• There are numerous reasons why a business valuation may be required, including:
o Inheritance tax (lifetime gift or death)
o Capital gains tax (gift or sale at undervalue)
o Enterprise management incentive scheme
o Loss of profits claim
Quoted and unquoted share valuation
• Valuation of shares quoted on a recognised stock exchange is of course a straightforward exercise of identifying the quoted price on the relevant date.
• Valuation of unquoted shares is much more problematic, as there is no ready market, and indeed often no market at all. Thus a modus operandi has developed over the years for the valuation of unquoted shares, particularly for tax purposes.
Conventions of Tax Valuation
• A distinction can usually be drawn between commercial valuations (which relate to transactions which may or will take place) and tax or loss of profit valuations, which relate to theoretical transactions.
• Because of this, it has been necessary for tax law and the courts to build up a series of conventions relating to tax valuations.
Inheritance tax valuation
• Inheritance tax operates on the basis of ‘diminution of value’; i.e. how much less is the taxpayer’s estate worth after a gift or bequest than before. Thus it is necessary to value what the taxpayer had before the event and what he/she had after it (if anything), rather than valuing what has been disposed of. This principle does not apply for other taxes such as capital gains tax.
Willing buyer and seller
• Another artificial convention of tax valuation is the assumption that there are a willing buyer and seller. In practice there is no real market for minority shareholdings in unquoted companies where there is a majority shareholder, but for tax purposes we assume that there is such a market.
The information standard
• The courts have ruled on the information which should be taken into account in valuing limited company shares for tax purposes. Whilst for a majority holding all available information is assumed to be obtained, for a small minority holding only publicly available information is taken into account.
Small minority holdings
• There are important tax planning issues arising from the information standard. The filing of statutory accounts at Companies House can have a dramatic impact on the value of a transaction for tax purposes if they show results significantly different from those of previous years.Thus a taxpayer may wish to file or avoid filing accounts just prior to a particular transaction, depending on the desired tax result.
• For instance, a taxpayer would prefer to submit accounts showing poor results or hold back accounts showing good results prior to making a significant gift for inheritance tax purposes.
• Similarly, when issuing EMIS options, the company may prefer to delay submission of accounts showing good results to minimise the option price and thus maximise the incentive effect for employees.
Importance of size of shareholding
• In a commercial sale, each shareholder will typically receive the same price per share, regardless of the size of their holding in the company.
• However, the situation in tax share valuation is very different, as the size of holding can make an enormous difference to the value per share.
• There are various key break points in company law in terms of size of shareholding:
o 90% – can buy out other shareholders at market value (“expropriation”)
o 75% – can pass a special resolution (usually required to change the company’s constitution)
o 50%+ – can pass an ordinary resolution, so have day-to-day voting control
o 25%+ – can block a special resolution
o 10%+ – can block expropriation
Impact of size of holding on value of shares
• Typically a shareholding above a particular break point will have a higher value per share than one below that break point. This is particularly pronounced in terms of the 50% breakpoint, as a majority holding will be worth considerably more per share than a minority holding in the same company.
Small minority holdings
• Thus, despite the fact that we assume that there is a market for these holdings, they are typically valued at a significant discount to majority holdings. The reason for this is simply that the minority shareholder has no freedom of manoeuvre; he/she is dependent on the decisions of the majority as regards the future of the company.
Going concern or break-up valuation
• The first step in any valuation is to consider whether the business is worth more as an ongoing trading entity or on a break-up basis. Whilst one would hope and expect that the former will normally be the case, the issue needs to be considered, particularly for loss-making businesses. This issue has a key influence on the valuation method.
Majority holdings in trading going concerns
• These would typically be valued on the basis of the company’s maintainable profits after tax (thus ignoring non-recurring items and seeking to identify future profit trends).
• This requires the identification of a price earnings ratio, which is the reciprocal of the required return on the investment in the shares. Thus, for example, if the required return was 25% the price earnings ratio would be 4.
• The price earnings ratio is largely determined by the risk associated with the trading activity. The higher the risk, the higher the required return to compensate for the risk and thus the lower the price earnings ratio.
• The price earnings ratio is then applied to the earnings per share to identify the value per share.
• It may be necessary to apply a discount to the value if the holding is below 75%, although any such discount is likely to be relatively modest in size.
Majority holdings in property or investment companies
• It is more likely that these might be valued on a break-up basis, largely depending on whether the investment strategy is based primarily on achieving growth or income
• Having said that, similar principles will apply to determining the valuation, whether on a going concern or break-up basis.
• In general one might expect the level of risk with a property company in particular to be lower than a trading company, and thus price earnings ratios of investment companies to be somewhat higher.
• The initial approach to the valuation of a small minority holding would typically be to consider a dividend basis, involving the identification of a maintainable future dividend and the dividend yield required by a purchaser (again higher the riskier the investment). A discount is likely to be required to reflect the fact that the shareholder in practice has no control over the company’s future dividend policy.
• Many unquoted companies do not pay dividends on a regular basis or at all, and in such cases resort will usually be required to an earnings basis. A significant discount will typically be required to such a value to reflect the fact that the minority shareholder cannot enforce the distribution of earnings in practice.
• For similar reasons great caution should be exercised in applying a break-up basis valuation to a minority shareholding, as the shareholder will have no power to enforce a break-up of the company, even if it would maximise the value of his/her particular holding. Again, therefore, significant discounts will typically be required.
Valuation of goodwill
• Goodwill is an intangible asset, reflecting the good name and customer base of a business.
• In my view goodwill can only realistically be valued as the ability of a business to earn super-profits, that is to say profits in excess of those expected to be earned at a reasonable required rate of return based on the tangible assets employed in the business.
• For example:
o A business generates profits of £200,000.
o It has tangible assets of £500,000
o A reasonable rate of return on assets employed is considered to be 25%
o The implication of the rate of return is that total assets are £800,000, and goodwill is thus valued at £300,000.
Summary & conclusion
• If you need to value your business, whether for tax, commercial or loss of profits purposes, please contact Mark Simpson to discuss your requirements:
o Telephone 0161 886 8062
o E-mail email@example.com