A well-defined minority interest can benefit all owners equitably.
Minority interest in business may sound like a straightforward concept – any percentage of business ownership amounting to less than 50% is considered a minority stake. However, the subtle nuances and conditions of a minority interest position are extremely important, since they determine how the control of a company is managed, how profits are distributed, and how the minority interest is treated during an exit event. Any investor, company, or group who purchases a minority stake in a business should fully understand their rights, responsibilities, and the options available to them.
In this blog post, we explain the various ways minority interest arises in a business setting, how it impacts valuation and accounting metrics, and some best practices for negotiating and managing a minority interest.
The concept of minority interest
A minority interest refers to the portion of a company not owned by the parent company or majority shareholder. A minority stake in a business can be anything under 50% but is typically between 20-30% of the company.
Minority interest in a business is also referred to as non-controlling interest or NCI. A minority stake can be either:
● Passive, where an investor may attend meetings and review financial reports, but generally plays the role of a silent partner in the day to day operations of the business.
● Active, where the investor has a more influential role, including potential say in operations, policy development, management decisions, and possibly a seat on the board of directors.
As an example, Prince Alwaleed bin Talal of Saudi Arabia purchased 5% of Twitter (now X) on the same day Elon Musk concluded his buyout, thus becoming a minority shareholder in X just as Musk became the majority shareholder.
How minority interest arises in companies
A minority interest can arise in several different ways, depending on the intent of the investor(s) and the specific circumstances involved. Scenarios that can lead to a minority interest include:
● Equity investments where companies or private equity partners make a strategic investment in a business without taking a controlling interest.
● Initial public offerings (IPOs) where shares of the company are offered to outside investors and the original owners’ stake decreases.
● Joint ventures where multiple companies or investment groups pool their resources, with each taking a varying ownership stake in the business.
A minority interest can also arise when regulatory limits restrict ownership percentages. A majority owner of a bank, hospital, or large manufacturing company may be forced to sell a percentage of their stake to assuage regulatory concerns over financial stability or an industry monopoly.
When additional shares in a business are offered to outside investors to raise capital, the original ownership stakes are diluted. Excessive dilution can be an unfavorable prospect for early investors in a business since it reduces their influence along with their potential ROI.
Challenges and opportunities for minority stakeholders
A minority interest in a successful business can be extremely lucrative, but it also comes with distinct limitations. Typically minority shareholders play a less influential role in day-to-day operations. Even an investor with a 49% ownership stake may need to defer to the majority owner depending on their shareholder agreement. Additional challenges commonly faced by minority shareholders include:
● Lack of control including day-to-day operations, management of the business as well as larger decisions such as overall strategy, financial changes, and exit options.
● Potential diminished exit liquidity when selling independent of the majority shareholder.
● Competing interests with other owners.
● Relationships with majority owners can sour, leading to limited or reduced information provided to minority owners.
At the same time, a minority interest comes with perks that can often outweigh these drawbacks. Enticing opportunities for minority shareholders include:
● Alliance-building with majority owners in new and diverse markets.
● Limited liability and exposure if the company underperforms or fails.
● Easier access to liquidity through the sale of the entire company.
● Regular payouts, such as cash dividends, to provide an ongoing revenue stream.
Minority interest in business valuation and financial reporting
Minority interest impacts the company valuation of both the majority and minority shareholders because minority ownership is a claim on the cash flow of the business. From a company valuation perspective, control is important. A minority interest valuation is often subject to discounts for lack of control and marketability.
Without full control, an owner cannot unilaterally elect directors or change management, set dividends or cash distributions, purchase or sell assets, or decide how or when to sell the full business. Discount for lack of marketability is a reduction in value as a result of a lack of ease selling the ownership interest in the market. This applies to all private companies in general but non-controlling ownership interests are especially impacted by a lack of marketability.
Minority Interest Reporting Guidelines
To account for the unique nature of minority interest in comparison to majority interest, specific accounting guidelines have been established under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). These guidelines define the allocation of profits and losses between majority and minority stakeholders on the income statement, inclusion of minority interest as shareholder’s equity on the balance sheet, and the inclusion of ratios such as minority interest/total shareholders’ equity.
Legal rights and protections for minority interest shareholders
The legal rights and privileges of minority interest shareholders vary depending on the type of company (public, private, etc.), relative size of the investment, and terms of the contract. However, all minority stakeholders have distinct rights and protections under the law. First and foremost, majority shareholders owe minority shareholders a fiduciary duty to work in the best interest of the overall business. Minority stakeholders also have the right to:
● Participate in major business decisions in accordance with the shareholder agreement.
● Access company books, records, and financial statements.
● Seek legal recourse when majority owners violate their duties.
A shareholder’s agreement is the legal document that dictates the terms of the investment and what happens in the event that business or legal issues arise, such as dilution of shares, unpaid dividends, sale of the business, or breach of confidentiality.
Strategies for managing and negotiating minority interest in business dealings
Before participating in a minority interest, either as a company seeking an investor or as the investor themselves, individuals should perform due diligence to evaluate the financial health and culture of the company under consideration.
Determining the appropriate valuation for a minority interest investment is also extremely important, since the rights and amount of control outlined in the shareholder agreement can have a large impact on valuation. Benchmarking the valuation practices of similar transactions can point you towards appropriate solutions, but every situation is different. Once the valuation is established, negotiations focus on payment methods, timing, contingencies, representations, and warranties, which are the promises and assurances made by the controlling shareholders. Each of these fine points can impact the success of the minority interest deal in the long run.
In conclusion
A minority interest can arise in many ways, but it is never a one-sided equation. It is important for majority and minority stakeholders to fully understand the nuances of minority interest to ensure both parties are treated fairly and maintain the levels of information and influence they need to meet their expectations. Shareholder’s agreements and other legally binding documents can set the stage for a successful minority interest partnership that benefits all owners equitably, while removing ambiguity and preventing conflicts. Most importantly, a well-defined minority interest can improve communication and trust among all stakeholders.