The issue of shares to employees in the United Kingdom raises various valuation issues:
- How should those shares be valued for financial reporting purposes, under the provisions of FRS 102 or IFRS 2 – Share Based Payment?
- What is the “money’s worth” of such shares for tax purposes? Shares issued at less than their “money’s worth” are earnings subject to income tax.
There are two motivations with employment related securities that lead remorselessly to the creation of special share classes:
- The major driver for the issue of shares to employees is that of incentives that bind: simple bonus schemes act as incentives; the issue of growth shares to employees provides an incentive whilst also acting as a form of golden handcuffs.
- The golden opportunity of stock ownership can appear to be base metal if the short-term impact of that ownership is a sizeable income tax liability without the cash to meet it.
Special share classes are also being shaped as a means of managing inheritance tax liabilities. Transfers can be made of shares that have little or no participation in current value.
The Worked Example Group comprises valuation professionals who facilitate the development of examples for possible agreement with the UK tax authorities.
There are a great many different facets to the valuation of special classes of shares. This is especially so in the case of growth shares: these are shares with little or no participation in a base value as at the valuation date. They have a stated participation in the value above a defined hurdle value. The hurdle value is often rather greater than the base value.
The Worked Example Group has decided that there is a need for some shape to the guidance available to business valuation professionals relating to such special share classes. They have therefore published an Exposure Draft as part of a policy of consultation with the broader business valuation community.
The Exposure Draft can be accessed on the Worked Example Group website: www.sharevaluationweg.org.
The starting point for the exposure draft is the guidance given in International Valuation Standards 2022 relating to special share classes. IVS 2022 states that valuers may use any reasonable method to determine the value of a special class of equity. Information is then provided on three possible means of valuing such shares:
- The current value model (CVM);
- The option pricing model (OPM);
- The probability-weighted expected return model (PWERM).
The current value model attributes values to different share classes based on the position at the valuation date. A realisation of the entire equity in an exit at that date is envisaged. Shares are therefore valued at their liquidation preference in a notional sale at the valuation date. If the total equity has a value of £5 million, there is no value (above amounts subscribed) for shares that only participate in surplus value above £6 million.
The main virtue of CVM is that of being conventionally intuitive. In the above circumstances clients would recognize that value in excess of £6 million does not yet exist.
The disadvantages are apparent:
- There is no requirement or expectation that the notional sale of a block of shares takes place in the context of the sale of the whole of the equity.
- Secondly, it is a quality of growth shares that the risks and benefits are not symmetrical: as they have a relatively low current value, the downside risk is modest. The upside potential can be very significant. There is some asymmetry of risk and reward in all shares. However, that quality is greatly enhanced with growth stocks. In technical terms there is a need to consider the option-like payoffs of growth shares.
- We cannot imagine that a majority stockholder would attribute no value to amounts in excess of £6 million in the above example. We can envisage a 100% stockholder being prepared to enter into a transaction in which rights in excess of £6 million were sold in an arm’s length transaction. The proceeds would reduce her investment in the company. She would be guaranteed up to the first £6 million in a sale. She would have received monetary compensation for limiting her upside.
Due to the option-like payoffs, International Valuation Standards only advocate the use of CVM in very restricted circumstances:
- A liquidity event is imminent; or
- The enterprise is at an early stage of development and no significant common equity value above the liquidation preference has been created;
- No material progress has been made on the company’s business plan;
- No reasonable basis exists for estimating the amount and timing of any such value above the liquidation preference that might be created in future.
PWERM is a favoured tool of private equity and some other sophisticated investors: it may be used to compare different potential trade sales transactions with possible IPO proceeds and with the future value to be obtained by retention and expansion of the business.
This is a labour-intensive tool requiring significant inputs and impressive skills of judgement. By considering various potential outcomes it is transparent. It recognizes the potential range of different outcomes and therefore embraces the uncertainties implicit in any predictions of future outcomes.
There is potentially great subjectivity in the selection of probabilities. However, the use of statistical modelling tools can greatly reduce that subjectivity. For smaller businesses it is unlikely that the skills or other resources will exist to undertake the heavy lifting required in the use of PWERM.
It is the view of International Valuation Standards that PWERM should only normally be used for the valuation of special share classes if a business is close to an exit and does not plan to raise any additional capital.
The longest section in the Exposure Draft is dedicated to various valuation tools based on Option Pricing Models. These are the Black Scholes Option Pricing Model (BSOPM) and other models with the same intellectual foundations, namely the use of Binomial Models and Monte Carlo simulation.
It is recognised that there are special challenges in using BSOPM for the valuation of any shares in a private company. As with so much in business valuation, some leaps of faith are required.
The first concern is that of dynamic hedging: the seller of a put or call option in respect of publicly traded stock can hedge the risk.
The technical result of this concept of dynamic hedging is that the seller of the options has no risk; in consequence the BSOPM includes the expectation of earning the risk-free rate of return. There is no equity risk premium within BSOPM as the risk has been stripped out by dynamic hedging.
By definition the owners of shares in family companies that issue growth shares are not able to hedge risk.
The second challenge is of equal moment: the BSOPM outputs are materially affected by changes to the volatility assumptions. It is extremely challenging to estimate what the volatility of the stock of a small private company might be if it were publicly traded.
The Exposure Draft has thrown out these stumbling blocks for the views of the business valuation community.
The Worked Example Group hope that the wider business valuation community will engage in responding to some or all of the many questions that have been thrown out by the Exposure Draft for consideration. We are seeking a better consensus and an improved quality of valuations of growth shares.
1. IVS 2022 200.130.5
2. IVS 2022 200.130.11