Edited by Stephen Antle
The necessity to determine the value of shares in a corporation can arise in several ways, including:
(1) a negotiated purchase;
(2) a shareholder dying or ceasing to be an employee of the company, or another triggering event under a shareholders' agreement;
(3) the exercise of a "shotgun" clause in a shareholders' agreement;
(4) the court ordering the company or another shareholder to buy the shares to remedy oppressive or unfairly prejudicial conduct, or as an alternative to liquidating and dissolving the company; and
(5) the exercise of a right of dissent under corporate legislation.
In all of these situations the buyer and seller can agree on the value of the shares. But what if they cannot? In those situations where the sale is compulsory, litigation or arbitration will be required to determine share value. That will almost certainly require expert opinion evidence. This article explores the legal and business valuation issues involved in such proceedings.
LEGAL ISSUES
General Principles
The Court of Appeal for British Columbia has taken pains to emphasize that the fair value of shares is a special problem in every case. Each case must be examined on its own facts. Factors which may be critically important in one case may be meaningless in another. Calculations which may be accurate guides for the value of shares in one company may be entirely flawed when applied to shares in another.
The one true rule is to consider all the evidence that might be helpful and to exercise the best judgment that can be brought to bear. No method of determining value which might provide guidance should be rejected.
Minority Discount
It is generally not appropriate to apply a minority discount in determining the fair value of shares when they will be purchased as a remedy for oppression or after a right of dissent from corporate action has been exercised. It would be inappropriate to penalize a shareholder who has been the victim of oppressive conduct or exercised a statutory right of dissent.
Minority discounts may or may not be appropriate in other situations. For example, when a sale occurs under a shareholders' agreement, the agreement may address whether a minority discount will be applied. If not, then the valuator will have to consider the issue, in light of the percentage of shares held, the share rights and restrictions, the history and pattern of dividends, any right to appoint directors, the shareholder's general ability to influence the company and other factors.
Valuation Date
Generally speaking, shares ordered purchased as a remedy for oppression are valued as of the date of the filing of the petition seeking relief. Shares purchased as a result of the exercise of a right of dissent are valued as of the date of the resolution approving or adopting the corporate action dissented from.
A well-drafted shareholders' agreement will address the valuation date for a purchase of shares as a result of a triggering event or shotgun clause. If not, then the court or arbitral tribunal is likely to select the date the right to sell and/or purchase arose.
Fair Value but for Oppression
If shares are purchased as remedy for oppression, the price must make allowance for any negative effect caused by the oppression itself. The price paid will be the fair value as of the valuation date, but for the oppression complained of. For instance, if the oppression included the majority shareholder appropriating some of the company's assets, those assets would be notionally brought back into the company for valuation purposes.
BUSINESS VALUATION ISSUES
Chartered Business Valuators
A business (and so its shares) can be valued by anyone; the law does not specify who is qualified to perform valuations. A number of court cases have, however, recognized the distinction between expert evidence provided by a Chartered Business Valuator and that provided by a person without the same level of education and professional expertise.
The Canadian Institute of Chartered Business Valuators is the recognized professional organization for business valuation in Canada. The Institute has established practice standards, as well as a code of ethics, to set out the minimum requirements for report disclosure, scope of work and file documentation in the preparation of a business valuation.
Types of reports
The Institute has established three levels of business valuation reports, distinguished by the scope of review, amount of disclosure and level of assurance provided in their conclusions. The three levels are Calculation, Estimate and Comprehensive valuations. A Comprehensive valuation provides the most assurance.
Information considered
In preparing a valuation of shares, assets or an interest in a business, the valuator generally considers, among other information, financial information (including, if available, the financial statements for the last five years), the most recent corporate tax return, the current budget or business plan, the operations of the business, market and transaction comparables, and industry research.
Valuation approaches
When determining the value of a particular business, an assessment must first be made of whether a going concern or liquidation methodology should be the primary method of valuation. The primary method should be the one that yields the greatest net contribution to the equity owners.
A going concern valuation can be based on one or more approaches, including asset-based, income-based and market-based approaches. Asset-based approaches are typically used for businesses where the going concern outlook may be uncertain, and for real estate or investment holding companies whose value is in their tangible assets.
Income-based approaches are appropriate when the business is a viable going concern and provides investors with a reasonable rate of return on investment, and where purchasers would value it on the basis of its stream of earnings/cash flows.
Valuation methodologies
Where the entity is an active operating business, the determination of going concern value is normally best developed with an earnings and/or cash flow based approach. These generally require:
(1) An assessment of the future prospects of the business. This normally is the amount of discretionary cash flows or maintainable earnings which the business prospectively is expected to generate, based on its historical operating results and perceived prospects.
(2) An assessment of the risk of achieving those prospects. That is, what is the appropriate discount or capitalization rate which is applied to the estimated discretionary cash flows or maintainable earnings? Generally, the greater the risk, the higher the required rate of return demanded by a purchaser.
(3) That redundant assets be identified and segregated. Redundant assets are those not required to generate the prospective discretionary cash flows or earnings of the business. Their net realizable value is added to the income-based value determined for the business.
A common asset-based approach is 'adjusted net book value', a measure of the value of the tangible assets subject to purchase, net of all outstanding liabilities. The adjusted net book value is the composite of the fair market values of the individual tangible assets employed in the business, less liabilities, assuming the business continues as a going concern. Where shares are valued (as opposed to net assets), a further adjustment is made for the tax shield difference between the market values of the assets and their cost base for income tax purposes.
The adjusted net book value (or a variant - the tangible asset backing) is also used to measure the risk associated with conclusions reached under an earnings or cash flow based valuation methodology. For example, when the earnings or cash flow value of a business exceeds its adjusted net book value, the difference is ascribed to goodwill and/or other intangible assets.
CONCLUSION
Valuing shares is rarely straightforward. There are a number of legal and valuation issues to be considered. If you are faced with the need to do so, you should obtain appropriate advice from qualified professionals.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.