A forensic accounting update
When valuing a company which has had recent transactions in its shares, the value ascribed to the shares in the transaction is a valuable source of verifiable evidence as to their value.
However, it is important to carefully consider the circumstances of share transactions and the parties involved when valuing a company using the so-called transaction basis.
The market value of a company’s shares is defined in the International Valuation Standards as being the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.
In owner managed businesses recent transactions are rarely conducted on an arm’s length basis and frequently do not adopt any formal methodology or recognition of the wider marketplace in determining the value.
Arm’s length basis
In owner managed businesses, share transfers commonly relate to the granting of shares (or options) to employees and are an incentive for the employees. In such instances, the value ascribed is commonly on the low side (for tax purposes). The idea here is that share options will motivate the employee to help the business (and the value of their shares) grow.
Share transactions occur where a previous shareholder is bought out. In such instances, the value paid is reached as a result of a process of negotiation, often depending on the negotiating power of the purchaser and seller and the quality of the relationship. If leaving on good terms, a higher value may be paid as a ‘thanks and good luck’, but parties leaving on bad terms may be subject to provisions in the articles of association or shareholders’ agreement which significantly reduce value.
Previous transactions can be helpful in addressing the issue of minority discount – often a contentious issue and one which can significantly impact the value of shares. Minority discounts apply to partial shareholdings where the owner of the shares does not have control over a company’s operations (for example where an individual owns 30% so can block a special resolution but not pass any resolutions without combining with another shareholder). Where a minority discount has been applied in the past it can be argued that the same may happen in the future. The issue here is that a formal valuation calculation is often not set out in writing and so it can be difficult to determine whether or not a minority discount was in fact applied.
Very rarely is a formal valuation obtained where unquoted minority shareholdings are sold. Occasionally the company’s accountant may have been instructed to prepare a valuation but, in our experience, these valuations are usually formulaic and can be very different to our own view on valuation at the relevant time.
A share transaction concerning parties involved in the business should, in theory, take into account any provisions stipulated within the shareholders’ agreement or articles of association. When preparing a market valuation a valuer should be aware of these provisions but it is also important to consider the extent to which the provisions would actually be applied in a commercial negotiation. The most common disparity here is the application of a minority discount.
From a commercial perspective the articles of association may state that no discount should be applied in determining the value of the shares but an external party considering the purchase of a minority interest would expect a minority discount to be applied and if a discounted value is the only offer on the table (and is accepted) then that is the value of the shareholding.
Another consideration is how recent were the transactions? It is not as simple as saying we should only consider transactions in, say, the last two years as attention needs to be given to the activity in the marketplace. A couple of years ago we valued a veterinary practice at a time when there were large conglomerates buying up smaller businesses and paying high multiples. Following production of our report the parties actually ended up selling the business and achieving a high multiple. However, had the transaction happened a couple of years earlier or later, the market value would have been far lower.
Finally, did the transaction actually go ahead?
In a recent case in which we were instructed to advise the wife, the husband had received various offers from third parties over the last five years to purchase a part or all of his company. None of these discussions had progressed past an initial offer and there were various underlying issues with the financial performance of the business which, arguably, would have led to the consideration paid being negotiated down following the due diligence process.
It’s not all doom and gloom though
Despite all of the above there are occasions were recent share transactions tick all of the boxes and stand out as being really informative of value at a certain point in time. Where there is a transaction between buyer and seller on an arm’s length basis and where full due diligence has been undertaken this evidence of market value is extremely compelling and needs to be given serious consideration.
In summary, while a valuer needs to be aware of recent share transactions, and to review the circumstances of those transactions in detail, the instructing parties should not be surprised if the valuer concludes on a value significantly different to that applied in earlier transactions.