Share valuation: when all is not as it seems

Share valuation: when all is not as it seems

We are increasingly being instructed to value interests in companies whose ‘stock’ comprises more than just ordinary share capital or the allocation of value is prescribed (to some extent) by the company’s articles of association or a shareholders’ agreement. There is often a misconception as to what proportion of a business is owned by a shareholder and it is important to recognise that the rights associated with different forms of business interest can significantly impact their valuation.

Below we take a look at how different types of interests may be approached in a valuation. 

Different share classes
Many owner managed businesses own different classes of ordinary share (e.g. A and B ordinary shares). These structures are often set up in order to enable owner managed businesses to pay unequal dividends to shareholders for tax planning purposes.

Where all shares have the same rights, the different share classes can largely be ignored for valuation purposes. Where some shares have voting rights, and therefore control a company’s resources, and others do not, there will be a difference in the value attributed to each share class.

A non-voting minority interest in an owner managed business has no control over the operations of the company, whether a dividend is paid or even over whether or not a sale of the whole company is approved. It is therefore worth less than a voting minority interest which can, in some circumstances, be influential if combined with other shareholdings.

Loan notes
A loan note is an agreement between a company and an investor for the provision of funds by the investor with a stated repayment date and interest rate. Recently we have seen loan notes ‘cropping up’ where there has been a reorganisation of a corporate structure, frequently where the founding or active shareholders have disposed of part of their interest with the payment consideration consisting of loan notes. Private equity investments regularly use these structures as it ties the former business owner in for a period of time.

The valuation of loan notes will ultimately depend on the rights of redemption. Usually the loan note requires repayment in X number of years until which interest at Y% will be payable or will accrue. The value will usually be equal to the final redemption value (plus any interest) discounted to reflect the time value of money (£ in the hand today is worth more than £ in one year’s time). 

The focus for any valuation will therefore be at what rate the final repayment value be discounted. The discount rate will need to take into account the return (i.e. the interest earned) and the risk (i.e. is there a chance the loan note won’t/can’t be repaid at the specified repayment date or at all). This needs to be assessed on a case by case basis but it is possible that the valuation of loan notes is not the same as their face value.

Preference shares
Preference shares are, in general, shares which rank in priority to the ordinary shares of a company. They can have differing rights to dividends and capital and can be redeemable or irredeemable such that they can be viewed as debt of the company or as share capital. 

The rights of the preference shares will be detailed in the articles of association and or a shareholders’ agreement which should be consulted to determine the valuation approach. Often the redemption value of preference shares will be limited to their nominal value plus any preferential return, meaning that they are rarely worth the percentage of overall share capital that they may represent.

Share options
A share option is a right to buy, at some point in the future, a specified number of shares at a predetermined price. Share options are often granted to employees as an incentive to tie them in to the business for a period of time and offer a reward for their efforts over the longer term. 

Where share options exist, consideration of both the value of the options and the pre-existing shares may be necessary.

The value of share options will depend on the conditions of exercise. Employee share options often vest after a certain number of years of employment or on the sale of the company. In the case of the former, the value of the share options will need to consider the likelihood of the employee still being involved at the exercise date as well as the likely value of the company at that time. In the case of the latter, whether or not the options are exercised on the sale of the company will depend on whether they are ‘in the money’ – i.e. whether the value per share on sale exceeds the exercise price.

The value of the pre-existing shares will also depend on the likelihood of the options being exercised (as exercising will dilute the interests of the pre-existing shareholders).
 
Allocation of value – hurdles and waterfalls 
Prescriptive methods for the allocation of value are common where there has been external investment in a company. They can be either relatively straight forward, such as a hurdle, or complex, introducing waterfall provisions. 

A hurdle requires a set amount to be paid to the holders of a specified share class prior to distribution to any other classes of share. These hurdles can exceed the total value of the company (if written with the expectation of future growth), in which case some share classes are worthless even if on the face of it they represent a significant proportion of the company’s total share capital.

A waterfall comprises a cascading structure of value. The tiers of value can either be predetermined or depend on specific factors at the date of valuation such as the length of ownership of the shares or a set multiple of EBITDA. 

Conclusion
The take home message here is to double check the nature of the share capital issued by a company before getting the calculator out to work out the percentage owned.