Seminar delivered by Andrew Marsden and Roger Isaacs on: Valuation of interests in unquoted companies

Transcript of seminars delivered by Andrew Marsden and Roger Isaacs on:  “Valuation of interests in unquoted companies and other businesses”

Note: It is recommended that you watch the videos of the seminars delivered by Andrew Marsden and Roger Isaacs rather than relying on this transcript. The videos of this seminar series can be seen at: https://commercialchambers.org/videos/

Good morning and welcome to this, the first in these two seminars examining the valuation of interests in unquoted companies and other businesses.

First, let me introduce myself. My name is Andrew Marsden. I’m a company and commercial barrister and I’ve been in practice for 25 years. My specialist expertise lies in the resolution of disputes between people in business together. Those include, of course, shareholder disputes, disputes between partners, disputes between members of limited liability partnerships and disputes between agents and their principals. And it’s in the context of those sorts of disputes that issues of valuation are always at the fore and are very often fundamental, indeed crucial, to the resolution of those disputes.

I’m delighted to say that I’m joined by Roger Isaacs of Milstead Langton. Roger is a chartered accountant. He’s also a licensed insolvency practitioner. He has a genuinely national reputation as a highly respected expert in the field of valuation of unquoted companies and other business interests. He’s hugely experienced having provided expert evidence on issues as to valuation on hundreds of occasions and even, he tells me, across the Zoom platform that we’re using today.

For my part, I’m going to review the legal principles applicable to valuation. Roger is going to give us the benefit of his views from the front line of expert valuation.

We have between us prepared a note that accompanies these seminars. We intend to circulate that note at the end of these seminars. It contains the references to the legal authorities for the principles that I’m going to be discussing and I will therefore try and avoid burdening you with a citation for every principle that I make reference to. As I say, all the relevant authorities will be contained within that accompanying note.

We’re very happy also to take questions either during or towards the end of this seminar. So if you do have questions, then please feel free to use the question and answer function that the Zoom platform provides and we’ll do our very best to try and answer those questions. We’ll try and keep an eye on any questions as they come in and, if we don’t answer them directly, we will turn to them towards the end of the seminar.

Let me start by giving you a quick overview of what we’re going to talk about today. After a short introduction, I’m going to turn to examine the role of experts in valuation and the courts’ approach to the determination of valuation issues. I’m then going to examine the different bases of valuation. And lastly, today, I’m going to identify market value and examine issues that surround the alternative bases of establishing market value; namely, asset based valuations and earnings based valuations. Next week, we’re going to go on to consider the use of comparators in valuation exercises and the treatment of surplus assets. We’re also going to look at an issue which arises in circumstances where a business is considered dependent to a substantial extent on the services of a particular individual. And we’re going to be looking at adjustments that are required to give a fair or equitable value? We’re going to be looking at the appropriate date for valuation for various purposes and, lastly, we’re going to be considering the significance of any agreement between protagonists as to methods of valuation. For example, methods of valuation prescribed by the terms of a shareholders’ agreement or articles of association.

So let me start, if I may then, with a very brief introduction to the subject. As I’ve already said, valuation of shareholdings and other business interests is often central to the resolution of disputes, whether those disputes are between shareholders or persons in partnership or members of limited liability partnerships, or between commercial agents and their principals. But the business of shareholding and business valuation is widely recognised not as a science but as an art. And my first question to you, Roger, is does that really mean that you consider yourself an artist as opposed to a scientist?

Well, I suppose in the sense that we are in the happy position in this country where business valuation is not entirely formulaic. So I and other expert witnesses who give evidence about business valuations are required to give our professional opinion rather than simply churning numbers through an Excel spreadsheet or a formula. But certainly the judiciary have a fairly dim view of the work we carried out whether it be as artists or scientists.

Famously, Judge Mostyn said that valuations, rather than being mathematical or an exercise in mathematical or accounting accuracy, were no more than a “chimaera”. He said that in his experience the valuation of shares in private companies were  some of the most fragile of valuations that can be obtained which I think reflects the fact that the courts accept that one needs to take a relatively broad brush approach to valuations. And certainly, in my experience, the courts tend to favour valuations which are grounded, first of all, in common sense and secondly, commercial reality. I work very closely with my colleagues in the corporate finance team to make sure that the question that I seek to answer when somebody says, “what is this business worth?”, is effectively to say, well, if this business owner came to see one of my colleagues and said, I want to sell my business, and they do regularly do that, and they then say, “and what might I reasonably expect to realise for it?”; that is essentially what the business valuer is seeking to answer.

Thank you, Roger. You’re absolutely right. The courts have, on many occasions ,emphasised the fact that they themselves retain the power to determine valuation issues and that they have the ability to entirely disregard the views of experts as to valuation and apply their own view as to what is fair and reasonable in all the circumstances of a particular case. That residual autonomy has been emphasised in the context of both disputes under section 994 for the resolution of alleged unfairly prejudicial conduct of the affairs of a company. It’s also, it seems to me, a residual autonomy that is likely to be considered to apply for the purposes of determination of compensation claims under the Commercial Agents Regulations and, indee,d for other purposes, such as for the purpose of valuation of shareholdings or other business interests in circumstances where a court is considering the making of financial orders consequent upon a divorce. So yes, for these purposes, the court has, on numerous occasions, emphasised its residual autonomy to determine issues of valuation.

But I think it’s fair to say, Roger, that the evidence of expert valuers, such as yourself, is usually central to the determination of value by the courts. In other words, it’s not only generally required, that is, expert evidence is generally required, but indeed it is also substantially relied upon by the courts when making determinations of value.

One other point worthy of note is the court’s attitude towards the status of the expert; its view of the professional expert witness. It’s been made clear, again, Roger, that a court is much likely to give less weight to an expert’s opinions if he’s considered a professional expert witness with little or no practical experience of valuation in the context of buying and selling companies and businesses. So your approach in terms of checking your methodology and the realistic nature of your outcome by reference to whether your colleagues in mergers and acquisitions would find it as a satisfactory conclusion, seems perfectly sensible in that context. Indeed, it’s been said on more than one on one occasion that valuation evidence that is based simply on an application of pure theory rather than based on verifiable evidence in the form, for example, of comparisons is likely to carry considerably less weight than evidence that does have the benefit of a basis in verifiable evidence, such as a relevant comparisons.

Certainly, once valuation theory has been applied, it’s been repeatedly emphasised that both the expert and, in due course, the court itself must stand back and assess their preliminary views against the commercial reality and business common sense that the matter presents.

I shall move on to just consider the courts’ approach in general terms to the determination of valuation issues. In a case called Northern Sky North Holdings v Southern Tropics the court emphasised the requirements to take a proactive approach to the determination of share and business valuation issues. And, indeed, the Court has the powers under the Civil Procedure rules to exercise case management in a way that requires early valuation evidence to be available both to the parties and to the courts. Whether that early valuation evidence comes in the form of separately instructed experts, or through a single jointly instructed expert or, indeed, from a court appointed assessor, the court is required to exercise those powers, those powers of case management, in order, of course, to further the overriding objective of dealing with cases justly. It’s to that end that the courts regularly give directions for the obtaining and exchange of expert evidence as to valuation at an early stage in the hope that the availability of valuation evidence at that early stage will encourage settlement. Indeed, it’s my experience, Roger, that in order to minimise costs and reduce the ambit of disputes between parties, the value of a company or business is now often ordered to be the subject of evidence from a single joint expert or from a court appointed assessor again, primarily, with the objective of encouraging settlement between the parties rather than prolonging dispute. Indeed, the courts often do give directions for the early instruction of expert evidence on the basis that the expert valuer should make certain assumptions that should form the basis of his report. So, for example, the courts may direct certain assumptions to be made as regards the facts of the matter, which still require determination by the courts. Therefore, in a claim for, say, relief under section 994 of the Companies Act, the court might direct an expert valuer such as yourself, of course, Roger, to provide your valuation evidence on the basis of assumptions as to say the extent of diverted business opportunities or as to the extent of misappropriated assets, or as to the appropriate date, for example, of valuation or as regards any allowance you have to make for prejudicial conduct.

Roger, my next question to you is this; where such directions are given as to the early obtaining and preparation of expert evidence and indeed the disclosure of that between the parties, do you experience practical problems in those circumstances in your role as an expert?

The answer is that, generally, I welcome being instructed as early as possible and certainly the increasing use of mediation means that I am more often than not instructed at a relatively early stage so that the parties can have an opportunity to explore various types of alternative dispute resolution before matters get too far advance and costs escalate too much. But one of the practical problems in unfair prejudice claims is that often there are allegations that business or contracts have been diverted to sister companies, often in which the complainant has no interest, and the difficulty there is how to break the catch 22 by which, if one only obtains disclosure in relation to the company over which unfair prejudice has been alleged, it’s impossible to see the contracts, which by their very definition have been diverted away from it. One can only see those contracts or those sales, the benefit of that work, if one looks at the business to which that work has been diverted, and the courts, in my experience, are very reluctant to order disclosure against those sorts of third parties unless there is very clear evidence that business has been diverted to them. Which leaves claimants in a catch 22 position; because, in order to get the evidence they need to have the disclosure ordered disclosure and round and round they go. And those cases are really quite difficult to crack because one has to try and find some way to prove that it is not. What the defendants always say or respondents always say is its a mere “fiishing exercise” to unlock the door and to get access to the information which often has to be done through some sort of whistleblowing. Sometimes it’s even done, I had a case recently where it was done, by accident. Where information was included in the disclosure bundle, which in retrospect the respondents rather regretted. But that catch 22 is a real practical problem.

Of course, before any valuation exercise is undertaken, the basis of that valuation first has to be determined. And the basis of a required valuation is ordinarily either a market valuation or what is known as a “fair” or nowadays more commonly perhaps an “equitable” valuation. As far as valuations under section 994, for the purposes of relief against unfairly prejudicial conduct, are concerned the value to be identified for the purposes of any purchase order is that which is described as a “fair” or “equitable” valuation of the relevant shareholding. In contrast, claims for compensation under the commercial agents regulations require a determination of the “market value” of the commercial agency, the subject of the claim for compensation. Similarly, valuations for the purposes of financial adjustment orders in the context of divorce arrangements tend also to require “market based valuations as opposed to “fair” or, as I say, what is now more, perhaps more properly described as “equitable” valuation. The important point to note in this context, Roger, is that, of course, “fair “valuation or the “fair value” of a shareholding or business interest as compared to the “market value” may be very substantially different things. Roger, how, as an expert, do you view the difference between “fair valuation” and “market valuation”?

Essentially, the difference is that an “equitable” or a “fair” valuation takes into account the existence of a special purchaser. So it typically arises in the assessment of the value of shares rather than the business as a whole. So, if one considers a company in which there are three shareholders, for example, two of whom have 49% of the shares and one of whom has 2%, the value of that 2% shareholding on an “equitable” basis or a “fair value” basis is going to be very different from a 2% shareholding in a company in which there are 50 shareholders each of whom have a 2% shareholding because in the latter case that 2% shareholding may well be subject to a quite significant minority discount because on its own, even if acquired by another shareholder, because it’s unlikely to give that shareholder any particular level of control. By contrast, in the case where you’ve got two 49% shareholders with one 2% shareholder, depending on whether there are pre-emption rights, but absent pre-emption rights, whoever acquires that 2% gets control. So one could imagine a bidding war between the two shareholders each of whom would want to acquire that 2% share to get control and would pay a significant premium. One might envisage over pro-rata value, and even if there were pre-emption rights, one might expect that, again, a premium would be paid because each of the two shareholders, even if they were only to acquire one share each would at least get a 50% shareholding, which would be more valuable than the 49% shareholding that they had to start with.

So that’s a fairly stark example but the basic principle is that an “equitable valuation” takes into account the existence of special purchasers. Typically for shares in private companies the most likely candidate ever to buy those shares will be an existing shareholder. The only other way in which they’re typically realised is on the sale of the company as a going concern; as a whole. It’s very, very rare that unconnected third parties buy a minority stake in unlisted companies.

Roger, did you say that that was a view that was reflected in the international valuation standards by the International Valuation Standards Council?

Yes. The International Valuation Standards Council, which is the body that has now renamed “fair value” as “equitable value”, they define those two terms “market value” and “equitable value”. And, as I say, the essential difference between those two definitions is that “equitable value” takes into account the existence of special purchasers.

Thank you Roger.

Whether we’re looking at the determination of a “market value” or a “fair” or “equitable” valuation, the starting point is, ultimately, the identification of the market value of the company or business as a whole. And that market value has been satisfactorily, I think, defined as the price that would be agreed, assuming a hypothetical, willing, but not anxious or forced seller and buyer. Indeed, that was the phrase used in the case of Holt v Holt in 1990.

So, starting with an examination of the determination of a market value of a company or other business interest, the choice really is as between essentially two competing approaches. The first is what’s often known as an income or earnings basis approach, and the second is an assets based approach. Which basis is appropriate in any particular case is of course itself likely to be the subject of expert evidence.

Generally, in in my experience, where a company or business is a trading or going concern, an earnings basis is likely to be recognised as the more appropriate basis for valuation. On the other hand, an assets basis may be considered appropriate where, for example, the company or business is not trading but comprises either an investment vehicle or it is in fact trading but only at a very low profit level which doesn’t fully represent an economic return on the capital invested.

Let me start, Roger, by looking at assets based valuations. Essentially an assets based valuation is a balance sheet valuation with suitable adjustment being made for assets and liabilities that are not reflected in or are identified at values below their true current market values within the balance sheet of the company or business.

An assets based valuation is not necessarily conducted on a breakup basis. The value of the whole business may be greater than the value of its individual parts, and so a breakup valuation may undermine the value of the business as a whole. Asset valuation will require revaluation of any assets or liabilities that, as I say, have been recorded in the balance sheet otherwise than their current market values. Again, expert evidence as to the current market values of particular assets may be required when carrying out the valuation exercise as a whole. So for example, there may be required valuations from property valuers, whether as to the market value of the property concerned or indeed from surveyors as to anticipated dilapidation or maintenance costs that may be associated with any particular property asset held by the subject company.

Roger, when in your experience would you use a net asset valuation as opposed to a going concern valuation based upon earnings or profits?

Net asset valuations are used in three occasions. The first of those where you’ve got a business that’s insolvent and then the net asset valuation is preferred, not on a going concern basis, but on a breakup or forced sale basis. The second occasion when one would typically use a net asset valuation, is in relation to businesses that are asset rich and income poor. The usual example would be a property investment or property holding company. Farms are typically valued on an asset basis.

Those are the two most straightforward ways in which net asset valuations are adopted. But valuation theory says that the definition of goodwill is the difference between the net asset value of the business and the value of the business as a whole. Goodwill is that extra bit; the icing on the cake. That is the balancing figure between what the business would be worth if it was sold and it’s simple net asset value. It’s the premium that attaches to all those intangible aspects of the business, the customer list, the reputation, the website, all of that sort of stuff. And if one values a business at net asset value by arithmetic definition, what one is doing is describing no value to the goodwill. And one occasionally finds businesses that are modestly profitable and which are not imminently intended to be wound up but for which, even if one applied a relatively high multiple to the earnings, one would still result in a valuation that would be less than net asset value. That would imply the existence of negative goodwill. And negative goodwill is a feature that is quite difficult to justify in the context of a profitable going concern. It typically only arises if you’ve got a business in distress or if the assets in the balance sheet aren’t properly valued. So, typically the rule of thumb is that the value of a business will be the lower of its capitalised earnings and the net asset value. Sorry, let me rephrase that. The value of a profitable going concern is very difficult to justify at less than net asset value which effectively forms a floor below which it’s very difficult to justify valuing a business. Where that often creates practical problems is in relation to businesses that have, for example, spent a lot of money on fixtures and fittings of a leasehold property. So a restaurant would be a good example where somebody spent a million quid fitting out a restaurant and that million quid will be capitalised on the balance sheet as an asset, and typically it will be amortised or depreciated over the term of the lease. Now, if the restaurant were to cease to trade, it would very difficult to realise any value. Somebody else would come in and strip out the kitchen, strip out all the decorations, and those improvements might have very little value. So the assessment of the value of those sorts of assets, it can be quite challenging, but fundamentally the net asset value is typically the floor below which it’s very difficult to justify ascribing a value of a profitable business.

Let’s turn to the “earnings basis” of market valuation. Where an “earnings basis” is considered appropriate the precise methodology that one can use for determining that market valuation either involves analysing forecasts of future cash flows that are anticipated to be generated from the business against a required rate of return that might reasonably be expected in the circumstances of the particular case or by forecasting future annual maintainable profits and applying a suitable multiple to those profits. Whether the suitable multiple of future annual maintainable profits approach or the future cash flow applied to the required rate of return is to be preferred as a method for assessing value in any case where an earnings basis is appropriate is likely again to be the subject of expert evidence itself.

To some extent, these alternative approaches are really, in my experience, properly seen as one and the same thing, although viewed through different sides of a prism.  They can in practice and should, I think, in practice, be expected to produce similar results, theoretically at least.

As far as I understand it, Roger, the most reliable valuation evidence is achieved through an analysis of future cash flow and the rates of return on investment that might reasonably be required by a hypothetical purchaser. However, the application of that primary methodology is often problematic in practice due to the absence of reliable future cash flow forecasts or the difficulty in identifying an appropriate rate of return on capital invested that might reasonably be required by a hypothetical purchaser in the circumstances of the particular case. Consequently, in my experience, Roger, in practice, expert valuers tend to value trading companies and businesses on an earnings basis that depends upon identification of future annual maintainable profits and the application of a suitable multiplier rather than the future cash flow analysis method that I’ve described.

Roger, when would you in practice seek to apply a discounted cash flow method as the suitable method for determining value based on an “earnings” analysis rather than applying a multiple to a future maintainable earnings figure?

Well, most business values would say that the discounted cash flow or DCF is the gold standard. But actually in practice, in my experience, when people are buying a business they don’t prepare complicated cash flows and work out rates of return. Most entrepreneurs who buy private companies work on a much more broad brush basis, similar to that applied to the courts. Simply asking how many years is it going to be till I get my money back? So the DCF is definitely theoretically the gold standard but commercially one typically sees businesses bought and sold on a multiple of profits. And as you say, the problem with applying a discounted cash flow approach is that very few businesses prepared detailed long term cashflow forecasts. Many don’t even prepare budgets for the year ahead, but certainly the sort of long term forecast that you need to apply a DCF is a fairly rare commodity. But where you do have to use a DCF approach is in a circumstance in which the business that is being valued is not in a steady state. So an example might be a start up business which has lost money last year, lost money this year, is expected to lose money next year, but then, perhaps, break even the year after that and then to rise into profits as the years go by. Now, the only way to value that sort of business is to apply a discount to the future cash flows, because if one applied a multiple it would be applied to the current losses. And the advantage of the discounted cash flow approach is it recognizes that a profit that’s expected in five years time has to be discounted by more than a profit that is anticipated next year because the further away it is in time, the more uncertain it is and the greater the risk that it might not be achieved.

Similarly, if a business is in decline or if there are known events which are going to cause fluctuations in profits, then the discounted cash flow approach has to be used because there isn’t any meaningful, long term average, maintainable earning figure that can be used as a proxy and to which a multiple can be applied.

Let’s then turn to consider earnings based determinations of value. But as we say, in practice, tends to follow the approach of determining future maintainable profits and the application of a suitable multiple. Let’s examine the identification of future annual maintainable profits for this purpose.

Those future annual maintainable profits can either be identified on the basis of post-tax or pre-tax figures. In practice, I think it’s more usual that pre-tax figures are used for this purpose. The appropriate multiplier, of course, to be applied to those future annual maintainable profits will of course vary dependent on whether post or pre-tax profits are being used for this purpose.

In a case called Sunrise Radio, a 2014 decision, it was identified that future annual maintainable profits are to be assessed properly from the perspective of a hypothetical purchaser. The question to be posed in this context is what would that hypothetical purchaser assess those future annual maintainable profits at?

And to answer that question, one will, of course, start by saying that any hypothetical purchaser will, of course, identify future annual maintainable profits only after deducting all costs properly associated with the earning of those profits. So those costs will include all costs of property, assets and goods utilised in the business and will include the costs of obtaining the services of all persons needed to generate those profits. Consequently, for example, hypothetical market rental costs may need to be incorporated in any calculation in respect of premises, even if the business currently doesn’t pay rent, but would be expected to have to do so after the hypothetical sale took place. Likewise, hypothetical market salaries will need to be determined and deducted in circumstances where, for example, the current owner or manager of the company or business concerned doesn’t charge for his services or doesn’t charge for his services at an appropriate market rate; being that to be expected between persons dealing at arm’s length.

Roger, in practice, what resources do you tend to turn to when assessing what cost to include, particularly in respect of the services provided by owners of a company or business where those owners aren’t currently charging market rates for the services that they’re providing.

Well, the assessment of that notional cost of management, whether it’s in a commercial agency case or a business valuation case, is probably one of the most difficult and subjective and notoriously difficult aspects. One can use a number of published benchmarks. The annual survey of hours and earnings that’s published by the Office of National Statistics can be quite a useful yardstick if you’re looking at relatively junior or low paid jobs. But, if you’re looking at director salaries, there’s a survey that’s published by Kroner that’s typically used by business valuers, which is probably about as good a benchmark as is available in terms of the statistics published. That analyses director’s remuneration by sector, by location and by size of companies. So that again is a good starting point. But ultimately I would caution against using any benchmark in isolation or as simply giving you a fixed answer. What one needs to do as a business valuer is to look at the work that’s actually been undertaken by the agent or the director. How many hours is devoted to the business? What particular skills and qualification the director or the agent has. And all of those inform the choice of the relevant cost of management.

I am dealing with a case at the moment where I’ve got two directors who run the companies based both in the UK and the US and there one has to assess not just what the UK salaries are but the remuneration in the US which tends to be quite a lot higher.

And then you have to apportion how many hours they spend and quite often it’s rather blurred because they spend time on the business and some of the UK business in one month be very great, whereas in other months they can be devoting much more time to the US. So one just has to try to find some sort of logical, sensible way to apportion salaries between the various businesses and also to recognise the regional differences in pay structure.

I did have one case recently where it was an unfair prejudice claim and the defendants in seeking to deduct the largest possible cost of management that they could put forward an argument that said, well, the directors undertake a number of roles. They act as administrators between nine and ten and then they are a sales director between ten and 1015. And then they’re doing an operational role between 1015 and 1045. And then they act in a secretarial capacity for another 10 minutes. And they worked out the salaries of each of the roles that the directors undoubtedly, quite fairly, undertook and added them all together and came up with a salary of about three quarters of a million a year and said that that that was what should be deducted. This case went to mediation. And even the mediator who was trying to be as neutral as possible, it was fairly clear what she thought of that approach. So I’m not sure that that would have got much traction in front of a judge. But again, it’s just trying to get some level of common sense and to reflect the commercial reality.

The best yardstick is what’s paid to a non shareholder director and one sometimes finds that on a board some of the directors have shares and will remunerate themselves by way of dividends as well as salary and some won’t have shares. And that’s a great yardstick as to what is the appropriate level of remuneration because what’s paid to a non shareholding director is the figure you’re trying to ascertain.

Although, input from shareholder directors or shareholder managers is sometimes so extensive as to perhaps not be properly reflected in some of these indexes as to national salaries. Some shareholder/directors and indeed, perhaps even the majority, seem to live and breathe their corporate existence or their business existence. And whether these directories or comparisons actually properly reflect the value that they are bringing in their dedicated way to their businesses I always have some suspicion of.

Well, I suppose that that is the extra input the entrepreneurial flair that perhaps is reflected in their return qua shareholder rather than their return for a salary. So I mean, that’s part of the theoretical debate about how one apportions the total return that a director receives between that which he or she receives as shareholder and that which is received as a salaried employee.

Turning from the identification of the future annual maintainable profits, let’s look at the question of the identification of an appropriate multiplier to apply to those profits to determine a market value as a matter of pure mathematics.

The appropriate multiplier is one which is identified as the reciprocal of the yield that is reasonably required by the hypothetical purchaser. So, for example, if the hypothetical purchaser would expect a yield on his investment of, say, 25%, then the value of the company or business is likely to be four times its future maintainable profits.

In practice, in the context of unquoted companies and businesses, in identifying the appropriate multiplier to be applied reliance is often placed on information published by accountancy practices as to prices achieved on sales of comparable unquoted companies or businesses and even, sometimes, on comparable quoted sales of comparable quoted companies or businesses.

In appropriate cases, an allowance may have to be made for risk of contraction or for the potential for growth if it’s not already accommodated for within the identification of future annual maintainable profits. Having said that, I should say that, for my part, it’s not always clear to me why potential for growth or the risk of contraction should not already have been accounted for within the identification of the future annual maintainable profits unless, for example, that growth or contraction is anticipated as arising beyond the period over which those future and annual maintainable profits have been assessed. But if account has not been taken of potential for growth or the risk of contraction then that potential risk ought to be reflected in the multiplier itself. Roger, how do you go about assessing the multiple? This is probably the real focal point of your expertise, is it not?

Happily, it is. And as you say, a good starting point are the published indices. So BDO publishes the private company Price Index, the CPI, about which I tend to be a bit cautious because like most of these indices, you can’t drill down into it and get details. So it’s effectively based on an undisclosed number of undisclosed transactions. There’s also an index that that is published by the UK 200 group called the SME Valuation Index, which tends to focus on smaller companies. And that probably is quite useful in giving a yardstick across all sectors and it’s surprisingly narrow in its range. So with a 95% confidence level, typically each year the range of multiples is only between from top to bottom one  to one and a half. So it’s a fairly narrow range that businesses, small businesses tend to change hands. But ultimately, what the valuer has to do is look at the particular business, its strengths, its weaknesses, the opportunities and threats that face it. And that is a matter of professional judgement which informs the multiple. All these published indices have one thing in common which is that they are based on real life transactions. I was doing a case some months ago which went to trial and I was acting for the respondent in unfair prejudice proceedings and the expert acting for the claimant had done a huge amount of research on actual deals in the sector. It was a software as a service business where the sector was really quite vibrant and all the data suggested multiples of ten or more. I had suggested that I thought that a multiple significantly less than that was appropriate and it was put to me in cross-examination that was went against all the available evidence. But the reality was this business had made about £100,000 a year, year in, year out for the last ten years. And the point I put to the judge was nobody’s going to pay £1,000,000 for a business that generates a hundred grand a year, because once you take off some tax, you’re going to be waiting a long time to get your money back. The reality is that businesses like that tend not to be sold because they’re not particularly attractive and the owner would probably quite happily stay collecting 100 grand a year than have to try to sell a business for a relatively derisory sum because they wouldn’t get it. In fact the businesses that sell are the ones that are going places, that are going to grow, that have potential and reliance on published data is all very well but it has to be recognised that it’s a skewed population because you’re only looking at multiples of businesses that are sold. And there’s a large rump of businesses that never reached the market simply because they’re not very exciting, they’re not growing, and they don’t attract the higher level of multiples. So one has to treat the published data with the degree of caution.

Indeed, for the reasons that you mention, there will be a lack of comparative data for businesses of that sort in order to test the common sense result or the result that you achieve by the application of valuation theory against the measure of common sense as well. So it’s a vicious circle in that sense, I suspect.

Yes.

Roger. We’ve been talking now for 50 minutes. We’ve got to the point where I hoped we’d get in the first of these seminars. There are a couple of questions that have come in. One that’s come in on the chat from Allison Hawes is a question that actually we’re going to be considering in the next of these seminars. So I’m going to answer it quite briefly, I think. She asks, How will a direction in the articles to value shares at a fair value sit with the divorce court? Will they ignore it? It’s a very good question, Alison. As I say, I’m going to slightly sidestep it today because we will be examining that very issue next week. But in essence, the courts do tend to sidestep such valuation provisions within the terms of articles. The same goes for valuation provisions contained within the terms of a shareholders’ agreements. Unless those terms are intended to apply in the very circumstances that are contemplated by the agreement or agreement contained in the articles of association. So the Court doesn’t tend to feel bound by valuation provisions within articles or shareholders agreements unless the circumstances that pertain are the very circumstances anticipated by the shareholders’ agreement or the articles of association as those in which that method of determination of value is to take place. As I say, Alison, it’s a subject that we will come back to next week when we conclude these talks and so I apologise, at this stage, for being so short in my answer. Is there anything you wanted to add to that?

I would say certainly in divorce cases, I think articles have a significant bearing because the reality is that that if a party to a divorce is to sell his or her shares, they are likely either to be sold as part of a sale of the business, as a going concern, in which case no minority discount would apply or they’ll be sold pursuant to the articles. And it’s very difficult to see how they would be realised otherwise. So for the Court to assess the equitable value of those shares, it seems to me that if the articles, for example, say that on any transfer the shares shall be transferred at an agreed price, or and as it often says, if that can’t be agreed, an expert will be appointed to determine the value of those shares and to determine them without the application of a minority discount, then it’s very difficult to see in what circumstances a minority discount would ever apply because the sale will either be as part of the business sale as a whole or pursuant to the articles.

Similarly, if there are pre-emption rights in the articles, that can have an effect. If you take the example I gave earlier of the company with three shareholders, 49%, 49% and two%, there’s a huge difference between circumstances in which the two 49% shareholders bid against each other for the entirety of the 2% shareholding. Or, if there are pre-emption rights, all they can do is acquire one of the two shares and those sorts of considerations I think have a very significant commercial practical effect on the value of the shares. So I think the, the articles are a significant factor certainly in divorce cases.

Thank you, Roger. The other question that’s come in and it’s really one for you primarily, Roger, is whether there are circumstances in which the discounted cash flow method as opposed to the application of a multiple to future earnings, is considered a more accurate and appropriate approach to adopt in any particular circumstance? Do you feel that the application of a discounted cash flow method to valuation is to be preferred in any particular circumstances?

It should be preferred if the company is not in a steady state and if you’ve got reliable forecasts. Often people think that the discounted cash flow forecast is more objective because the calculation of the discount rate is typically set out in a complex mathematical formula which has the appearance of objectivity, which I’m sometimes rather dubious about, because some of the ingredients to that formula are just as subjective as those that inform the choice of a multiple.

And Roger, there’s one further question that’s come in on the Q&A function, and this is from Sarah Jackson, who says, how is evaluative mediation? Is this something that you think the courts or parties should push for? What’s your view about the merits of the courts encouraging evaluative mediation?

Well, you see, I’m a bit of a mediation purist, I have to confess. I think it’s quite difficult to make that transition from mediator to determiner. It can be done. I think there are better tricks or methods that can be used by mediators. If the parties know from the outset that the mediator is going to give an opinion, I think that can make it in some ways harder to be open and honest with the mediator, to test, to do the reality testing. That I think is a really important part of mediation. So I think blurring mediation with some sort of evaluation is quite difficult. Having said that, the in the divorce world, the financial dispute resolution hearing is effectively a non-binding evaluation process and that is hugely successful. So I think there is a role undoubtedly for a person other than somebody who’s going to be making a binding determination to give a professional evaluation as to the strengths and weaknesses of each party’s case. But whether that should be a mediator, I think is a more difficult issue, because I do worry that it undermines the neutrality of the mediator from the outset.

And Roger, my view is very much the same in the sense that my experience as a mediator is one that recognises that generally in the context of mediations of these sorts of disputes shareholder, partnership, agency, commercial agent/principal disputes, a mediation is conducted against the backdrop of some level of expert evidence or expert opinion as to valuation being available to the parties in any event at that stage. And so the mediator, standing back and maintaining a purely facilitative role as a classical mediator, wearing his classical mediator’s hat, it seems to me, is to achieve the best of both worlds. If he’s able to do that with a level of expert valuation opinion before him that he can turn the parties attention to and which they can chew over during the course of the mediation itself.

Roger, thank you very much indeed for today. I look forward to speaking with you again next Tuesday at 9:00.

Thank you, everybody, for joining us. I hope you found this instructive and we certainly look forward to you joining us again next week. Many thanks, indeed, and good bye from me.