In the absence of market value – how do you obtain a fair value for your shares in a private company? The issue of valuation is fundamental to the owners of the business, and particularly important when considering a sale or when a company is faced with a shareholder dispute.
Naturally, there are some basic principles the business owners can follow to arrive at an agreed share valuation, however, in the event of disagreement, the shareholders can apply to the court to determine the fair value of their shares.
In this article, we will look at some of the most common business valuation methods and how they can be used and interpreted by the courts.
Methods of valuation
There are three well-established methods that can be used to value a business; these include either the company assets, earnings or cash flow valuations. However, the choice of the valuation method will often be driven by the type of business, its future growth prospects and the industry benchmarks.
i) Asset-based valuation
An asset valuation is often performed when a company has considerable assets at its disposal; real estate, investment and manufacturing businesses are the most common examples of asset-based valuations. The method is calculated by adding up all of the company’s assets and subtracting all of its liabilities, in accordance with the company’s balance sheet.
However, the asset method does not take into account the company’s future earnings potential, as such, it might not be the most appropriate method for some companies and thus, the earning-based valuation might be preferred.
ii) Earnings-based valuation
The earnings-based valuation approach is the most common valuation method as it includes both the business’s historical and prospective earnings. It is certainly suitable for businesses with little to no assets and the ones that have considerable earnings. It can be used to determine a company’s future profit-generating capacity and therefore, more likely to provide a fair value for the company’s shares. (Re. Bird Precision Bellows Ltd [1984] Ch658).
The earnings method is derived by calculating the ‘maintainable profits’, achieved by adjusting historic profits and removing any exceptional, non-recurring costs from the operating activities. This figure is then multiplied by the P/E ratio, which is calculated by dividing the share price by the earnings per share. To put it simply, a company However, the earnings method is also subjective and can be controversial; earnings can be manipulated and the ratio doesn’t factor in any debt levels the company might have on the balance sheet. These elements are complex and courts frequently rely on independent experts to justify the figures.
In turn, the experts often rely on comparable listed companies’ multiples that can be applied to similar private businesses. Cases like Blue Index Ltd [2014] EWHC 280 and Re Planet Organic Ltd [2000] 1 BCLC 366 have addressed these issues and examined the difficulty of applying the appropriate multiples.
iii) Cash-flow valuation
A discounted cash flow (DCF) is yet another form of valuation. This method is often utilised for established businesses with a solid and steady operating history and significant cash flows. The DCF method determines the present value of future cash flows by making a number of assumptions.
First, a valuer estimates the expected future cash flow (typically for a period of 5-10 years) and then applies an appropriate discount rate, which reduces the future cash flow to the equivalent of today’s money, thereby reflecting the reality that money’s worth diminishes with time.
The DCF method is likely to be more suitable for private companies, albeit it also relies on assumptions, and in particular a sustainable cash flow forecast. This was emphasised by Snowden J in ESO Capital Luxembourg Holdings II v GSA Invest Management SA [2017] EWHC 1351, stating that DCF valuation is “not a precise science” and has a number of variables that “depend upon subjective judgement of the valuer”. Therefore, it is typically recommended that the DCF valuation is used in conjunction with other methods of valuations rather than as a replacement for them.
In the context of litigation, especially in respect of unfair prejudice petitions brought under s.994 of the Companies Act 2006, the issue of a fair valuation lies at the heart of the process. The Court has the power to order the transfer or sale of shares under s996(2)(e), and therefore it can provide protection and a remedy for the minority shareholders to realise the value of their investment.
However, the process not only requires petitioners to submit a non-binding valuation of their shareholdings but also raises vital questions as to how the shares should be valued. Given the court’s wide discretion in determining the value and the importance of the valuation figures to both, respondents and petitioners, it is well-advised that parties consider the issue of valuation at an early stage and seek appropriate professional advice.
How we can help?
At Linkilaw Solicitors, we provide advice to our clients on a broad variety of corporate, employment and litigation concerns, which often require determining the value of the company’s shares.
Naturally, we are thoroughly committed to understanding your business, its long-term objectives and the industry in which it operates in order to assist in selecting the most suitable valuation approach for your business.
Book a call with our legal team today.
Our legal commentary is not intended to be a comprehensive review of all developments in the law and practice. Please seek legal advice before applying it to specific issues or transactions.
