11 Jun 2018
In the recent Versteegh case, which was heard by the Court of Appeal in February 2018, it was noted that “The valuation of private companies is a matter of no little difficulty” and in H v H it was said that “valuation of shares in private companies are among the most fragile valuations which can be obtained”.
In the Versteegh case Lord Justice Lewison made some general observations regarding the difficulties faced when valuing private companies and identified 5 reasons for the perceived fragility of such valuations. In the following paragraphs I consider each of the reasons in more detail.
1) There is no obvious market
Shares in private companies are less liquid than those in publically quoted companies, as there is no formal market on which prices are quoted. However, shares in private companies do change hands regularly and for “open market values”.
The number of transactions in 2017 was 15% higher than in 2016, according to one M&A industry source, although deal values were down suggesting a greater number of smaller deals.
Transparency in respect of the financial details of private company transactions varies making it difficult to make general market predictions about price / value.
2) Valuers using the same method can produce widely differing results
Valuation is an art and not a science. The science part is in the valuation formulae which exist, for example Future Maintainable Earnings × Profit Multiple. The art element exists in the assessment of FME and selection of an appropriate Profit Multiple.
Where the art element requires a subjective assessment of a figure then every valuer is capable of arriving at an infinite range of answers, depending upon the weight applied to each relevant factor. It is the interpretation of those factors that can lead to widely differing results. Assessing future earnings is to a degree crystal ball gazing. Identifying the appropriate profit multiple can be informed by actual transactions, but is still a subjective exercise.
3)The profitability of private companies may be volatile
Private companies tend to be less diversified than larger quoted companies, and diversification is one way to reduce the risk of volatility in earnings.
In addition smaller private companies often have much smaller membership, and less passive investor shareholders to answer to than publically quoted companies. Therefore, private companies suffer less scrutiny of their results, and can afford to have a bad year once in a while without significant consequences.
It is also not unknown for private company results to be flattered in the run up to a sale, to get a better price, or be suppressed when a divorce settlement is being considered.
The lack of audit requirement for companies with turnover less than £10.2m, and the reduction in the levels of disclosure required for small companies and micro entities means less ability to publically scrutinise results.
4) Difference in quality of valuations based on opinion evidence compared to hard cash
It is often said of valuations that “There are many values but only one price.” The offer of hard cash to buy the company will always be more convincing than any academic opinion as to value, however well informed.
But, would most sellers would not accept the first offer to sell? In our experience sellers wouldn’t accept an offer until the reasonableness had been tested.
We often look at company values following receipt of an offer, in contentious and non-contentious scenarios, to help inform the would-be seller.
5)The acid test of any valuation is exposure to the real market
It is true that the only way to accurately test any valuation is to put the business up for sale, to find its market price. There are many values but only one price.
However, the market value can also be tested by reference to comparable transactions which goes someway towards a real market test. Most valuers have access to transaction databases which list the prices paid for private limited companies. And if no directly comparable company can be found other sales in the same sector may give an insight to the actual market value achievable were the company to be put up for sale.
So are private company valuations fragile? Based on the headline 5 reasons alone you may be forgiven for thinking no private company valuation is worth paying for.
However, scratch beneath the surface of each of the 5 reasons, as I have done above, and it can be seen that valuations of private companies are not as fragile as the quote from H v H would suggest.
Staying with H v H, Justice Moylan asked “Why, a party might ask, should my share be fixed by reference other than to the real values of the assets?” So a broad brush valuation of a private company often has real utility, and can be undertaken without extreme expense.
To discuss any valuation issues please contact Adrian or Leigh on 0121 711 2468.