Valuing company 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 Share Incentive Plan, HM Revenue & Customs must agree that the proposed award price is neither materially more nor materially less than fair market value at the date of award. For the CSOP Scheme, the exercise price must not be materially less than fair market value, although it may be more. For the SAYE Option Scheme the exercise price must not be materially less than 80 per cent. of fair value, but may be more.

Share valuations for employee shares schemes, and indeed most other purposes, are negotiated with Shares and Assets Valuation ("SAV"), a specialist branch of HM Revenue & Customs based in Nottingham. SAV will agree values in advance of certain events, such as the issue of shares or grant of options under statutory schemes. In other cases, the share value can only be negotiated after the deal is done.

Where a company is listed, the value of the shares is easy to ascertain. For share scheme purposes an average of several days' mid-market prices (typically three to five) are sometimes taken, although where scheme shares are being purchased in the open market, SAV is usually prepared to accept the actual price paid. Where a company is quoted but not listed, for example on the Alternative Investment Market, SAV will normally accept a price at or close to the quoted price or the previous closing price as "fair value", although if the shares are thinly traded, officials may seek adjustments in respect of any perceived distortions to the market. If the shares are quoted on a matched bargain basis, then SAV 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 a prudent and willing buyer and seller, assuming the buyer has all the information he or she might reasonably expect to receive (see also "Other considerations").

The fair value of an unquoted share will reflect a variety of factors including the restrictions, if any, which apply to the shares. Only certain types of restriction, generally to do with voting power and compulsory transfer on leaving employment, are permitted for the Share Incentive Plan, SAYE Option Plan and CSOP Scheme. However more widely restricted shares can be used for the Enterprise Management Incentive, and restricted shares are often used for awards of unapproved share options, LTIPs or other non-statutory awards of rights over shares. Quoted shares are generally not subject to restrictions although there are a few quoted non-voting shares.

HM Revenue & Customs takes the view that even very common restrictions, or restrictions that apply to all the shares of a company, will have an effect on the value of an unquoted share. For example, the directors of almost all private companies have the power to refuse to transfer a share without giving reasons. SAV will discount the value of a share for this factor alone by as much as 10 per cent. or sometimes considerably more. Where an employee acquires a share but pays less than the unrestricted value, part of any subsequent gains may be subject to income tax rather than the more favourable capital gains tax treatment. Employees acquiring such securities can make an election which results in their being treated for tax purposes as if the value of the securities acquired was the full unrestricted value. This can lead to an income tax charge for the year of acquisition if the price paid was less than the unrestricted value, but may save larger amounts of tax in the future if the shares rise in value.

SAV valuers will negotiate the fair value of unquoted shares by reference to a variety of valuation methods, depending on what is submitted to them and what they regard as appropriate. These methods can be 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 the valuation of unquoted shares, and any applicable restrictions, is an uncertain process. In practice, individual SAV valuers may have substantially different opinions of "fair value" in different situations even when the facts are similar.

The estimation of fair value will depend in part on the information available to the "prudent buyer" mentioned above. This will vary with the size of the shareholding being valued. The recipient of options over a small stake of one or two per cent. of a company might expect to have little if any more information than is available publicly. They might not, for example, have access to the company's budgets or forecasts. The purchaser of a sizeable stake, however, and especially a majority shareholding, would expect to receive a much greater level of detail. In practice, the negotiation with SAV is likely to go more smoothly if all relevant facts are disclosed, irrespective of the size of shareholding being discussed.

Valuation of sustainable earnings

The concept of "sustainable earnings" is supposed to represent the true, continuing 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 usually 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.

In order to obtain an idea of the underlying profits of a business, SAV will consider not just at the results for one year but the pattern of earnings over several years, including forecasts if available. Strictly, if only a small minority of the share capital is being valued, SAV should not expect to see any detailed information which is not in the public domain since this would not be available to hypothetical buyers and sellers of such shareholdings. At the other end of the scale, if a substantial minority (25 per cent. plus) or a majority shareholding is being valued, or if the investment is costly, SAV will assume that no prudent buyer would proceed without access to detailed records and any available forecasts. In practice, if forecasts have been adopted by the Board these are normally supplied to SAV even for small minority valuations, since this provides greater transparency and may help the negotiations proceed more smoothly.

Historical and prospective earnings should then be adjusted for any factors that are not 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. If the company is likely to be sold or floated in the next few years, it may also be necessary to adjust levels of salaries, bonuses, pensions or other benefits if these are markedly out of line with the normal market rates that would be likely to apply on eventual sale or flotation. If no exit is in prospect, however, and a small minority is being valued, it may not be appropriate to adjust for these factors since minority shareholders will have no power to change them.1

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.2 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.

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, SAV 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.

Adjustments to the price earnings ratio

In practice, many SAV 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 abnormal items. This figure will be higher for companies with strong earnings and good prospects and lower for weaker companies.

The price-earnings ratio may need to be adjusted in relation to the rights and restrictions attaching to the shares. Common restrictions include lack of voting or dividend rights or an obligation for an employee shareholder to offer the shares for sale on leaving employment. Restrictions normally reduce the value of a share.

On the other hand, if a large stake is being valued the pro-rata value of the shares is likely to be higher, as follows:

In practice, each set of circumstances is different and the above ranges may not be applicable in individual cases. However the underlying considerations are:

• A holding of 10 per cent. or more cannot be compulsorily acquired in a take-over.3 Since most acquirors insist on 100 per cent. control, this effectively blocks most take-overs unless there is a drag-along arrangement in place.4
• A holder of more than 25 per cent. of the shares can prevent the company passing special resolutions. These are required for important company decisions such as alterations to the share capital or the articles of association.
• A holder of 50 per cent. of the shares can prevent the company making any decisions at all, unless a shareholders agreement is in place which sets out how different decisions are to be made and a procedure for resolving disputes. Clearly a holder of 50 per cent. or more has the power to control the company but the value of the shareholding will depend on whether the remaining minorities have powers to block company decisions or a sale to a third party.

The values attributed for tax purposes to small minority holdings in an unquoted company may appear quite low in relation to larger holdings in the company, or to quoted companies more generally. 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.

On the other hand a low share valuation can be a positive advantage for statutory employee share schemes. With a low valuation, 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 are not valued separately since they are 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 any 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. If employees are to receive substantially greater dividends than other shareholders, HM Revenue & Customs may attack the arrangements on the grounds that national insurance contributions are being avoided on payments that would otherwise be made in the form of salary or bonus.

If the shares generally pay high dividends, their value on a dividend yield basis may be higher than on an earnings basis. To obtain a dividend based valuation, the average dividend yield of comparable quoted companies, or more commonly, of a suitable index, is grossed up by a discount factor of between 60 and 80 per cent.5 This grossed up yield is then applied to an estimated average dividend to give an overall capital value.

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. If the shareholdings being valued are relatively small, SAV may be prepared to accept that the prudent purchaser of such shares would not be aware of these developments and they should therefore not be factored into the price. This view will be more likely to be taken if no definitive agreement has been signed and the facts of the offer are not known to the workforce generally or the public. This can provide opportunities to issue share incentives on favourable terms ahead of a possible change of control.

Obtaining agreed valuation

Statutory schemes

In the case of the Share Incentive Plan, CSOP Scheme or SAYE Option Scheme, HM Revenue & Customs will not normally agree a valuation for unquoted shares until the scheme has been formally approved. This 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 SAV prior to the options being offered, SAV is bound to consider it. It is generally advisable to agree the valuation beforehand since if SAV 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.

HM revenue & Customs normally states that a valuation agreed for one purpose, such as an EMI scheme, cannot be used for other purposes. In practice, it is difficult for officials to argue for different values in relation to transactions in similar numbers of shares which take place within a short time of each other.

Valuers at SAV 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.

Valuations for EMI, SAYE and CSOP schemes are normally valid for 28 or 30 days,6 although SAV is sometimes prepared to issue valuations that are valid for 60 days. SAV 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 SAV 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 SAV for an opinion. In the case of an unquoted company this can lead to considerable uncertainty since if the price agreed is later deemed by SAV to be incorrect, there can be adverse tax consequences. For example, if the price paid is deemed to be too low, HM Revenue & Customs will impose an income tax charge on the acquiror in respect of the undervalue.

If the shares are not readily convertible assets 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 and to assist with this SAV 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. SAV will not volunteer valuation estimates of its own unless it is seeking to asses a taxable amount after a benefit has been received.

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 information on future prospects, such as forecasts or budgets;7
• details of any dividends paid since the last audited accounts; any transactions in the shares within the two previous years or which are actively in contemplation, and any other recent valuations performed.

It is also good practice to submit company brochures or website details in order to give SAV officials an idea of the nature of the business involved.

If a valuation for a Share Incentive Plan is being prepared by an adviser, a form Val230 should completed. For an Enterprise Management Incentive the form is a Val231. The forms, which can be downloaded from the HM revenue & Customs website, 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. In the case of other employee share schemes, a form 64-8 can be submitted which provides a general authority for the adviser.

1. Unless the situation is so extreme that minority shareholders could sue for oppression under the Companies Act.»
2. Cares should be taken with terminology in this context. Forecasts are an attempt to predict outcomes while targets are usually more aspirational in nature. The term "budget" is sometimes used to denote a forecast and sometimes a target. It may also mean a minimum that must be met. A distinction should also be made between figures which are merely being discussed by management, and those that have been formally adopted by the Board.»
3. The Companies Acts provide that a minority holding of less than 10 per cent. can be compulsorily acquired on the same terms as offered to other shareholders. If there is more than one class of share capital, the 10per cent. limit applies to each.»
4. A drag along arrangement may be incorporated in a company's articles of association, or a shareholders' agreement, and provides that if the holders of a certain proportion of a company's shares agree to sell, they can require the remaining shareholders to sell on the same terms.»
5. This is analogous to the discount of 60 to 80 per cent. which is applied to quoted price earnings ratios; see "Adjustments to the price earnings ratio" above.»
6. This may be reduced if the valuer considers that there are short-term factors at work.»
7. As noted earlier, for valuations of small minorities, SAV should not expect to have access to detailed and private information such as budgets but generally it is best to disclose all relevant material.»