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When drafting or interpreting legal documentation, such as company’s articles or shareholders’ agreements, care should be taken to distinguish between market value (also referred to as open or fair market value) and equitable value (previously known as fair value). For certain shareholdings, particularly minority shareholdings, the two definitions can give very different results.
The most common definition for valuing individual shareholdings is market value. The International Valuation Standards Council (“IVSC”) defines this as “the estimated amount for which an asset or liability should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion.”
In accounting standards such as FRS 102 or IFRS a very similar interpretation is applied when a company is required to fair value its shareholdings.
In any market valuation the valuer looks closely at the size of the shareholding being sold. For minority shareholdings the low level of entitlement to financial information and ability to influence board decisions has a significant impact on their market value. Minority shareholders looking to dispose of their shares in the open market will incur very large discounts with the unconnected buyer effectively taking a “punt” on the potential for a dividend or disposal of the entire share capital at some undefined point in the future.
In comparison the IVSC defines equitable value as “the estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties.” This definition reflects the desire to be fair to both parties in any valuation particular of a minority stake where the transaction is not in the open market but between parties already connected to the company or even the company itself. Therefore the valuer considers the value of the acquisition to the buyer in addition to the value of what is being disposed of by the seller.
This can often result in a significant reduction in any discount to reflect the lack of control and information rights of a minority shareholder.
As a result equitable value can be around 5x more than market value in certain circumstances. It is therefore very important to understand what the intention of the parties is when agreeing or interpreting exit mechanisms and ensure the drafting reflects those wishes.