Ideally, shareholders should first mutually agree on the value of each other’s equity interest in the company under various circumstances, then detail these decisions in the shareholder agreement for future reference. They should also be reviewed and revised with the annual business reports.
Unfortunately, reaching a mutual agreement amongst shareholders involves its complexities and challenges. A typical shareholder agreement would then state the methods for valuing a company’s equity interest under different circumstances.
The frequently used methods and the necessary considerations are listed below:
1. Using a valuation formula
Such a formula usually use an established multiple derived from the company’s past records of its revenue or the value of its assets. This may induce bias in the results as the multiple may not consider all the variables influencing a business valuation.
Examples of such cases are described below:
- A multiple based on the company’s overall revenue (i.e. net income, net cash flows, earnings before interest and tax) would be inaccurate when the company’s financial performance was excellent or poor in certain years.
- A multiple based on the average of earnings across a number of years would help curb the impact of annual fluctuations, but it would also ignore some of the relevant business trends and changes in a particular year.
- A multiple derived from book value may not consider the latest market value of the business assets and the goodwill of the business.
2. Engaging an independent expert
All the involved parties need to agree with the expert engaged and have confidence in this expert to conduct a comprehensive independent valuation. For this, the shareholder agreement would usually specify an expert or a list of viable candidates previously approved by all the shareholders. These candidates would not be related in any way to the company or any of the shareholders hence they should not include the company’s auditors.
When even the experts are unable to help reach an agreeable conclusion, the shareholders would proceed with method (4).
3. Obtaining a consensus amongst the shareholders
4. Taking arbitration or accepting mediation
This may incur a high cost due to the appeal process and procedures, which involves selecting and engaging suitable arbitrators or mediators. So the shareholder agreement would also state the list of viable candidates previously approved by all the shareholders.
Now, how do we determine and decide on the type of value for valuation purposes? Lets look at this next article.