Deal Diary: How to Handle Minority and Marketability Discounts in Operating Agreements

Recently, while putting together an operating agreement for a surgery center, we used a formula-based redemption price but had an appraisal out if someone objected. Should our operating agreement allow the appraiser to apply minority and marketability discounts or should that be off the table?

To step back, buy/sell provisions in ownership agreements establish the terms on which owners are bought out, including valuation of the departing owner's equity. Sometimes it's based on a formula, sometimes appraisals, sometimes something else, and the overall valuation can change based on whether the departing holder is leaving for a positive/neutral reason or a negative one.

Minority discounts are applied to reduce the valuation of a minority stake in a business, reflecting the lesser control such equityholders have over business operations and decisions. Marketability discounts are used to lower the valuation of an asset that might be difficult to sell, considering factors like the lack of a ready market or restrictions on transferability - things that apply to almost all private businesses.

Obviously, majority holders are in favor of minority and marketability discounts, as they mean the equity of their partners can be purchased for less.

Obversely, minority holders dislike them, as it makes their equity worth less.

Beyond self interest, what's the right way to go?

Many businesses don't have a controlling holder, and in those situations, a discount likely isn't appropriate.

For those that do, a minority discount may make sense. For example, the physician owners of a surgery center are often minority participants, whereas a PE-sponsored entity is often the 51%+ controlling holder. Generally, the PE owner has more governance and other rights. In that situation, applying a discount seems logical, but disadvantages the equity holders that drive the business's revenue - the doctors who do cases at the center.

Also, if the valuation methodology used by an appraiser incorporates a control premium (like a precedent transactions analysis does), using a discount removes the premium.

Finally, in a formula-based valuation with a fair-market-value appraisal out that uses discounts, the use of discounts may discourage costly and time-consuming appraisals in favor of the formula if it doesn't incorporate a discount.

BOTTOM LINE: There are more dimensions to this, but the key takeaway is that on the way in, know how you're equity will be valued on the way out.

(Would love other thoughts on the rational approach here from the perspectives of both valuation and legal professionals.)