share sell for if it were put on the market, the answer might not be
$100,000. It might be difficult to sell the 10% share. As a
result, it might sell for less. If that is the case, its owner has
experienced what in accounting circles is termed a “minority
discount.” The 10% interest is a minority, and its value is a
discount from the face value of 10%.
A sizable industry has grown up to apply discounts in the
valuation of minority interests. In the valuation of the
assets of an estate, for instance, it is important that a taxpayer’s
heirs not be forced to pay taxes on more than what the estate is
really worth. Minority discounts were originally applied to
small, fractional interests for which there might be only a tiny
market of buyers. But over the years the practice of applying
minority discounts has grown to the point where the “minority” may
be a 50% owner – say, the husband in a husband-and-wife ownership of
an asset like a house. Until recently, no one thought of a
half interest like that as having less than 50% of the whole value.
Now, many advisors do. And when they do, the practice of
applying a minority discount begins to fly in the face of our common
understanding of what a share is worth.
The logic of minority discounts is sound. Often, the minority
interest is a 1/100th share or less. A general partner, not
the minority owner, makes decisions as to whether to upgrade the
property, convert it to condominiums, or sell. The minority
owner has no voice and no control. A partnership may operate
under rules that penalize shareholders when they sell their
interests to outsiders, limiting their market to only a small group.
With issues of lack of control and lack of marketability of this
kind, the logical conclusion is that the minority share suffers a
The problem for appraisers is the lack of direct proof.
Appraisers experience considerable discomfort when market data are
unavailable to back up even the most logical assertion. The
“proof” of minority discounts and of the rate of discount that it is
appropriate to apply comes from data involving resales of shares in
a small group of real estate partnerships formed in the 1980s.
The analysis of the data, including the calculation of the discount
rate, is by a third party, not the appraiser making use of it.
To the extent that the data are derived from trades of very small
fractional shares in very large properties, the data may be less
than relevant to the valuation of a 50% interest in the store block
owned by a husband and wife. Without good-quality, comparable,
hard data, the appraiser is without an anchor. Any value
conclusion is as good as any other, because no good real-world proof
is at hand.
The method of valuing a minority interest by applying a discount to
its face value is a method devised by a different profession.
It has been adopted by appraisers for long enough for appraisers to
have discovered its flaws. Appraisers are not generally
content to do things only one way. Appraisers have
traditionally sought multiple methods to estimate value.
One alternate method of valuation of a minority interest is to
examine its history of cash flows. If a 1/100th share of a
group of apartment buildings has a history of consistently throwing
off (and looks like it will continue to throw off) an annual
dividend of $200, if 99 other shareholders are available as
potential buyers of the 1/100th share, and if 5% represents a
reasonable rate of return, we could apply the standard appraisal
logic of the Income Capitalization Approach to conclude that the
value of the share is $4,000 ($200/.05 = $4,000).
But the method of valuation that appraisers most prefer is the Sales
Comparison Approach. It is a second alternate method. If
something has sold in an arm’s-length transfer, isn’t that price the
strongest proof of what an identical thing is worth? If we
have an abundance of data from sales of small shares in hundred
million dollar assets and if we are confident in the computations
that show a minority discount, then the minority discount method may
be acceptable. On the other hand, if the comparable sales are
of small shares in big assets and the thing we are valuing is a half
interest in a three-decker – a large share in a small asset – we
have a mismatch, and we need to look for better comparable sales.
When we look for comparable sales for quarter or half interests, we
come up empty. Call a commercial broker’s office and ask
whether anyone has a half interest or a quarter interest in
something for sale, and the broker will draw a blank. Go to
Ebay or to Craigslist. Look for the same thing. You will
find little or nothing. Brokered sales of half, quarter, or
10% interests very seldom occur.
Four people form a partnership to acquire a small office building.
Five years later, one dies. What happens to that partner’s
share? Typically, the matter is settled internally. The
estate may have the property valued, and the three survivors
re-finance and buy out the estate’s interest, at face value.
Or, the survivors find a new fourth partner, who buys out the estate
– again, at face value. The estate has no interest in selling
at a discount. The survivors have no interest in taking on a
stranger as a fourth partner. So the share is never exposed to
the market. An arranged sale at face value is what occurs.
To provide better answers to what minority interests are worth,
appraisers need better data. Sales of quarter interests and
half interests are not handled through brokers. They are not
publicly reported. They are not compiled as data.
Without comparable sales, appraisers are on uncomfortable ground.
The demand for the data exists. Minority interests and sales
of them, in fact, are as common as mustard seeds. They happen
every time an internal, arranged sale occurs. In the valuation
of minority interests, billions of dollars are at stake. Given
the pent-up demand for data to tell us the prices at which minority
interests have been bought out in the internal transactions that
occur all the time, we can expect that, in time, the information
will become available for appraisers to use.