Valuing a Minority Shareholder’s Common Stock Amid Capital Restructurings

Anthony Law

As seen in Corporate Finance Review

A Case Study of Auto-Supply Corp

Our goal with the following case study is to provide insight into the challenges of valuing assets and to share a variety of best practices from real-world scenarios.

Valuing investments in private companies requires a flexible approach. Each situation is unique. Our goal with the following case study is to provide insight into the challenges of valuing these assets and to share a variety of best practices from real-world scenarios. Though we use a generic company name—in this case “Auto-Supply Corp”—the transactional and valuation­ process details come directly from our experience. The Auto-Supply Corp case explores ways to approach valuing a minority shareholder’s stock holdings in a private company given limited public information and financial statements. This case features a reverse auction, two separate special dividends, recapitalization through a term loan, and somewhat volatile industry multiples. It is a prime example of the valuation challenges that minority shareholders can encounter when an active majority shareholder affects significant capital changes and only limited information is available to minority shareholders.

This case highlights a valuation analysis where traditional application of the income and market approaches is either limited or not available, emphasizing the need to explore other potential indicators of value. One place to look for clues is the company’s financing activities. From these transactions in the capital structure, we were able to derive significant information about the enterprise and equity value of the company at different points in time, despite having no insights to the financial projections looking forward.

Applicable valuation considerations

The following list highlights valuation considerations applicable in the Auto-Supply Corp case. This wide range of issues should be considered at the outset in order to successfully synthesize the character of the security in the context of its history, its fact set and features, its relative sensitivity to key input estimates, and its overall quality of information. By framing the security in this manner, we can assess the valuation approaches most relevant to Auto-Supply Corp. The contextual framework also makes clear the inputs that would be required of a particular approach and how uncertain, as well as sensitive, such inputs may be. Our ability to gauge inputs is based on our knowledge of Auto-Supply Corp and, even more, on our experience obtained from performing a wide variety of portfolio valuations.

  1. Complexity of capital structure
  • Debt/equity mix
  • Presence of preferred, convertibles, or senior equity securities
  • Common stock equivalents and dilution (e.g., warrants, stock options, profits interests, and restricted stock)
  1. Recent historical transactions in the company’s equity
  • Preferred stock financings
  • Dividend recaps and special dividends
  • Active grants per equity incentive plan
  1. Ability to measure the company’s total enterprise value
  • Income approach
  • Market approach
  • Pre-revenue vs. established operating company
  1. Liquidity event expectations
  2. Majority vs. minority shareholders
  3. General availability of information and depth of specific industry
  4. Previous encounters with financial distress

Case background

A previous debt holder, our client holds a common stock position in Auto-Supply Corp as a result of the company’s voluntary bankruptcy filing undertaken to facilitate a restructuring and deleveraging. The client’s term loans were converted into common stock as part of an Asset Purchase Agreement entered into with the majority shareholder that lifted the company from bankruptcy. The newly created equity structure has authorized preferred shares, but none are currently outstanding. The common stock itself is economically fungible with only some minor distinctions in the form of voting rights (there are Class A and B common shares). At this time, the company has not developed an Equity Incentive Plan, nor has it authorized or issued any convertible securities on its common stock (e.g., no warrants, stock options, or restricted stock is yet outstanding). Thus, relatively speaking, the emergent equity structure is fairly simple. The common stock is held by a majority investor and minority shareholders with limited information rights and strong restrictions on sale and transferability. Since emerging from bankruptcy approximately a year and a half ago, minority shareholders have consistently received quarterly, unaudited financial statements with a brief management discussion and analysis. However, other forms of shareholder communication, such as periodic management calls and detailed financial presentations, have heretofore been nonexistent.

The expectation is that the majority investor will seek a liquidity event through an IPO, but the timing is uncertain. The company has folded-in a small acquisition and has a cash pile that could be used for future acquisitions.

Since emerging from bankruptcy, the company’s operating performance has been strong, despite some market volatility in the sector. While sector valuation multiples have bounced around, the company’s underlying performance has shown consistent and steady growth in revenues and profits, indicating that margins are intact and business fundamentals are healthy.

Almost one year after the effective date of the amended Articles of Incorporation, the majority shareholder conducted a Dutch (reverse) auction (the auction) in which it offered to provide existing shareholders with a one-time limited liquidity opportunity. Such an auction offers to buy tendered shares up to a “not-to­exceed” per-share price for a defined aggregate dollar amount. Tendered offers will be transacted first from lowest price proceeding in reverse order to the highest price until the total proposed dollar amount is invested, thus making the number of shares transacted in the auction variable.

General valuation concepts applicable to common stock

Narrowly defined, common stock represents a residual equity claim. As such, the value of common stock will be a function of the entity’s total equity value at a point in time. Of immediate distinction is the difference between valuing the company’s total equity and valuing its common stock. This can be critical to level three valuations of common stock where it is less frequently the case that the two are essentially one-in-the-same, meaning the common stock is simply a per-share representation of the total equity value (i.e., divide total equity by outstanding common shares). More often we encounter equity structures that range in complexity and do not allow for a simple per-share expression of the common stock value. Complexities generally arise in connection with outstanding classes of preferred stock that have economic rights superior to or distinct from common shares as well as warrants, stock options, and restricted stock, which all represent potential common stock equivalents and are typically dilutive. Additional complexities, to a lesser significance, manifest when there are different classes of common stock with varying degrees of voting and liquidation rights, seniority, dividends, etc.

Of significant interest in the valuation of common stock are any historical transactions in the company’s shares as well as any past and currently paid dividends. A direct transaction in the stock may provide significant valuation information, which should consider both the timing and nature of the transaction, including an understanding and evaluation of the extent to which it is arm’s length, involves sophisticated investors (new and existing), compares to a prior round, and/or reveals any level of distress. While perhaps less direct than a transaction, dividends are a cash flow to the shares and may be associated with a recap of the company that may again provide a strong signaling element to the stock’s value.

Case-specific valuation issues for the common stock

The primary issue in valuing Auto-Supply’s common stock has been the privacy of the stock and its limited information. Our client indicated that lack of insight into the company in terms of both operational and financial information has been the main source of difficulty in valuing its stock position since inception. Outside of providing the standard financial statements, which are unaudited and absent footnotes, the minority shareholders receive little else with which to base its valuation (e.g., no projections or forward-looking measures). This, however, is not particularly unusual for minority positions.

The result was our client’s decision, following the auction process, to mark its investment at the stated price in the Dutch auction, even though it represents a maximum price that may or may not reflect fair value and would best be assessed in the context of the auction’s results. The other result has been the client’s reluctance in subsequent quarters to move the mark from the auction price unless there is strong evidence in either operating performance or market multiples that suggests a move in position.

Yet despite the private nature of this minority common stock holding and its associated valuation challenges, the holding has had some significant events, coupled with favorable operating performance, that have provided relevant insights to value and the ability to frame the value and make reasonable updates to the mark across periodic reporting dates.

Specifically, our periodic valuations have been able to consider both significant transactions in the company’s equity and profitable operating performance with general improvement from quarter to quarter. The specific transactions involved the auction sponsored by the majority shareholder and two large dividend recaps, all three occurring within the span of 18 months. Such events provide meaningful insight to the equity value and its changing profile. In addition, profitable operating performance greatly facilitates the application of a market approach based on multiples either observed in recent sector-related corporate transactions or multiples measured via sector-specific guideline companies selected for valuation purposes. Where limited information is made available and a discounted cash flow analysis is not supported, these market events in the stock have played an important role in making a reasonable valuation possible through variations of a market approach.

Original valuation date

In the valuation hierarchy, direct transaction in the company’s shares is considered a strong indication of value and generally takes priority to valuations based on comparable measures or valuation models. As such, the auction was an important consideration, but not the only consideration. Specific to the auction, we considered its size (total dollar amount committed), the participants, and the motivation for the auction. The auction was considered arm’s length and the participants sophisticated investors, which are supportive of the auction as an indication of value. The limited pool and insider nature of the participants and the purpose being to provide liquidity were considered mitigating factors, which would manifest in our weighting of the auction in our valuation, as opposed to an adjustment to price.

Without initially knowing the results of the auction process, we decided to make note of its maximum offer price but did not weight it in our valuation, preferring instead to incorporate the auction based on its results once the information was made available (the next reporting period or following quarter). Depending on participation, the maximum price may or may not have significant meaning. Of note, we considered that the auction’s price discovery process implicitly priced in the illiquidity of the shares. Thus, when considering this event in our valuations, we did not apply an additional marketability discount to the auction price, which we felt was being reflected in the tender prices made by participants.

In our original valuation we relied exclusively on a market approach based on guideline company multiples. We formulated LTM EBITDA and estimated a range of total equity values, considering book value of debt and cash levels on the balance sheet. Our EBITDA multiples reflected the company’s sector and its current market dynamics. We selected at the lower end of the range to reflect the recent emergence from bankruptcy and the accentuated illiquidity in the minority position.

The result was a valuation range sensitive to the selected range of EBITDA multiples, the calculated net debt (book value of debt less excess cash), and the marketability discount. Our client marked its common stock value at the auction price, viewing this price as both timely and the most reasonable indicator of value in a stock that otherwise had no trading history at all. After applying a discount for lack of marketability1 to our market approach, our valuation range encompassed the client’s independent mark. The corroboration between the auction price established by a knowledgeable majority shareholder and our market approach reflective of sector valuation multiples implied a reasonable value range had been obtained.

Subsequent valuations

Our first year-end valuation included two significant additions to the original market approach. First was the inclusion of the auction as a pricing mechanism for the common stock. The newly presented quarterly financials did not specifically address the results of the auction, but we were able to infer some meaningful information from the balance sheet and cash flow statements about the actual results. Specifically, treasury stock was a new line item in both the cash flows from financing activities and the shareholders’ equity. Additionally, the reduction in both the number of Class A and Class B shares outstanding was measurable based on the reported shareholders’ equity on the balance sheet. Dividing the treasury stock book value by the total reduction of common shares yielded a per-share value that exactly matched the maximum offering price from the auction. This indicated that the tendered shares were all tendered at the maximum auction price and that the auction did not reach its full potential subscription. We considered this transaction in the common stock to be meaningful and included this price derivation in our valuation (25 percent weight).

Second, the company issued a term loan resulting in a material change to the capital structure. The proceeds were used to (1) refinance the existing first and second lien debt and (2) pay a special dividend to all the common stock holders (again, no economic distinctions or preferences to consider among the equity holders). The recap and dividend are more significant economically and mechanically to the mix of individual securities comprising the enterprise than to the actual enterprise itself. Such a financing reallocation can signal a positive message about the company’s recent performance, or something potentially more troubling. In this case, the signals were positive; accumulated earnings had become slightly bloated and significant cash, well beyond a required level, was present on the balance sheet. As a result, the dividend was economically equivalent to a paydown on the equity, essentially a monetization of future dividends.

Our primary market approach remained consistent to the original valuation date—same technique and same guideline company comparable set. Again, we applied an EV/EBITDA multiple to infer total enterprise value, which was then adjusted based on net debt to estimate total equity value. This is the point where the effect of the dividend was felt on the equity value. Since total equity was measured by subtracting net debt from enterprise value, the total equity value following the dividend necessarily decreased as the debt increased and the cash decreased, causing an increase in net debt. We considered excess cash part of equity. Said another way, excess cash can be used to paydown debt, which reallocates enterprise value to equity. Following the dividend, the cash balance decreased and the net debt value increased, reducing the total equity value almost dollar-for-dollar the amount of the dividend, while the enterprise value remained relatively unaffected.

In selecting our range for the EBITDA multiples, we considered the new leverage and found at the high end of the comparable range the debt/TIC ratio was 40 percent and at the low end of our range the debt-to-equity ratio was still a relatively safe one-to-one.2 As such, we did not seek to lower our selected multiples because the recap and dividend did not significantly increase the enterprise risk. Our client adjusted its original per-share value down by the per­share dollar equivalent of the dividend paid for its year-end mark. This price was in our range based on EBITDA multiple market approach (75 percent) and the auction-dividend adjustment approach (25 percent).

Subsequent valuation dates have been variants of this same theme. Financial projections remain unavailable, so an income approach (in the form of a DCF) has not been incorporated. The quarterly financials have shown continued strength and improved performance. The guideline companies have shown some volatility as the sector was exposed to some market swings, causing the multiples to move across valuation dates. As time passed, we began to weight the auction price less and less, but we still held it in mind as the lone data point in the stock’s trading history. Just prior to the most recent valuation date, the company performed a second significant dividend recap, this time upsizing its outstanding debt balance and paying another comparable large dividend. Similar to the first time, this event played an important role in our analysis, and we followed a similar approach. Our client also, for the first time, provided a mark based on a market approach using EBITDA multiples from its selected comparables.

Conclusion

Auto-Supply Corp has presented some interesting facets in the valuations of its common stock. The absence of forward­looking financial information and guidance from senior-level management has highlighted the importance of transactions in the company’s equity as well as the role a significant alteration in its capitalization can play. This case emphasizes some of the difficulty a minority shareholder can encounter when the stock is particularly illiquid due to terms and conditions of a majority shareholder’s active involvement. But despite some of the more traditional valuation approaches being unavailable, there were still significant guideposts that provided meaningful value indications in the subject company securities that made an otherwise opaque security a little more transparent.

The key lesson or takeaway is to be flexible when performing a private company enterprise or equity valuation. Each situation is unique. Look to gather and make use of not only financial metrics and projections, but also how the company is financing itself. Bear in mind the context of the company’s recent historical performance and outlook to help assess what inputs and assumptions may be required and how reliable they may be when applied in a selected valuation approach. The discounted cash flow is a go-to approach, but at times it is clearly not the most reliable. Instead, the financing activity can prove to be an excellent basis for a valuation, especially when access to information is generally limited.

We quantified the DLOM by using a Protective Put model, which is a quantitative approach using the Black-Scholes option pricing model and volatility and restriction period as key inputs to the amount of discount estimated.

TIC is total invested capital; thus, the debt/TIC ratio expresses the percentage of the capital structure funded by interest-bearing debt. Except for some potential nuances, a debt/TIC of 0.5 is equivalent to a debt/equity of 1.0.


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