In Practice - Share valuations - Valued business?

Valuing a business or shares in a company can be one of the most challenging assignments in which an accountant is involved.

If 100 equally competent accountants were asked to value the same business, at the same date, it might be stretching the point to say that you would get 100 different (but equally valid) answers, but there is nevertheless an underlying truth. General valuation principles are long established, but these are generic and their application requires a considerable measure of subjective judgment. Relatively small variations in the approach to evaluating specific assets and liabilities may, when added together, produce different results.

There is one situation that is fraught with danger for any company auditor.

The articles of association of many private companies contain a clause stipulating that if circumstances require the shares of a minority to be purchased, either by other shareholders or the company itself, and agreement cannot be reached concerning their value, the auditors shall be appointed to value the company for this purpose, acting as experts rather than arbitrators. Usually the articles will require the valuation to be undertaken on the assumption of an arm's length transaction between willing buyer and willing seller, allowing no discount for minority status.

Picture the scene. The shareholders are at each other's throats. Legal claims, redundancy notices and heaven knows what are fluttering like leaves in autumn. Into this acrimonious cauldron is pitched the hapless auditor.

He is in a no-win situation. If he declines the appointment, or worse still, values the shares too high, he risks losing a valuable audit client.

But if his valuation is too low he risks being on the wrong end of a negligence action brought by the disaffected minority shareholder. The following examples, based on cases in which we were appointed to act as experts by solicitors acting for the defendant firms, set the problem into context.


As the cases on the next page demonstrate, the valuation of shares, particularly those of companies with specialised or unusual assets, can be problematic.

It is not unusual for complex specialised issues, such as the impact on the value of any outstanding options, to arise part way through the assignment.

These claims failed, partly because the firms involved were able to demonstrate that they had the appropriate expertise and experience to undertake the valuations. There are obvious dangers for a firm being tempted to take on tasks that are, in all honesty, beyond its expertise.

Whenever an accountant is appointed in such circumstances it is imperative that he or she maintains a scrupulously impartial attitude towards the parties. Almost inevitably he will have more cause to contact the company's directors, usually the majority shareholders, than the minority shareholder whose shares are being valued, since the company is the source of the relevant financial information. However, it is essential that the minority shareholder is copied in to correspondence and is given an opportunity to express his point of view on any issues on which it is appropriate to consult him.

Above all, it is vital that each stage of the valuation process, including any preliminary research and discussions with partners or others within the firm, is documented in full, even though it will not normally be disclosed.

The file should contain sufficient information to enable a third party to understand precisely the accountant's approach, the work he has undertaken and how the conclusions concerning each of the variables were arrived at.

CASE STUDY 1: Auditors not in the picture

The audit firm was appointed by a company to value the shareholding of one of its former directors, who had been dismissed from his position after it was discovered that he had falsified his expense claims. The company's principal asset was an untried experimental photographic development process.

Some months after delivering their valuation, the auditors were notified that the minority shareholder was bringing a negligence action against them. The claimant alleged that the auditors had been negligent in their approach to the valuation of the process.

Valuation of the process

The auditors valued the process on the basis of the costs incurred in developing it up to the valuation date. Some months later, but before the auditors had completed their valuation, the process was sold to a large photographic development company for consideration, that was more than eight times the total costs incurred. The claimant argued that, on the basis that subsequent sale proceeds are usually the best indicator of the value of an asset, the auditors' apparent disregard of the post-valuation transaction constituted negligence.

On the issue of liability, the defendants contended that, for complex reasons never fully explored, the purchasing company had based its price for the process, not on the process itself, but on its desire to secure the claimant's know-how, connections and other products. Hence, the consideration for the development process had been artificially inflated as a result.

As expert for the defendant I argued that, irrespective of the strength of their arguments on liability, the claimant's case must fail on causation grounds.

Unbeknown to the auditors when they undertook their valuation, the purchasers of the process had discovered, shortly after buying it, that it was fatally flawed and had been from the outset. They had been obliged to consign it to scrap. I therefore argued that, since the process had not been undervalued by the defendants - it was in fact utterly worthless throughout the entirety of its life - the claimant had suffered no loss.

We applied the following analogy: if a purchaser of a piece of green glass offers to pay 1m in the belief that it is in fact a rare type of emerald, such an offer in no way alters the reality that the subject of the proposed transaction is and always has been, a worthless piece of glass. If the transaction falls through, the seller has lost nothing, since he had nothing of any value in the first place. If anything, the defendants had overvalued the process - the development costs incurred by the company could justifiably have been written off. Following the exchange of experts' reports the claimant dropped all allegations.

CASE STUDY 2: In the frame

The company's main asset was a substantial collection of works of art, principally paintings and sculptures. The claimant, who had been made redundant by the gallery following a dispute between the directors, alleged that the valuation of his 20% holding by the auditors was negligent in the following respects:

Valuation of the works of art

The company's articles included a clause that entitled the auditors to seek the assistance of specialist art valuers for the purposes of their valuation of the company. The auditors instructed the valuers to value the portfolio of artworks at their best price on the assumption that they would be sold to a single purchaser in a single transaction. The specialist valuers stated in their report that they had allowed a discount of 15% of the gross value, to reflect their valuation as a portfolio and the auditors incorporated this discounted value in their valuation of the company.

The issue in dispute was whether such an approach was reasonable. The defendants argued that since a hypothetical purchaser of 100% of the company's shares would, in effect, be purchasing the entire portfolio in a single transaction, anyone buying the company would be obliged to purchase the works as a 'job lot', including those which did not 'fit in'. They contended that such a purchaser may reasonably seek a discount to reflect the inconvenience of having to re-sell any unwanted works and the risk that their values decline in the meanwhile.

The articles also stipulated that no discount should be applied to the value of a minority holding. However, for the purposes of their valuation the defendants had applied a discount of 10% to the value of the claimant's shares to reflect their unlisted status. The claimant argued that such a discount was inappropriate being, in effect, a minority discount by another name.

The parties provided the judge with a template to enable him to calculate the range within which a reasonably competent accountant would have valued the claimant's shares. Despite his finding that the application of a discount to the gross values of the artworks was inappropriate, his assessment of the other variables in the valuation exercise, including their application of a 'lack of marketability' discount, resulted in the defendant's valuation falling within the range the judge considered reasonable. Accordingly, the claim was dismissed.

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