If you are a business owner who has entered into a shareholder's agreement, I am sure you have come across clauses and statements which refer to 'fair market value', 'willing buyer and willing seller', 'discounts', 'premiums', 'minority stake', 'majority stake' and 'determination by independent auditor'.
These terms are often included in clauses which govern options, sale or transfer of shares, or other shareholder exit mechanisms, and are used to determine the valuation of the business or a block of shares.
For many this begs the question, what is a fair market value and who is responsible for undertaking the valuation, especially if an independent valuation is required. I have seen many shareholders’ agreements which puts the onus on the shareholders to appoint the company’s auditor to undertake the valuation of the respective shareholders’ equity. The role of an auditor is to express an independent opinion on the fairness and reasonableness of the company’s financial statements.
Does it therefore make sense that they value the shares of the business? If the valuation results in any potential change or adjustment to the financial statements as presented, for example goodwill, or the impairment thereof, based on the valuation prepared by the auditor and the independent auditor then audits those financial statements, how may his or her independence be affected? It could be the same as marking your own homework. Another question to ask is, is it the role of an independent auditor to perform valuations, or is it simply in their job description? In my opinion it is not, and I will explain why.
Undertaking corporate valuations is a specialisation, still many assume that all accountants can undertake valuations. A common question I have been asked is how corporate valuations are undertaken and whether it is an art or a science. Well, it is neither an art nor a science - it is a craft.
A craft is a skill which is developed over time and requires both technical skills and experience. More often than not, those who undertake corporate valuations have an accountancy background, but this is not a requirement and not all accountants have the skills and experience to undertake corporate valuations.
A corporate valuation is not a simple mathematical exercise. Whilst there are general principles, guidelines and best practice, the specialists who undertake corporate valuations have acquired the skills and experience to be able to undertake valuations.
These individuals are required to obtain a deep understanding of the business, the industry the business operates in, the economic climate, the impact on value of contracts and restrictions contained in shareholder agreements, the customer agreements, financing facilities, regulations, etc. In simple terms, they need to understand what drives and impacts the value of the business, and make subjective assumptions using their expertise.
They also need to be abreast of the current market dynamics influencing value and the level of merger and acquisition activity in similar markets, sectors and industries. There are various methodologies which may be adopted to ascertain the value of a business and therefore a block of shares. The corporate valuation specialist assesses which is the most appropriate valuation methodology to adopt and often more than one methodology is used to arrive at a value or valuation range. In this article we will provide a brief overview of some common valuation methodologies. You will often hear corporate valuation experts refer to the Income Approach and the Market Approach. These are two approaches often used, however there are also others.
The Income Approach is often adopted when the future cashflows of a business can be reasonably forecasted. It is premised on the principle that the value of a business can be derived from the forecasted future cashflow and the targeted capital (funding) structure of the business. This approach, or variations of it, is the most common approach used.
The Market Approach is based on the principle that the value of the business can be derived from the valuation of the business’ peers, competitors, or other related businesses as well as the business’ maintainable earnings. Maintainable earnings refer to the earnings or adjusted profit of the business which can be achieved into the foreseeable future.
The effect of exceptional circumstances, one-off costs, high-growth periods, etc. need to be adjusted for prior to arriving at the maintainable earnings figure. We often refer to this as a market driven valuation and it relies on the use and availability of reliable market data. Being able to obtain and appropriately adjust market data is a key component. Comparative data must be used and it is often difficult to obtain a true comparison due to the size of markets, the sectors, geographies, etc. Therefore, skill and experience are used to adjust available data for it to be comparative. We often use this method to benchmark against the valuation derived from the Income Approach to check for reasonableness.
There is an argument that the Income Approach derives the value of the business whereas the Market Approach derives the price of the business, and that the value and the price of the business can be different. We won’t discuss or go into further detail in this article, but what is important to note is that a corporate valuation specialist needs to be able to ascertain the difference between the value of the business and what a shareholder may expect to sell his or her shares for. We undertake valuations on behalf of clients for various reasons. Shareholders often appoint us to value their shares when they are contemplating selling their shares or to assess whether an offer they have received is fair. We also often undertake valuations to assist with shareholder disputes.
Shareholder’s agreements sometimes require that the shareholders undertake periodic valuations of the business. In some instances, we undertake valuations to assist with company and group restructures, share swap deals, for transactions and strategic decisions, or for fair value estimations for financial reporting purposes, or reporting back to shareholders, investors, funders etc.. We would strongly recommend to all business owners or shareholders to undertake a professional corporate valuation of their business and their shareholdings on a periodic basis. Whilst it comes at an additional cost, we believe the benefit far outweighs the cost. Often our clients come to us when they have already progressed with sale or purchase discussions without having obtained a fair value of their shares. When one starts to talk and negotiate value without understanding what they should reasonably expect, they open themselves up to transaction risk and possibly unnecessary negotiation tension.
Knowing the reasonable value of your shares gives you the opportunity to make important decisions early on and not waste time and resources negotiating a transaction if you are not ready to sell or buy at the expected value. It also provides confidence in the value you put forward and enables you to negotiate with a level of confidence, supported by accurate and reliable information. If you are considering appointing a corporate valuation specialist, you need to ensure that they have a wealth of experience in undertaking valuations of a similar nature. You should ask them for credentials to support their proposal and why they should be selected. You will be asked to provide information to assist the corporate valuation specialist in determining the best valuation approach as well as information to perform the valuation.
You should ask them to explain what valuation approach they would adopt and why. Any competent corporate valuation specialist will not hesitate to provide you this information. A good corporate valuation specialist will understand that many of the concepts will not be known to their clients and should be able to explain complex concepts in simple terms so that you understand the key factors which affect the value of your business or shares.
MICHAELA POWELL-REES & CRISTI SMITH*
*At Merero Partners, we have professional Corporate Valuation specialists with experience across various sectors and geographies. If you are considering undertaking a corporate valuation or would like further information, please do not hesitate to contact us ([email protected]). Article written by Michaela Powell-Rees FCA, CGMA and Cristi Smith CFA. Michaela and Cristi are experienced Corporate Finance practitioners and are Directors of Merero Partners, a boutique and all women led advisory firm based in Gaborone. Merero Partners offer Corporate Finance, Risk Advisory and Management Consulting Services. You can find out more about us on our website www.merero.co.bw