Share transactions

When there is a share transaction involving private company shares the big question is what are the shares worth? The answer will always be debatable. This is because different circumstances produce different values for the same shares.

Starting point with company share transactions

Any transaction involving shares in private companies includes working out the price.  In some cases the articles or shareholders agreement sets out the formula to be applied.  In other cases the entire company is being sold and this determines the price per share.  But for the many share transactions in the middle negotiation is required.  We find that debate about the price of shares is most likely to arise:

• Where the company is planning to buy back shares held by a shareholder and then cancel the shares uplifting the shareholdings for the remaining shareholders;
• If the company is planning on a re-organisation and swapping shares in one company for shares in another; or
• Where a shareholder is exiting the business and either wishes to sell shares or is forced to sell shares on leaving under the articles.

Valuing shares

The job is made difficult by the fact there is little published data available relating to private company share transactions as this is confidential to the shareholders concerned.  This means that pricing shares in private companies is not a precise science. There are no fixed rules and experts will arrive at different conclusions. There can be multiple valuation methodologies to consider.

We can help you formulate the most suitable methodology to achieve your desired outcome.

The background to the share transaction should be considered as this influences pricing. For example:

• A share valuation for investment purposes will focus on the commercials and anticipated growth. Under the more formal methods of valuation the company may be worthless especially if the business has not yet gone to market – but investors are prepared to pay a premium based on the potential value.
• A share valuation for the purposes of an internal transfer of shares will usually be more focused on present day value. The achieved value per share can be displaced by the identity of the purchaser and seller and their willingness to transact.
• A share valuation for the purposes of agreeing with HMRC a tax liability will take a fiscal approach. A fiscal approach usually produces a lower valuation than a commercial valuation would as there is less emphasis on goodwill and hope value.

Approaches to valuing shares

There are three main types of business valuation used to reflect the price of a share in a private company.

Dividend basis

The dividend basis of valuation is adopted for a shareholding where the main benefit of holding shares is the right to receive dividends. It is usually used for minority shareholders of mature businesses. The dividends basis looks at the company’s past dividends, dividend growth patterns, fluctuations and the likely dividend policy going forward.

What is examined is the dividend yield per share. There are quoted company comparisons that can be drawn and which can be helpful. The influence of the minority shareholder is not considered. However, where the majority shareholder is also a director with the power to determine if dividends are voted that level of influence should be considered as it could reduce the chances of receiving dividends.

Loss making businesses

In loss making businesses or businesses still in investment mode the dividend basis of valuation is not appropriate. Similarly, if the shares are non-dividend bearing, alternative methods of private company share valuation will need to be found.

Earnings basis

The earnings basis of valuation is popular and often used when a business is being sold. It looks at the future profit-generating potential of the company after tax, interest and dividends are paid out (known as ‘maintainable profits’). The maintainable profits are capitalised and multiplied by a quoted company equivalent ratio to give the present value of the company.

The earnings basis is mainly used to value majority shareholdings or entire businesses where one shareholder has control over the future of the business.

Asset basis

The asset basis valuation is used either on company’s liquidation or where the company’s asset backing is greater than the capitalised value of dividends and earnings. It is supported by the idea that the asset backing of the business must be reflected in the share price. Investment companies such as property companies are valued on an asset basis.

Adjustments to profits

In order to arrive at the value of the shareholding the value of the business needs to be discounted to reflect commercial and legal aspects of the business. Before any discount is applied company profits often need to be adjusted to reflect the market conditions. For example, if the directors have not been paid commercial salaries company profits will have to be adjusted.

Share and company valuations – facts to take into account

Many different considerations are applied and often a valuation is a combination of various approaches. There will be common themes such as:

Size of shareholding

The importance of shareholding size is primarily in terms of control over company’s decision making. Minority shareholding discounts can range from around 5 – 90% depending upon the facts.

Voting rights

Voting rights in shares have inherent value because voting power offers influence over how profit is enjoyed, whether assets (including the business) are sold, how the company is managed and how the internal market in the shares is operated. However, voting power is only indicative of control and does not need to correspond to the number of shares held. If it can be shown that a majority shareholder has no effective control over the company it will be taken into account. 51% + shareholders are presumed to have control over the company’s affairs.

If shareholders are connected it is fair to assume that they will join together and their combined voting power can be considered.

The right to veto certain decisions

Typically, a minority shareholder who holds 25% or more voting rights can block a special resolution of shareholders which means that he can veto certain decisions of the majority shareholder. However, a shareholders’ agreement or articles of association can also provide that a shareholder with an even smaller than 25% shareholding can veto decisions in which case the value of his shares increases. Therefore, the constitutional documentation is important.

The right to have a director on the board

Being able to appoint a director gives a shareholder insight into everyday running of the company. It offers control over directors meetings and influence over board meetings. Not many minority shareholders have a right to appoint a director unless they are director-shareholders themselves with power to influence the board.

The number of shareholders

The division of ownership of shares has an impact on the impact shareholders can exert. If there are two shareholders with the 80%-20% split, the minority shares have a ‘nuisance value’. If however there are five shareholder holding 20% each then the minority shareholder has greater control and the value of his will increase.

Marketability

The marketability of the shares plays a role in valuation. How easily can the shares be sold? Are there any restrictions on the sale of shares in the corporate documentation? The degree of influence depends upon a range of factors, both legal and economic and can vary significantly from company to company. For example, one company may permit shares to be transferred to non-members while another may impose restrictions on transfer. Any restrictions on transfer decrease the value of shares as marketability of shares is low.

Future income potential

Future ability to increase earnings, e.g. when an IPO is planned or imminent, will impact the value of the shareholding.

Strategic value

There might be reasons why a minority stake might be particularly valuable. Minority shareholding can have strategic value when it can prevent a business sale or when mere possession of a single share can ensure access to the customer base. The strategic value is enhanced when there are no transfer restrictions on minority shares in the articles of association because shares can be transferred to e.g. a strategic investor or competitor.

Information available

Small minorities are generally assumed to have limited access to unpublished information and no guarantee of board representation. However, this may not be so if the shareholding has some strategic significance. Directors should not  disclose confidential information without board consent. Therefore, unless special circumstances exist no knowledge about additional facts will be presumed.

Articles of Association/Shareholders agreement

Articles of Association set out the rights attaching to shares as well as restrictions on the transfer of shares. A review of Articles of Association is one of the first steps in share valuation.

Matters to look out for impacting on share pricing

In addition to point set out above you may need to consider:

• Casting vote – a casting vote swings an otherwise deadlocked vote. A casting vote gives control to a shareholder in a 50-50% share split and can carry a premium.
• Dividend rights attaching to shares. Dividend entitlement which is fixed, e.g. preference shares, increases the value of shares.
• Capital rights – as with voting rights the greater entitlement to the company’s capital the higher value of shares.
• Transferability – Articles often specify who the shares can and can’t be transferred to which impact marketability of shares. Restrictions increase the discount and lower their value.
• Fair value provisions – Articles or a shareholders’ agreement often provide mechanisms explaining how company shares should be valued upon transfer. This can work for or against a higher valuation depending upon the wording and actual circumstances.
• Drag and tag along rights – the rights to allow a minority shareholder to benefit from the same rights and protections as the majority shareholder on business sale. If the company only has standard articles downloaded upon incorporation drag and tag rights will not be present. This will decrease the private company share valuation for a seller.