The importance of considering company forecasts when valuing growth shares.
We consider below the importance of share valuation in general and provide an update on HMRC’s approach to valuing growth shares.
Why does sound share valuation matter to PE funds?
Broadly, share valuation matters to PE funds because it feeds into the UK tax treatment of share acquisitions and disposals by management in situations where the BVCA/HMRC memorandum on management interests in private equity backed companies does not apply. Employment tax charges may arise where shares are acquired or disposed of at what the law considers to be an undervalue. When a share valuation is challenged, it is a concern for management and PE investors. Liabilities can be large, and litigation lengthy, expensive and damaging to management incentives and focus. Whether management shares are growth shares, or shares issued under some other non-MOU compliant share plan, it is vital to get the valuation right.
Growth shares and relevance to PE funds
Growth shares accrue value after a certain threshold for equity proceeds is achieved. Growth shares are typically used as a management incentive where there is already significant value in the equity, for example where there is no leverage, leverage is limited, or shares are issued after value has increased. Ratchet shares are also a type of growth share, so the question of valuation is also relevant where they’re non-MOU compliant.
General share valuation principles
What is meant by ‘value’ is a legal as well as economic question, and will vary depending on the nature of the shares and the type of transaction (e.g. where shares have restrictions on dealing, those restrictions should be ignored when the shares are valued on acquisition). However, the starting point for most valuations of unlisted shares is the price which would be paid for the shares on the open market by a willing hypothetical buyer to a willing hypothetical seller.
For UK tax purposes, there are particular information standards that govern what information should – and should not – be taken into account when valuing shares. Not all commercially relevant information should necessarily be considered. In particular, it may not be appropriate to take forecasts into account when valuing uninfluential minority holdings (as it would be assumed that a hypothetical minority shareholder may not reasonably have access to internal forecasts). But can forecasts really be ignored in the case of growth shares? HMRC thinks not.
Valuation of growth shares: what is HMRC’s view?
HMRC is clear in its guidance that it considers forecasts to be relevant when valuing growth shares because ‘the growth prospects are intrinsic to the investment and no sale would proceed without access to additional information such as company forecasts’.
This was recently reiterated by HMRC, along with several other interesting comments on valuing growth shares:
Although the legal information standard hasn’t changed recently, what it is being applied to has. HMRC is seeking a way forward in these new areas such as growth shares.
A company’s historic forecasts may be relevant. Where they have been robust, and history shows they’ve been hit, it may be reasonable to place a greater weight on today’s forecasts.
Where growth shares are used to incentivise employees or management, it isn’t realistic to say they have no value – otherwise, there would be no incentive. Forecasts may provide a way forward.
Our view
HMRC’s view comes as no surprise to us. Growth shares are now a well-recognised concept in legal, tax and valuation circles. Their value is defined commercially in terms of meeting or exceeding defined targets or thresholds for profit or equity proceeds, and, therefore, by the prospects for growth. Is it realistic to say that a hypothetical purchaser would purchase such shares without understanding at least something about forecasts? Arguably not. This common sense view not only aligns with HMRC’s view, but was also recognised by a First-tier Tribunal judge in the 2017 case of Netley [2017] UKFTT 442 (although it was not relevant to his ultimate decision).
Whether considering past valuations of growth shares (in the context of an HMRC challenge, or diligence on an existing share scheme) or carrying out new valuations (from a compliance perspective with a view to minimising the risk of a future HMRC challenge), HMRC’s view is clearly a factor which needs to be considered. Happily, building in consideration of forecasts, and making adjustments for uncertainty, is something that valuers and economists are familiar with. However, it remains important to consider the legal framework on a case by case basis, as appropriate valuation methodology and information standards may vary.
The importance of considering company forecasts when valuing growth shares.
We consider below the importance of share valuation in general and provide an update on HMRC’s approach to valuing growth shares.
Why does sound share valuation matter to PE funds?
Broadly, share valuation matters to PE funds because it feeds into the UK tax treatment of share acquisitions and disposals by management in situations where the BVCA/HMRC memorandum on management interests in private equity backed companies does not apply. Employment tax charges may arise where shares are acquired or disposed of at what the law considers to be an undervalue. When a share valuation is challenged, it is a concern for management and PE investors. Liabilities can be large, and litigation lengthy, expensive and damaging to management incentives and focus. Whether management shares are growth shares, or shares issued under some other non-MOU compliant share plan, it is vital to get the valuation right.
Growth shares and relevance to PE funds
Growth shares accrue value after a certain threshold for equity proceeds is achieved. Growth shares are typically used as a management incentive where there is already significant value in the equity, for example where there is no leverage, leverage is limited, or shares are issued after value has increased. Ratchet shares are also a type of growth share, so the question of valuation is also relevant where they’re non-MOU compliant.
General share valuation principles
What is meant by ‘value’ is a legal as well as economic question, and will vary depending on the nature of the shares and the type of transaction (e.g. where shares have restrictions on dealing, those restrictions should be ignored when the shares are valued on acquisition). However, the starting point for most valuations of unlisted shares is the price which would be paid for the shares on the open market by a willing hypothetical buyer to a willing hypothetical seller.
For UK tax purposes, there are particular information standards that govern what information should – and should not – be taken into account when valuing shares. Not all commercially relevant information should necessarily be considered. In particular, it may not be appropriate to take forecasts into account when valuing uninfluential minority holdings (as it would be assumed that a hypothetical minority shareholder may not reasonably have access to internal forecasts). But can forecasts really be ignored in the case of growth shares? HMRC thinks not.
Valuation of growth shares: what is HMRC’s view?
HMRC is clear in its guidance that it considers forecasts to be relevant when valuing growth shares because ‘the growth prospects are intrinsic to the investment and no sale would proceed without access to additional information such as company forecasts’.
This was recently reiterated by HMRC, along with several other interesting comments on valuing growth shares:
Although the legal information standard hasn’t changed recently, what it is being applied to has. HMRC is seeking a way forward in these new areas such as growth shares.
A company’s historic forecasts may be relevant. Where they have been robust, and history shows they’ve been hit, it may be reasonable to place a greater weight on today’s forecasts.
Where growth shares are used to incentivise employees or management, it isn’t realistic to say they have no value – otherwise, there would be no incentive. Forecasts may provide a way forward.
Our view
HMRC’s view comes as no surprise to us. Growth shares are now a well-recognised concept in legal, tax and valuation circles. Their value is defined commercially in terms of meeting or exceeding defined targets or thresholds for profit or equity proceeds, and, therefore, by the prospects for growth. Is it realistic to say that a hypothetical purchaser would purchase such shares without understanding at least something about forecasts? Arguably not. This common sense view not only aligns with HMRC’s view, but was also recognised by a First-tier Tribunal judge in the 2017 case of Netley [2017] UKFTT 442 (although it was not relevant to his ultimate decision).
Whether considering past valuations of growth shares (in the context of an HMRC challenge, or diligence on an existing share scheme) or carrying out new valuations (from a compliance perspective with a view to minimising the risk of a future HMRC challenge), HMRC’s view is clearly a factor which needs to be considered. Happily, building in consideration of forecasts, and making adjustments for uncertainty, is something that valuers and economists are familiar with. However, it remains important to consider the legal framework on a case by case basis, as appropriate valuation methodology and information standards may vary.
