What it means
The overwhelming majority of companies in the world are closed corporations, even though listed companies attract nearly all the attention. Some jurisdictions offer a specific statutory form with a cap on the number of shareholders and a ban on public offerings, while in other places the term is simply descriptive of how the ownership happens to be arranged.
The main commercial consequence is illiquidity. An owner who wants out cannot sell into a market at a quoted price, so value has to be negotiated, and disagreements about what a minority stake is worth are one of the most common causes of shareholder disputes.
Well-run closed corporations deal with this in advance through a shareholders' agreement. That document typically sets out pre-emption rights, drag-along and tag-along clauses, and an agreed process or formula for valuing shares on death, retirement or a forced exit.
Valuers usually start from what a comparable listed business would be worth, then apply a discount for lack of marketability because the buyer cannot sell easily. A further minority discount may apply where the stake carries no ability to influence dividends, pay or strategy, and the two discounts together can be substantial.
Governance in a closed corporation is often informal because the owners and the managers are the same people, which works well until interests diverge. For that reason many legal systems give minority shareholders specific protection against oppressive or unfairly prejudicial conduct by the controlling group.
In practice
Real-world examples.
Example
A third-generation printing business has 14 shareholders, all descendants of the founder. When one shareholder wants to emigrate, the shareholders' agreement forces her to offer the shares to the family first at an independently assessed price before any outsider can be approached.
Example
A two-founder engineering consultancy takes on a minority investor. The investor insists on tag-along rights so that if the founders ever sell the company, the investor can sell on identical terms rather than being left holding an unsellable stake.
Example
A regional bakery chain is owned by its chief executive and a private equity fund. The fund's exit clock forces a sale process after seven years, which is the practical reason many closed corporations end up listed or acquired eventually.
Formula
Calculation
Value per share = (comparable listed equity value / shares outstanding) x (1 - discount for lack of marketability).
Rivermill Tools, an invented family manufacturer, has 200,000 shares outstanding. An adviser concludes that a comparable listed peer group would value the equity at $10,000,000, and applies a 25% discount for lack of marketability because the shares cannot be sold on any exchange.
Step 1: $10,000,000 / 200,000 shares = $50.00 per share on a listed basis.
Step 2: $50.00 x (1 - 0.25) = $50.00 x 0.75 = $37.50 per share.
Step 3: $37.50 x 200,000 shares = $7,500,000 for the whole company.
A retiring cousin holding 10% of the company owns 20,000 shares, so her stake is worth 20,000 x $37.50 = $750,000. Had a minority discount also been applied, that figure would fall further, which is precisely the sort of gap that a pre-agreed valuation formula is designed to prevent.Case study
Seen in the real world.
The following is an illustrative and entirely fictional scenario. Kettleworth Fasteners was owned by four siblings in equal quarters, with no shareholders' agreement because the founders had never expected to need one. When the eldest sibling died, his quarter passed to two children who had never worked in the business and immediately asked to be bought out.
The remaining owners offered $1,500,000, being a quarter of the $7,500,000 valuation, or $1,875,000, less a further 20% minority discount. The heirs argued that no minority discount should apply to a sale forced on them by the company's own structure and held out for the full $1,875,000, leaving the two sides $375,000 apart.
Eighteen months of legal costs later, the parties settled at $1,687,500, the midpoint of the two positions. The surviving siblings then commissioned the shareholders' agreement they should have had at the start, complete with an annual valuation, a fixed discount schedule and life insurance funding a buy-sell arrangement for each owner.
Watch out
Common mistakes.
- Assuming a closed corporation is the same as a small company. Size is irrelevant, and some very large businesses with billions in revenue remain closely held by a family or a founder group.
- Valuing a private stake using listed market multiples without any adjustment. Ignoring the discount for lack of marketability overstates what a buyer would realistically pay for shares that cannot be sold on.
- Treating a handshake between founders as sufficient. Without a written shareholders' agreement, exits, deaths and divorces are resolved by default company law, which is rarely what any of the owners actually wanted.
Questions
People also ask.
Is a closed corporation the same thing as a private limited company?
In everyday use the terms overlap heavily, though some jurisdictions define a closed corporation as a distinct statutory form with extra restrictions on share transfers.
Can a closed corporation raise outside capital?
Yes, through private placements, bank debt or a private equity investment, but it cannot advertise shares to the general public without converting to a form that permits it.
How is a controlling stake valued differently from a minority stake?
A controlling stake usually attracts a premium because it carries the power to set dividends and strategy, while a minority stake is typically discounted for the lack of that power.
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