When embarking on a valuations engagement there are many components that individuals may not be aware of, or have the knowledge on. Hugh G. Livingstone C.B.V, a member of Crowe MacKay’s valuation team, addresses common concepts associated with family business.
This is intended to be general in nature, as all of the topics have complexities not covered in this memo.
Fair Market Value
Fair market value is looked at from the buyer’s perspective. The essence is, “What would an independent third party pay for an acquisition of shares or assets?” Fair market value assumes there is more than one buyer with access to all relevant information and financial resources. This creates an actual ‘market’ that will compete to determine fair market value.
As Chartered Business Valuators, we are often asked to determine fair market value in a ‘notional’ market place, i.e. when no actual sale of shares or assets is taking place.
The simplest way to describe a minority discount is by way of example. Assume a company has a fair market value of $10,000,000 and one shareholder owns 10% of the shares of the company. At first glance, the 10% shareholder might believe his/her 10% shareholding is worth $1 million. In many cases, this would not be true. As a minority shareholder, you do not control the company. Therefore, you cannot dictate when, or if, you get a return on your investment or a return of your investment. A 10% minority shareholder has little say on the running of the business, i.e. who are the officers and directors of the company, what industries do they invest in, what assets do they buy or sell, what does the company pay its employees, etc.
Remember, from an investor’s perspective, what would they pay to ‘step into the shoes’ of the 10% shareholder? The answer is likely a lot less than $1 million. The difference between the $1 million and what an investor would pay is the minority discount and dependent on many factors. If the investor is only willing to pay $400,000, due to his/her expectation of the timing of cash flows, then the minority discount would be $600,000 or 60%.
Fair value for a private company is a defined term in the valuation community, and it means fair market value without a minority discount or premium. This is a definition often used by the Courts when fairness is the goal. For example, in a matrimonial situation, the Courts would think it unfair to tag one spouse with a large minority discount.
In a non-matrimonial situation, the Courts would have no problem recognizing a minority discount between disputing shareholders.
It is beyond the scope of this article, but it should be noted that Canada Revenue Agency has its own thoughts and policies on minority discounts.
It is not unusual for investors, the Courts, and CRA to have differing thoughts on the value of shares or assets. The Chartered Business Valuator needs to identify the users of his/her report and determine and communicate which are the appropriate set of principles or rules to be followed.
Reference to Minority Discount in Shareholders’ Agreements
It is very helpful when drafters of shareholders’ agreements for private companies address the issue of minority discounts in the shareholders’ agreement. The agreement should reflect the wishes of the shareholders. Do the shareholders want the departing minority shareholder to be hit with a minority discount or not? There is no right answer.
In some family businesses, the shareholders’ agreement states that any departing shareholder will not be hit with a minority discount when selling to existing shareholders.
My personal preference is for the shareholders’ agreement to address the matter rather than be silent on the matter. Furthermore, I would rather the agreement state the method of determining the value of the shares to be “as determined by a Chartered Business Valuator.” Formulas are often used (i.e. three times the average of the last three years’ earnings) resulting in unforeseen and unintended consequences.
Early in the valuation process, the valuator must determine whether the business is a going concern. If the business is not a going concern, the valuator has a number of liquidation approaches in his/her toolkit. If the business is a going concern, there are a number of valuation approaches, including the net assets approach and the capitalized earnings approach.
Net assets approach
The net assets approach is best understood by realizing that it is not used where goodwill is expected to exist. The net asset approach relies on the underlying value of the assets. This approach is often used when valuing holding companies; including real estate holding companies.
Capitalized Earnings Approach
The capitalized earnings approach is used when the size, processes, management team, etc. of the business yields higher profits or returns than the assets on their own. It all comes down to earnings or cash flow and the market's perception of the continuance, or risk of interruption, of the cash flows.
For example, investors may look at a particular business and determine the appropriate rate of return, given their assessment of the risk of interruption, is 20% per annum. If this business generated earnings of $1,000,000 then the fair market value of the business would be $5 million (the math is 1 divided by .2 (or 20%) = 5 times earnings). If the fair market value of all of the assets less all of the liabilities is $4.2 million, then goodwill would be $800,000. There is a fair amount of work that goes into calculating the appropriate earnings and rate of return (risk factor) to be used in the capitalized earnings approach.
The above excerpt addresses some of the valuation concepts. If you have any questions regarding the above or any other valuation matter, please do not hesitate to contact any member of our valuation team.