Valuing unlisted shares
All employee share schemes whether statutory and non-statutory have actual or potential tax implications and the value of the shares used must therefore be agreed with HM Revenue & Customs.
The nature of that agreement varies from scheme to scheme. For an Enterprise Management Incentive or Approved Share Incentive Plan, HM Revenue & Customs must agree that the proposed exercise price is neither materially more nor materially less than fair market value at the date of award. For the Approved CSOP Scheme, the exercise price must not be materially less than fair market value, although it may be more. For the Approved SAYE Option Scheme the exercise price must not be materially less than 80 per cent. of fair value, but may be more.
In some cases, share values are negotiated before the scheme is operated, and in other cases afterwards. For further details see page 94.
If the shares are restricted by reference to other shares of the same class, they will not be acceptable for use in an Approved CSOP Scheme, Approved Share Incentive Plan or Approved SAYE Option Scheme. However they can be used for options granted under the Enterprise Management Incentive Scheme and in this case the market value is normally reduced to take account of the restrictions. However the unrestricted value is used for the purposes of the statutory £100,000 limit - see page 58 for details.
Where a company is listed (see Glossary), the value of the shares is easy to ascertain. For share scheme purposes it is normally an average of several days’ mid-market prices (typically 3 to 5). Where a company is quoted but not listed, for example on the Alternative Investment Market, HM Revenue & Customs will normally accept a price at or close to the quoted price as “fair value”, although it may seek adjustments in respect of any perceived distortions to the market. If the shares are quoted on a matched bargain basis, then HM Revenue & Customs may need evidence that the quoted price is a proper reflection of the “fair” value of the shares.
Where the company is not quoted, a valuation must be arrived at by a process of analysis. Market value for this purpose is taken to be the value that would be agreed between prudent buyer and willing seller, assuming the buyer has the information he might reasonably expect.
Share valuations for employee shares schemes (and indeed most other purposes) are negotiated with Shares Valuation (“SV”), a specialist branch of HM Revenue & Customs based in Nottingham.[103] SV will agree values in advance of certain events, such as the issue of shares or grant of options under statutory schemes.
SV valuers will seek to negotiate “fair value” based on sustainable earnings, net assets, discounted cash flow or even dividend yield. By far the most common basis is sustainable earnings. It should be stressed that valuation of unquoted shares is more of an art than a science. In practice, individual SV valuers may have significantly different opinions of “fair value” even when the facts presented are closely comparable.
Earnings based valuation
The concept of sustainable earnings is important. It is the level of earnings which represents the true economic profit of a business when exceptional and extraneous factors have been removed. The earnings are then valued by comparison to the values attributed to other companies of a similar type. The measure used is the price earnings ratio, being the ratio of the price per share to earnings per share. Earnings for this purpose are normally taken after deduction of tax and minority interests.
SV will normally look not just at the results for one year but the pattern of earnings over several years, including forecasts if available. Strictly, SV is not entitled to see forecasts if these are not in the public domain, since these would not be available to the hypothetical “arm’s length” buyer or seller. However, as a matter of custom and practice the forecasts are normally supplied. Adjustment will then be made for any factors that should not be considered as part of the pattern of sustainable earnings, such as non-recurring gains or losses on asset sales, exceptional tax charges or credits, one-off bad debts or unusual relocation expenditure.
Every valuation submission is different. However, a typical formula would be to take net profits after tax for the two most recent audited years, estimated net profits for the current year and forecast net profits for the subsequent year. Weightings of, say, 15 per cent., 45 per cent., 25 per cent., and 15 per cent. might then be ascribed to these earnings. A price earnings ratio would then be applied to the weighted average.
What price earnings ratio should be applied? Frequently, the first step is to identify other companies that are in broadly similar fields of activity, and for which valuation data is available. In general, this will mean companies that are quoted on a public exchange. Summary data on these companies should be presented, including any evidence of special factors that may distort the value of their own shares. An average of the ratings of these companies is then taken, adjusted as necessary.
Often there will be no quoted comparable companies. In these cases, it can be helpful to look at the average ratings of all quoted companies in the same sector of business activity. Statistics of this kind are published by the Financial Times in association with the Faculty and Institute of Actuaries, under the heading FTSE Actuaries Share Indices. The information is classed in 11 major categories and 39 sub-categories. However a company’s business may not fall easily into any of the available categories and in this case it may be necessary to start with a stock market average, such as the FTSE All Share, the FTSE small cap (excluding investment companies) or the FTSE Fledgling Index.
Adjustments to the price earnings ratio
In practice, many SV valuers tend to pay lip service to the use of comparable quoted companies for valuation purposes and instead use a standard all-purpose private company price earnings ratio, which is usually around 4-5 times net profits after tax (after adjustment for exceptional items). This figure will be higher for companies with strong earnings and good prospects, and lower for weaker companies.
Once an acceptable price earnings comparison has been established, it is necessary to adjust this for factors specific to the subject company. Where the shares are unquoted, SV will normally expect a large discount in share value as compared to a similar quoted company, to reflect the fact that there is no market in the shares and therefore no certainty as to when, or if, a purchaser could be found. This discount is generally in the region of 60-80 per cent.
It is increasingly common for companies to offer non-voting shares for the purposes of employee share schemes. In these cases a further discount would be applied to reflect the lack of voting power. However in the case of an employee share scheme this discount should normally be in the region of 10 per cent. or less. This is because the employee shares will represent a small minority of the equity. Whether or not the employee shares have votes, their owners will have little effective power to influence the management of the company (unless, exceptionally, a small number of voting shares would hold the balance of power within the company).
The shares to be valued may be restricted by reference to other shares of the same class. For example, employee shareholders who leave the company may be required to sell on leaving employment. A further discount may be appropriate to take account of such factors.
As a consequence of these discounts, valuations accorded to shares used for employee share schemes in unquoted companies can be very low in relation the value of the business as a whole. This can be unhelpful in two ways:
- The value of the shares being awarded under option or in trust may look miserly in relation to the statutory limits. One solution is for the company to take independent advice as to the likely commercial value of the company on sale or flotation, and make this known to the employees at the time the shares are being offered.
- Existing shareholders may feel that they are entitled to what they regard as a reasonable commercial value for shares they sell to the trustees of an employee scheme. A possible solution to this is described on page 79.
Nevertheless, a low share valuation can be a positive advantage for statutory employee share schemes. If the value is low, then larger numbers of shares can be appropriated to employees, or offered under option, than would otherwise be the case within the statutory scheme limits. The employees can therefore look forward to larger gains at favourable tax rates when the “true” value of the company is realised.
Alternative methods of valuation
As mentioned above, shares may be valued in exceptional cases by reference to their entitlement to assets, if the value so produced would be higher than that arrived at by other methods. A “fair value” of assets for valuation purposes may however be very different to balance sheet value. The true market value of plant and machinery, and especially of items like office equipment, may be far lower than its balance sheet value. Equally, there may be property assets in the balance sheet which have not been revalued for many years.
A common error is to estimate share value based on sustainable earnings, and then increase the value by adding a figure for net assets. Normally, the assets will not have a separate value since they will be necessary for generating the earnings. Only when the assets concerned are genuinely not required for business purposes – for example, excess cash or property – might an adjustment be made, and even then the earnings attributable to the surplus assets will need to be stripped out of the earnings used for that part of the valuation based on sustainable earnings.
Sometimes it is appropriate to use shares with special dividend rights for the purposes of an employee share scheme. Care must be taken to avoid Revenue suspicions that part of the purpose of the scheme is to put NIC-free dividends in the hands of employees, since this may lead to approval of the scheme being denied or withdrawn. However, if the shares to be used for the employee schemes are given favourable dividend rights SV may be persuaded that they have a higher value than would otherwise be the case, assuming that the dividends to be paid are comfortably covered by net profits. For a private company, an appropriate yield will usually be at least 10 per cent., and often up to 20 per cent. or more, reflecting the commercial risk.
Other considerations
It is not uncommon for private company shares to be valued at a time when an offer for the company has been received, or is in prospect. In general, as long as there is no definitive agreement and the facts of the offer are not known to the workforce generally or the public, it will not be necessary to take account of the valuation implied by the prospective offer. This can provide opportunities to issue share option schemes on very favourable terms ahead of a possible change of control. SV has in the past been prepared to “turn a blind eye” in this way even where a small number of employees were aware of the impending offer.
Obtaining agreed valuation
Statutory schemes
In the case of the Share Incentive Plan, Approved CSOP Scheme or Approved SAYE Option Scheme, HM Revenue & Customs will not normally agree a valuation until the scheme has been formally approved. This therefore increases the total time taken to implement the scheme. The share value must be agreed before the scheme can be operated and must be agreed again prior to each occasion on which share rights are offered to employees.
For the EMI, a prior agreed value is not required, but if one is submitted to SV prior to the options being offered, SV is bound to consider it. It is generally advisable to agree the valuation beforehand since if SV subsequently insists on a high valuation for the shares (perhaps with the benefit of hindsight) the option holder will have an unwelcome charge to income tax at exercise.
SV states that a valuation agreed for one purpose (such as an EMI scheme) cannot be used for any other purpose. In practice, if there are two or more awards under different schemes involve similar holdings of shares and taking place at about the same time, SV will normally be flexible.
Valuers at HM Revenue & Customs are under instructions to give special priority to statutory employee share schemes. They will normally reply to employee share scheme valuation submissions within two weeks of receipt, and sometimes more quickly. Once a valuation has been submitted in writing, negotiations are often conducted over the telephone.
Valuations for statutory schemes are normally valid for 28 or 30 days,[104] although SV will usually grant an extension if the company gives an assurance that there have been no material changes in its commercial or financial position. For Share Incentive Plans only, a valuation can be agreed for up to 6 months if the company provides a declaration that it is unaware of any impending changes in circumstances and that SV will be informed of any material changes that do occur.
Non-statutory schemes
HM Revenue & Customs will not negotiate share values prior to the grant of unapproved options, the gift of shares to employees or any other non-statutory arrangement. The company and the recipient should report the transaction after it has taken place and this will be referred to SV for an opinion.
If the shares are not readily convertible assets (see Glossary) then PAYE will not be due and the transaction need not be reported until after the end of the tax year in question. However if PAYE is due this must be accounted for promptly (pages 35 and 111) and to assist with this SV may be prepared to agree a non-binding “health check” on the company’s proposed valuation.
Documentation
In order to obtain an agreed valuation, an estimate must first be submitted. SV will not volunteer valuation estimates of its own unless it is seeking to asses a taxable amount after a benefit has been received.
SV is required to approach share valuation on the basis of the information available in the public domain. In the case of a private company, this would be limited to Companies House information only. In practice, negotiations with SV are likely to proceed more smoothly if as much relevant information as possible is provided. This will help to allay any SV concerns that the company is trying to obtain an artificially high or low valuation for the purposes of tax avoidance.
A valuation estimate should normally be accompanied by:
- the last three years’ audited accounts, where available;
- the memorandum and articles of association, together with any amending resolutions;
- any shareholders’ agreements;
- the documents relating to the employee scheme(s) together with the resolutions adopting the scheme(s);
- current year management accounts and any available forecasts;
- details of any allotment of shares or dividends paid since the last audited accounts, or any other recent valuations performed;
- details of any transactions in the shares within one year of the valuation date, and of any that are in “active contemplation”.
It is also good practice to submit company brochures in order to give SV officials some idea of the nature of the business involved.
If a valuation for an Approved Share Incentive Plan is being prepared by an adviser, a form Val230 should completed. For an Enterprise Management Incentive a form Val231 is required. In each case the forms give the adviser authority to deal with HM Revenue & Customs on behalf of the client and provide a checklist of the information required for valuation purposes. No specific forms are prescribed for the Approved CSOP or SAYE Option Schemes.