Top Tips for Business and Share Scheme Valuation in a move to Employee Ownership
Our experts Garry Karch and Becky Mitchell of RM2 provide some top tips for owners wishing to establish the worth and value of their business and that of the future employee shares.
Understanding what your business is worth
It is important to understand that a valuation produces an opinion of company value, while price reflects what is actually paid for the business. In the context of a sale to an Employee Ownership Trust (EOT), the valuation opinion represents the maximum amount the EOT can pay for the company’s shares. But of course, owners are free to sell for something below the valuation.
Determining the value of the business
There are several widely accepted techniques for valuing a business on a going concern basis. These methods are all based on the future ability of the company to generate positive cashflow.
A valuation expert will generally look at all three of the following primary valuation techniques in forming an opinion as to the value of the business:
The Discounted Cash Flow (DCF) methodology
Under DCF, the present value of the future cash flows of the company represents the enterprise value of the business. These cash flows are discounted using the rate of return an investor would require to invest in the company.
The next two techniques are based upon cashflow multiples (EBITDA is one commonly used measure) from comparable listed companies and comparable transactions.
Cash flow multiples
Comparable listed companies
If comparable listed companies trade for 10X EBITDA, that serves as the basis for valuing the privately held business. Multiples for listed companies are for minority stakes in the business, so a control premium would be added.
If comparable transactions are valuing companies at 10X EBITDA, that would serve as the starting point for the valuation. This would be a control price, so no premium is necessary.
Valuation multiples are reduced for the smaller size of the company being valued and for the lack of liquidity that comes with being privately owned. The difficulty with these methods is often finding directly comparable companies and transactions.
Under all three methods, outstanding debt is subtracted from the calculated value and excess cash is added to determine equity value.
Share Scheme Valuation
The valuation of private company shares, and any applicable restrictions, is an uncertain process – and is frequently described as being “an art, not a science”. Naturally, different situations may call for different valuation approaches – here are some of the common ones:
Determining the value of shares for employee share plans
A number of employee share plans, such as the Enterprise Management Incentive (EMI), Share Incentive Plan (SIP) and Company Share Option Plan (CSOP), have tax advantages, and it is therefore important to determine the fair value of the shares prior to awards being made so that both the Company and employees can be certain of their tax position from the outset and to ensure that no statutory plan limits are breached. It also provides certainty to any potential third party, if there is a company exit event in the future.
Where a company is listed on the London Stock exchange or similar overseas market, the value of the shares is easy to ascertain. For unquoted shares, valuation proposals are submitted to HMRC’s Shares and Assets Valuation (SAV) for acceptance prior to awards being made under one of the statutory employee share plans.
Methods that can be used
For unquoted shares such as those in an employee owned business, the fair value will reflect a number of factors including the restrictions, if any, which apply to the shares. This might include lack of voting rights and transfer provisions on ceasing to be an employee. The fair value can be negotiated with SAV using a variety of methods, depending on what is most appropriate at the time of submission, such as sustainable earnings, net assets, discounted cash flow or dividend yield. The most common basis is sustainable earnings – the level of earnings after tax and minority interests which represents the true economic profit of a business, excluding exceptional and extraneous factors.
Under this method the value of the share is calculated by multiplying the earnings by a price earnings (p/e) ratio. The p/e ratio is initially assessed by reference to the price earnings ratio of comparable quoted companies. Where no comparable companies exist, a broader sector or market index may be used (e.g. FTSE All Share, FTSE SmallCap as published in the Financial Times). However, SAV accepts that unquoted shares should normally be valued at a large discount to quoted comparables, in the range of 60 to 80 per cent, because of lack of marketability. Additional adjustments may be required if the shares have restricted rights.
The valuation of shares used for an employee scheme may therefore be very low in relation to the value of the company as a whole. It is important that this is carefully explained to employees, so that they understand the potential upside if the company is sold or floated in the future. Low valuations also make it possible for companies to offer larger numbers of shares within the limits that apply all the statutory schemes.
SAV valuers give special priority to statutory employee share plans. They will normally reply to submissions within two to three weeks, and sometimes more quickly. Once a valuation has been accepted by SAV, it is normally valid for 60 days or, in the case of a Share Incentive Plan usually 6 months, as long as there no material changes in the commercial or financial position of the company. Negotiation with SAV is likely go more smoothly if all relevant facts are disclosed at the outset.