Share Valuation clauses in Shareholder Agreements
19 March 2021
The merits of well written Shareholder Agreements cannot be understated. One of the more important clauses you might expect to see in Shareholder Agreements relate to the transfer of shares from a shareholder. These could be to an existing shareholder or to a new shareholder altogether.
Shareholder Agreements are usually quite prescriptive with regards to the process of share transfers. Most Shareholder Agreements will include what is known as Pre-emptive Rights, which give existing Shareholders the right to acquire shares from other Shareholders, who may wish to sell their shares, before they are offered to a third party. Similarly, if a company issues new shares, these are first offered to existing shareholders.
Shareholder Agreements, by their nature, provide guidance to Shareholders for certain circumstances. But a question that is often raised by clients is how should the shares be valued?
On the face of it, hard coding a formula into the Shareholder Agreement so Shareholders know what the price is before they transact sounds practical, simple and avoids angst. However, there are also pitfalls with this approach.
Shareholder Agreements that hard-code equity value methodology within them run the risk that the answer is nonsense or obsolete. If that’s the case, it’s unlikely a transaction will conclude, so why have them in the first place?
The Capitalisation of Earnings methodology involves adopting a normalised future maintainable earnings figure and then applying a multiplier to it. The multiplier is linked to the underlying risk of the business including factors such as industry risk, key person risk, reliance on key customer risk and so on. As circumstances change, so does the risk profile of the business.
As an example, if 50% of total turnover is derived from one customer, this poses quite a threat to the profitability of the business should that customer take their business elsewhere or worse still, fail. If the business was able to diversify that risk away by bringing on more customers and reduce the exposure of that one large customer to 25%, this significantly changes the risk profile of the business. It is likely the business is worth more given the reduced risk. As a general rule, the higher the risk, the lower the multiplier and the lower the risk, the higher the multiple.
There are various business valuation methodologies and the correct one to use depends on the circumstances. Perhaps a better approach is to simply agree that someone independent will be appointed to value the shares and the parties can use that as a starting point.