Today's post is written by Andrew Strickland of Scrutton Bland, Chartered Accountants. Andrew holds the positions of Head of the BVIUK Board and Head Tutor for the BVIUK Credentialing Programme. Additionally, he serves as Chair of iiBV's Educational Committee. With a specialisation in corporate finance and business valuation, Andrew brings extensive expertise to his roles. He is a member of the Valuation Committee of the ICAEW and is recognised as a subject matter expert. Andrew has completed numerous business valuation assignments, particularly in shareholder disputes and divorce cases. He also conducts fiscal valuations for various tax purposes.
Introduction
Companies frequently issue shares of varying classes: there may be different economic rights such as preferential dividends or no dividends; there may be enhanced or reduced rights in a winding up or in the proceeds of sale. The varieties of share classes are endless.
Differential voting rights are relatively frequent in companies with various share classes. We therefore need to consider how these should be valued. In their most extreme form shares may have voting rights but no economic rights. Valuation challenges therefore abound.
The Irish Experience
The Irish tax authorities use an established precedent that voting rights comprise 15% of the whole. We can therefore consider the simplest situation to illustrate the principle:
Shareholder A has economic rights but no votes; and
Shareholder B has voting rights but no economic rights to dividends or proceeds of realisation.
Shareholder A receives no financial benefit over the longer term unless dividends are declared or approved. This is effectively in the gift of shareholder B.
Such a structure may be considered to be akin to a trust, but in a corporate form. It enables access to wealth to be controlled.
In the above circumstance, a value of say €10 million is allocated as to €1.5 million to the voting shares and €8.5 million to the economic shares.
The 15% is allocated pro rata to the voting shares: if one person has 51% of the voting shares, the value of that block of shares is not 15% of the whole but only 7.65%.
USA Paired Studies
Various academic studies have been undertaken in the USA into the market values of voting and non-voting shares of some public companies.
There has been a very wide divergence in findings. This reflects, in part, some of the studies not controlling for economic differences between classes. There is therefore a large amount of “noise” in the data.
As far as conclusions can be drawn, it seems that the differential is some 2%, with non-voting shares being discounted by this amount from shares which are identical save for having voting rights.
Why should miniscule holdings of shares in public companies carry a premium if they have votes? I assume that this relates to the prospect of slightly higher consideration in the event of a takeover or other exit.
These studies provide only modest assistance in the valuation of shares in private companies as voting control in private entities will often be highly concentrated.
The New Zealand Experience
The New Zealand divorce case of Holt v Holt related to the farming company, L J Holt Limited and the various benefits to be obtained from a 7,000 acre farming estate. This went as far as the Privy Council ((New Zealand) [1990] UKPC 34).
As this case was decided by the Privy Council, this is the most directly relevant for those of us in the UK.
There was one A share and 999 B shares. The A share, held by the husband, had 10,000 votes and each B share had one vote. The A share therefore held 90.9% of the voting rights. The economic rights were pari passu, with the A share entitled to 0.1% of distributions and realisations.
This is therefore very close to the example that I used to illustrate the procedure followed in Ireland – a near total separation of votes and economic rights.
The voting rights enabled the husband to occupy the farmhouse and to enjoy the various lifestyle benefits deriving from occupation of a large New Zealand farming estate.
The written decision explained that the farm could be run at a profit or loss depending on the amount which the husband chose to spend on upkeep and improvement. This power notwithstanding, it seems that there was little prospect of significant profits beyond reasonable remuneration for the husband.
The Privy Council provided details of three proposals that the A shareholder could put to the B shareholders:
• the A shareholder could purchase their shares for 50% of the net asset value;
• alternatively, the B shareholders could purchase the A share, again for consideration equal to 50% of the whole;
• the third alternative was for the farm to be sold, based on a prior agreement that the A shareholder was to receive 50% of the proceeds.
The Privy Council considered that any of these proposals would be potentially attractive to the B shareholders.
The New Zealand Court of Appeal had confirmed a value for the A share of 23% of the whole. The Privy Council had no desire to overturn this decision based, as it was, on a question of judgement and therefore for judicial discretion. It is however telling that the Privy Council included three scenarios in which the A share could be valued at 50% of the whole.
The Family Investment Company
Family investment companies commonly hold portfolios of listed investments. The parents hold the voting shares and therefore the powers of distribution. The economic shares are held by the ruly or unruly offspring.
The voting shares act as a tap and a sanction: dividends may or may not be declared, and the parents keep the firmest grip on their powers as headspring of the family wealth.
Can we compare and contrast a family investment company with the case of Holt v Holt? In that case the A share provided palpable benefits in respect of occupation of the farm and the trappings of a landed gentry lifestyle. It might be argued that the absence of such benefits for the older generation in the family company would reduce the benefits of voting control from 23% to some lesser percentage.
However a brave soul who pursues such an argument could be countered, if not stopped in his tracks, by a reference to the Privy Council’s view that the starting point between voting and economic rights in Holt v Holt was 50:50.
The hypotheticals deliberated by the Privy Council can also be applied to the family investment company. With no rights to determine distributions, and the prospect of potentially ultra long-term rollup of value within the investment company, how much of a discount would non-voting shareholders accept in order to realise the wealth locked within their shares? I can imagine that they would find a discount of 25% or more to be attractive in those circumstances. They are then replacing uncertainty with relative certainty.
Viewed from the perspective of those holding voting shares, they could acquire access to the economic rights. They would be aware of the power in their palms with their voting rights. They may similarly expect that power to be reflected in an appreciable discount of 25% or more to the value of the underlying assets. Alternatively, they could give up the powers of voting control but expect significant recompense for so doing.
Control and Non-Control in a Private Trading Company
Classic education in the mysteries of business valuation focussed on the two aspects of the discount for lack of control (“DLOC”) and the discount for lack of marketability (DLOM”).
The concept that the DLOC could be derived from an observable control premium in the public markets, whilst mathematically pleasing, has been under mounting pressure and is no longer considered best practice. The penalties arising from a lack of control are complex and multi-layered. They can scarce be determined by a single percentage deriving from takeover bids in the public markets.
The focus of a lack of control is now more appropriately considered by reference to two underlying sets of cash flows. These are the cash flows applicable only to control holdings, boosted by factors such as excess remuneration and other crafty benefits extracted by stealth or otherwise.
These can be contrasted with the non-control shareholders who have no means, outside expensive and uncertain litigation, of accessing cash flows beyond those left for them, either as dividends or in the increase in the capital value of the company.
Andrew Strickland