The value of a company is not the same as the price paid for it, and neither is the same as the figure a court will adopt in a dispute. Value is the outcome of a method applied to assumptions; price is the outcome of a negotiation. Understanding where the two diverge is what prevents most arguments about valuation.
Valuation questions arise in law in three recurring settings: a sale or acquisition, a dispute between shareholders, and the division of assets on a divorce. The method that is appropriate, and who chooses it, differs in each.
Net asset value
The net asset value takes the assets on the balance sheet less the liabilities, adjusted to current values. It is simple, verifiable and backward-looking, and it says nothing about what the business will earn. It suits holding companies and property-owning entities, and it systematically undervalues a business whose worth lies in its customer base, its people or its contracts.
Profitability value
The profitability value capitalises normalised results: the maintainable profit divided by a required rate of return. It is a step closer to economic reality, and its weakness is that it treats profit as a proxy for cash and depends heavily on the required return chosen, which is where valuations by two experts diverge most.
Discounted cash flow
The discounted cash flow method projects future free cash flows and discounts them to present value. It is the method most used in transactions and generally regarded as the most defensible, because it makes the assumptions explicit: the forecast, the discount rate and the terminal value. It is also the method most sensitive to those assumptions, and a small change in the discount rate moves the outcome substantially.
Valuation in a shareholder dispute
Where a shareholder is bought out under the statutory arrangements – a withdrawal or an exclusion claim – the court determines the price, in practice by appointing one or more independent experts. Two questions dominate these cases. The valuation date, because value can change materially between the events complained of and the judgment. And whether a discount applies for a minority holding or for the absence of a market, which is contested and depends on the circumstances and on the conduct of the parties.
The articles of association or a shareholders’ agreement often prescribe a method or a mechanism for appointing a valuer. Where they do, that mechanism generally governs, which is a good reason to look at those documents long before a dispute arises.
Valuation on a divorce
Where a business falls within the assets to be divided, it must be valued at a date the parties agree or the court sets. The tension here is between a valuation that reflects the business as a going concern and the reality that the spouse who continues the business has to fund the payment out of it. Courts take that into account in the payment arrangements rather than in the valuation itself.
Practical points
Agree the method and the valuation date before instructing anyone, because disagreement afterwards is what turns one report into three. Where a valuation will be contested, a jointly instructed expert carries considerably more weight than two partisan reports. And separate the valuation from the terms: an earn-out, a deferred payment or a warranty package can bridge a gap that a further round of valuation will not.
Advice
We advise on valuation clauses in articles and shareholders’ agreements, act in buy-out and exclusion proceedings, and work with valuers in transactions and divorces. Please contact Law & More.
