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The lack of precise valuation provisions in legal agreements is one of the main causes of valuation disputes. For shareholders and their legal advisers it is critical to understand the different valuation bases that exist and how these might affect the future pricing of the shares when drafting Articles of Association or shareholders’ agreements.
Listed company shares have one value, a price which may constantly move but which, nevertheless, is transparent and represents the value at which market participants can trade. In contrast, there are few, if any, markets for private company shares and so some form of valuation calculation is required. The valuation basis describes the fundamental assumptions on which the reported value will be based and will have a material impact on the final pricing of the shares.
A basis of value can fall into one of three main categories:
It follows from the above that the right valuation basis will depend upon the particular circumstances that the legal agreement seeks to cover. For example, a market value basis is unlikely to be appropriate for valuing a share in a joint venture which would not be marketed generally and whose main benefits flow to the joint venture partners. In this context a fair value or intrinsic value approach might be more suitable.
This is defined under International Valuation Standards (“IVS”) as, “The estimated amount for which an asset or liability should exchange on the date of valuation between a willing buyer and willing seller in an arm’s length transaction, after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion”.
A valuer would typically use a range of valuation techniques when carrying out a valuation under this heading, notably an assessment of the prices of comparable listed companies and relevant precedent transactions. Where the subject of the valuation is a minority shareholding then a discount against the full company value would normally be applied to reflect the lack of voting power and influence that the shareholding carries.
The market value is the same for all parties, that is, the value is not affected by the identity and nature of the actual (or prospective) buyer and seller.
Market value is the most commonly used valuation methodology and in the absence of any other valuation basis specified in the relevant legal documents it will normally be used to arrive at the value of the shares.
Open Market Value or Statutory Open Market Value
This is sometimes used interchangeably with market value, however, there are differences between market value for tax and non-tax purposes. The term specifically refers to the basis for charging Capital Gains Tax under s.272 of the Taxation of Chargeable Gains Act 1992; similar provisions exist for Inheritance Tax. The precise methodology for determining tax market value in any particular instance is heavily driven by case law.
International Valuation Standards define fair value as, “The estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties”.
Shareholders are free to set out in the legal agreements how fair value shall be defined and calculated. For example, this is sometimes specified as the market value but without any minority discount.
However, in the absence of any detailed guidance in the legal agreements, the use of fair value gives the valuer wide scope to determine the valuation methodology and the importance of factors such as size of shareholding and the contribution that the shareholder has made to the success of the company. The requirement to be fair to both sides may mean recognising the position of buyer and seller including their status within the company, such as a director with a remuneration package.
To illustrate the above point, suppose a shareholder owns 5% of the share capital of a company and wishes to sell. The value of a purchase to an existing 46% would be higher than that to a 10% shareholder because the transaction would give the former control. The valuer would need to consider not just the value of the 5% shareholding being sold, but how the acquirer’s total interest in the company would be enhanced by securing control with 51% ownership.
It should be noted that in financial reporting, fair value has a different meaning, “Fair Value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” (IFRS 13). FRS102 includes a slightly different definition, “Fair value is the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm’s length transaction”.
Fair Market Value
The term comes from North America and is most commonly used in tax cases. Its definition would generally equate with market value in the UK. However, the term is best avoided because in the UK it conflates two very different valuation bases as can be seen from the previous sections.
Intrinsic or Owner Value
This is based on the benefit that the asset confers on its owner and may be equated with “deprival value”. A valuer would most commonly use an income capitalisation method under this basis, such as a discounted cash flow analysis.
Synergistic or Marriage Value
Defined under IVS as, “An additional element of value created by the combination of two or more assets or interests where the combined value is more than the sum of the separate values”.
The term is unlikely to be specified in the Articles of Association or a shareholder’s agreement because synergistic value is particular to a very specific set of circumstances, notably in a transaction involving a strategic buyer or special purchaser.
Occasionally, other valuation bases may be relevant, for example liquidation basis where a company is no longer a going concern or its asset base exceeds the value which could be achieved under an income based valuation method.
Determining the most appropriate valuation basis depends on a range of factors, including the nature of the ownership arrangements and objectives of the parties. Legal advisers should be careful not to simply use the standard precedent document and assume the valuation provisions will be suitable for all cases. Obtaining advice from a valuation expert on the legal terms at the start of the venture will invariably avoid disputes later and ultimately save shareholders much time and cost.
For further information about valuation matters please contact:
T: 07831 255302