Business Valuation
vs
Share Valuation
In recent matters we have been involved in, the issue of business valuation versus share valuation has been a key issue. This is likely to be pertinent when seeking investment in a fledgling company at the early stage of trading or one in distress and contemplating restructuring or entering an insolvency process. It is also a relevant consideration for insolvency practitioners as they seek to realise the value of a company’s assets.
Distressed companies will usually have cash flow difficulties and / or may have liabilities that are more than assets even if its underlying trading business is profitable or has reasonable prospects of being so. The Enterprise Value of a trading business will usually be based on expectations of its future earnings.
The value of the shares (Equity Value) takes account of the net debt position of the company including its external debt, its working capital requirements versus is current position. Therefore, if a company has significant liabilities, including tax and bank or other finance obligations, the Equity Valuation of the Company may be £nil even if there is a maintainable trading profits and accordingly a potentially significant Enterprise Value.
Investment Challenges for Distressed Companies
A profitable company but with significant liabilities may not have access to further external debt in its current form. To secure its future, shareholders may consider a share sale, sale of the business and / or seek third-party investment in order to meet its liabilities and improve its trading performance so as to avoid entering an insolvency process.
Seeking a share sale is difficult where the equity value is likely to be assessed as £nil. This does not rule out strategic or special purchasers, but this is not easy to assess.
It may be possible to sell its trading business and associated assets and use the proceeds to meet its liabilities before dissolving the company (or seeking alternative trading options). In doing so, the shareholders are unlikely to realise value for their shares as the company retains its liabilities which will be paid from the process of any business sale – any surplus may be available as a dividend or for investment. This limits the possibility of a share sale.
Alternatively, the directors may seek investors willing to invest funds into a company in return for an equity stake (or a convertible instrument). Crucially, investment of that nature does not mean a third party is offering consideration to existing shareholders for shares, and it may be that investors seek to have rights attached to their equity (or instruments) investment such that it is realised first on sale/liquidation.
Equity Value Misconceptions and Shareholder Disputes
A common misconception and a source of disputes is that an investment in the company to meet existing finance costs and working capital requirements needed to trade profitably, automatically increases shareholder value. It does not necessarily, but it does, hopefully, secure the future of the company to continue to trade. If an investor offers £400k in return for issuance of shares for 40% of the company, this does not automatically mean that the existing shareholders (who now hold 60% rather than 100%) hold shares with a market value of £600k. The existing shareholders have diluted their shareholding in order for the company to have the funding that it needs.
The difference between Equity Value and Enterprise Value frequently features in shareholder disputes and disputes arising from insolvency. A low or no Equity Value does not rule out parties wishing to invest in the business in the form of debt or equity stake – there may be strategic reasons for doing so. Securing the necessary investment does not mean the existing shares immediately gain in value, even if the trading prospects are enhanced.
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