No Discount: The Question of Intrinsic Value
National Legal Research Group, Inc.)
As noted above, the concept of a minority discount is based upon the notion of transferable value. A minority interest is clearly subject to a substantial discount when sold on the open market to an unrelated third party. If transferable value to a third party is the standard for measuring value, a minority discount generally must be applied.
To a greater or lesser degree, however, courts are beginning to question the notion that transferable value to a third party is the proper valuation standard. For example, in the common situation in which a majority of the shares are owned by one spouse’s family, there is no doubt that any sale to an unrelated third person would be at a discounted price. But it is unrealistic to assume that such a sale would ever happen; many family businesses are simply not bought and sold on the open market in the same manner as publicly traded companies. When an actual sale to a third party is unlikely, it is hard to see why transferable value to a third party should be the proper measure of value. The above cases do not question that a minority interest has less value on the open market; they hold that an open market does not exist, and that the business must be valued according to the transfer which is most likely to occur a sale to a family member at a nondiscounted price.
Once we start questioning the notion of transferable value, however, that concept appears surprisingly weak. Many assets which cannot be transferred on the open market are still given substantial value for purposes of divorce. Retirement benefits and stock options, for example, are commonly given the value of the future benefit which the owner will receive from possessing the asset. Likewise, assets which can be transferred are often not given their full transferable value. For example, when the marital home is valued, it is error to subtract capital gains taxes and broker’s fees unless the home is actually being sold as part of the divorce case. Turner, supra, 7.03, 8.10. Such taxes and fees are hypothetical expenses which will not actually be incurred in the foreseeable future.
But is there not an argument that the same rule should apply to a minority discount? Few, if any, close corporations are ever sold as part of the divorce proceedings. In the great majority of cases, the owning spouse continues to operate the business for many years after the divorce. If transfer will not immediately occur, however, why must the business be given its transferable value? Moreover, why must the standard be transferable value to an unrelated third party, when, as a general rule, transfer to an unrelated third party will never occur?
Courts which have taken the time to ask these questions have not been able to find satisfactory answers. As a result, a growing number of decisions are adopting a broad rule against minority discounts in divorce cases. At their core, these holdings reject the notion that the standard for valuation is transferable fair market value. They adopt instead a standard of intrinsic value the present value of the actual income which the business is likely to produce. Under this standard, so long as no actual sale is likely, and as long as a minority shareholder-spouse is not actually likely to be oppressed by a hostile majority, a minority discount is not appropriate.
A leading New Jersey decision observes:
That which has been labeled a "marketability discount" reflects the theoretically limited market for the sale of a privately-held, small business. That which has been labeled a "minority discount" reflects a theoretically more limited market for sale of a non-controlling interest in such a business. The significance of a limited market is that the asset is illiquid. Both discounts represent an attempt to account for the fact that unlike shares in a publicly-traded company, shares in a closely-held corporation have limited liquidity.
But liquidity is of little consequence here. As between James and his brothers, the only other shareholders, there is no evidence of a contemplated sale of all or part of the business, forced or otherwise. All of the evidence supports the likelihood that the business will continue under the present ownership for the foreseeable future, with James and Richard each continuing to be the active owners and officers, each holding 47 1/2% of the outstanding shares, and Gilbert holding the remaining 5%. The distinction between fair [intrinsic] value and fair market value appears to us equally applicable in the valuation of one spouse’s interest in his family’s closely-held corporation for purposes of equitable distribution.
Brown v. Brown, 348 N.J. Super. 466, 487-88, 792 A.2d 463, 476-77 (App. Div. 2002).
The law in Virginia is similar:
To that figure, the expert applied a discount of 40% for lack of marketability and 30% for minority status. That reduced the market value of the husband’s interest to $105,177. The trial court rejected the husband’s reasoning for discounting for minority status and marketability. It found the discounts inappropriate because no transfer of the partnership interest was foreseeable and no one in the firm, nor any group within it, exercised majority control. . . .
. . . We conclude that the trial court did not err in selecting the method of valuation or in the application of it to the facts presented in this case. The wife’s valuation of the husband’s interest in his law firm was supported by substantial and competent evidence.
Howell v. Howell, 31 Va. App. 332, 345-46, 523 S.E.2d 514, 521 (2000).
A Louisiana court reached the same result:
H & H is a family business which has been in existence for more than 20 years. Kenneth worked with his father and purchased his father’s interest in the business. Kenneth’s two sons apparently work with him in the business. Kenneth mentioned in his testimony that one of his sons would continue to run the business after him. The record establishes the probability and Kenneth’s intent that H & H will continue to be a family-owned business providing for the Head family.
Where a sale of the business to a third party is not contemplated, the value of the stock should be determined without discounting for lack of marketability.
Head v. Head, 714 So. 2d 231, 238 (La. Ct. App. 1998); see also Fogel v. Fogel, 2002 WL 653318, at *4 (Conn. Super. Ct. 2002) ("[N]o credible evidence was offered to the court that an involuntary sale or transfer of the business or any portion thereof would result from the filing of this action"; "in arriving at the value of the business for purposes of equitable division of the marital estate it is equitable and appropriate that no minority or marketability discount be applied to the valuation of the husband’s shares").
Brown relied heavily upon case law holding that a minority discount should not be applied in calculating the value of the stock of minority shareholders when exercising a statutory right to dissent from a corporate merger. The analogy to dissenting shareholder cases was expressly rejected in R.V.K. v. L.L.K., 2003 WL 553268 (Tex. App. 2003):
With respect to the Medical Practice Group, D.H. valued the assets, liabilities, and income stream of the corporation as a whole its "enterprise value," "the highest level at which a company’s worth may be assessed." Swope, 74 F. Supp. 2d at 911. But "enterprise value by its nature does not include a discount based on shares’ minority status or lack of marketability . . . ." Id. Enterprise value may thus be an appropriate means of valuing the stock of an ongoing business to determine its "fair value" in the context of a stockholder who dissents to a merger or acquisition since "the purchase contemplated gives the buyer total control over the corporation. . . ." Id. Similarly appropriate was the use of enterprise value in anticipation of merging the imaging centers to form the Medical Equipment Business. But "enterprise value" is entirely inappropriate in the context of valuing a minority position in stock subject to a buy/sell agreement for purposes of divorce.
Id. at *6; see also In re Marriage of Tofte, 134 Or. App. 449, 895 P.2d 1387 (1995) (minority discount is permissible even where the owner has no present intention to sell the business).
One possible objection to the intrinsic value standard is that the court is valuing present property by using future benefits, and therefore dividing future income. This objection runs contrary to the actual practice of the business world. When businesses are valued for the purpose of setting an actual transfer price, in a transaction completely unrelated to any divorce case, the future earning capacity of the business is almost always a dominant factor in the valuation. This is true because the earnings of a business depend upon many intangible factors other than the personal efforts of the owner. Most prominent among these factors are the location and reputation of the business. These factors are to a large extent transferable, so that a business which has a high income-to-assets ratio under one owner is likely to have a similarly high ratio under another. It is admittedly important to exclude the value of the owning spouse’s future efforts from the valuation, but most income-based methods do this by looking only to the net earnings of the business, after subtracting a fair and reasonable salary for the actual contributions of the owner. To the extent that the transferable value of the business is less than the intrinsic value, after the owner’s postdivorce efforts are included, the difference is the goodwill of the business as an ongoing concern.
There is, of course, considerable debate over whether unmarketable goodwill is marital property. Turner, supra, 6.22. Most of the states moving most aggressively toward an intrinsic value standard are those which treat unmarketable goodwill as marital property. Even if goodwill must be marketable to be marital property, however, there is no requirement that it must be marketable to a third party. When the overwhelming likelihood is that any actual sale will be to a close family member for an undiscounted price, the business may well have marketable goodwill in excess of its discounted value.
In sum, when sale on the open market is a likely result of divorce, or when a minority is actually likely to be oppressed by a hostile majority, a minority discount is required in any state. Where sale is not imminent, and actual future oppression is hypothetical or speculative at best, the courts are having growing doubts about applying a minority discount. The argument in favor of such a discount relies heavily upon the concept of transferable value to a third party, but where sale to a third party is unlikely, the standard of value may well be different. In cases where there is no apparent ongoing economic impact traceable to minority status, the argument for a minority discount is likely to remain weak.
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