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You may have heard the terms “minority interest” or “minority stake” before, but what do they mean in connection with your business? While the terminology is likely clear, the implications might not be. What does it mean for you to have a minority interest? What happens if another firm takes a minority stake in your business?
Reviewing the benefits and limitations of minority stakes can help you determine whether or not taking one is right for you and your company.
A minority interest refers to the portion of a company not owned by the parent company or majority shareholder. While any ownership stake under 50% qualifies, the minority interest typically holds 20-30% of the company in question.
Depending on the size of the stake, the minority shareholders generally have less say in the business’s operations or strategic decisions. For this reason, minority stakes, especially those below 20%, are often referred to as “non-controlling interests.” However, control rights are negotiable. In exchange for an investment, private equity (PE) firms and other investors usually prefer to negotiate a seat on the company board.
There are two main types of minority stakes: passive and active.
Passive minority stakes hold 20% or less of the company. Except for cases where it’s specifically negotiated (often with PE or professional investors), this level of ownership typically doesn’t entitle the minority shareholder to much influence. Although they may legally have some audit rights or permission to attend partnership or shareholder meetings, these types of investors generally play the role of the silent partner.
From an accounting perspective, a passive ownership stake is recorded as an investment at cost, and the minority stakeholder records dividends paid under dividend income.
On the other hand, stakeholders with 21-49% active minority interest generally enjoy a more influential role. Although the majority shareholder may hold veto rights, an active minority stakeholder has a voice in the company. They may influence company management decisions, policy development, and even a seat on the company’s board of directors.
Active minority stakeholders record dividends and their portion of the minority interest’s income on their income statement via the equity method.
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Let’s assume Chart Inc. purchases 40% of Simulator Corp., a $100 million company. Assuming the equity method of accounting is used, at purchase, Chart Inc. records a debit to “Investment in Simulator Corp.” of $40 million and an equal credit to “Cash.” As a result of a profitable year, Simulator records $10 million in net income and issues a $1 million dividend.
Chart Inc. would then record a debit of $4 million (40% of $10 million) to “Investment in Simulator Corp.” and an equal credit to “Investment Revenue.” The dividend would be booked as a debit of $400 thousand (40% of $1 million) to “Cash” and an equal credit to “Investment in Simulator Corp.”
The ending balance of “Investment in Simulator Corp.” would increase to $43.6 million ($40m + $4m – $0.4m), which would be found on the balance sheet. On the income statement, you would see the $4 million of “Investment Revenue.” And on the cash flow statement, you would see “Cash Flow from / (to) Investing” with a negative $39.6 million balance ($40 million cash outflow offset by $400 thousand dividend inflow).
There are some critical benefits to holding a minority stake in a business. The investing company is often looking for higher returns on capital deployed. A well-managed target company paying a regular cash dividend can be an attractive investment to any company.
In other cases, the investment is more strategic. Maybe the minority investment company is hoping for an inside look at emerging technologies or indirectly investing in additional capacity. The investor may also intend to build an alliance relationship, perhaps gaining access to target markets or blocking competitors from doing the same.
For some, the limited rights of a minority stakeholder mean the risks and limitations of minority ownership in a business outweigh the benefits.
Depending on the percentage of ownership, your influence can range from having zero say in the company to holding veto rights on all significant decisions. However, even an active investor with a 49% stake might need to defer to the majority owner, including when the owner makes a poor decision that puts the business at risk.
Further, receiving cash distributions and dividend payments from the majority owner can be challenging. Majority owners have multiple options available to arrange to avoid releasing payments. For example, they might decide to purchase new equipment or pay themselves a higher salary. In this situation, a minority owner’s options for forcing a payment might be limited.
Additionally, a minority shareholder needs to proceed cautiously if the business is to be sold in the future. The existing owner may be able to structure the deal to favor the majority owner over the minority.
Taking on a minority investor (or even taking a minority stake in a target business with your company) has both pros and cons. While there are some limitations, minority interests can bring advantages to both sides of the table. Before proceeding with a minority interest, it’s essential to understand who’s getting what from the arrangement and design the legal agreements accordingly.