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Share Valuation
A Little Certainty
MICK RUSE suggests some share valuation adjustments that might reflect the restrictions imposed on unquoted restricted securities.
Share Valuation
A Little Certainty
MICK RUSE suggests some share valuation adjustments that might reflect the restrictions imposed on unquoted restricted securities.
MUCH HAS BEEN written concerning ITEPA 2003 and its concept of employment-related securities which are also restricted securities. The reach of the legislation, its income tax and NIC consequences, together with the electing and reporting procedures involved, have all received comprehensive attention. Even so, three fundamental questions are still being asked by companies and their advisers.
* What are restricted securities?
* What is meant by initial unrestricted market value (IUMV)?
* By what percentage adjustment might a particular restriction reduce IUMV?
The answers to these questions should not be beyond a competent tax practitioner with reasonable experience of fiscal share valuation. Alas, the conjunction of woolly wording within ITEPA 2003, early misconception on the part of Shares Valuation and weak representations from accountancy firms has created a bit of a muddle.
With the proviso that there cannot be precise rules to rely on, the aim of this article is to conclude brief guidelines on the general principles involved as regards unquoted shares, which hopefully will help to demystify the topic.
Restricted securities
Shares Valuation now accepts that shares in companies which through their articles of association impose identical restrictions on all their shares and on which no additional restrictions have been imposed, are not restricted securities. It had been suggested previously that the existence of any restriction (for example, an essential restriction on the right to transfer shares as required by the Companies Act 1948 to qualify for private company status) would render shares to be treated as restricted securities.
So with this clarification, and seen in the light of the overall intention of ITEPA 2003, Part 7 Chapter 2, one can start to make sense of the definition of restricted securities in ITEPA 2003, s 423.
Initial unrestricted market value
IUMV is the market value of shares when acquired as would be computed using normal capital gains tax criteria in accordance with TCGA 1992, s 272 and, in connection with unquoted shares, TCGA 1992, s 273. Any personal or employee specific restrictions are ignored, with only those restrictions as are imposed on all members, as such, by the articles of association being taken into account.
Personal or employee specific restrictions do fall to be considered in the context of the 'market value' of shares when acquired and when viewed as restricted securities.
Inverted commas are used in the paragraph above because it seems to me that the same share on the same day cannot have two market values; a greater value which ignores any personal or employee specific restrictions and a lesser value purporting to have regard to such restrictions which, to comply with the capital gains tax definition of market value, cannot be viewed as transferable to a purchaser. This is self-contradictory. We know what the draftsman is driving at, but surely in s 423(1)(b) an expression such as 'restricted value' would be preferable and would avoid any possibility of the subsection proving to be technically defective.
Price
Price is different from value, but nevertheless if for commercial reasons the price which is paid for restricted securities is equal to or exceeds their IUMV, no adjustments need to be made.
Appropriate adjustments to IUMV
The two most common restrictions when dealing with appropriate percentage share valuation adjustments to IUMV are:
* transfer restrictions; and
* forfeiture restrictions.
Less commonly met are:
* voting restrictions; and
* dividend restrictions.
Other restrictions are rare, so I comment only on the four categories shown above.
Transfer restrictions
Following the Companies Act 1980, both public and private companies can choose not to impose transfer restrictions on shares. The reality, though, is that the vast majority of unquoted companies do impose transfer restrictions, ranging from a simple directorial discretion not to register a transfer, through to complex pre-emption provisions.
Further, and irrespective of their transfer restrictions, few unquoted companies offer much opportunity to sell shares. Many unquoted company shares are to all intents completely unmarketable with members having to accept they are locked in.
The courts have on many occasions considered the effect of typical unquoted company restrictions on market value; e.g. Attorney-General v Jameson [1905] 2 I.R. 218 C.A.,
CIR v Crossman [1936] 1 All ER 762 and In re Holt [1953] 1 WLR 1488. In these cases, the measure of adjustment was by way of addition to a comparable quoted yield and that addition averaged about 25% to 30%. These elderly precedents are carried into modern share valuation practice (where the emphasis has moved from yield to earnings) through adopting a price/earnings ratio which is at least 25% lower than would otherwise be in point.
Full undiluted transfer restrictions — see paragraph below — can be seen to attach to quoted shares. Prior to ITEPA 2003, and using market evidence gleaned from US letter stocks and the like, I have advised income tax valuations reflecting discounts of up to 30%, and sometimes more, from quoted share prices where there were sales prohibitions of up to two years.
Putting an additional transfer restriction on unquoted shares which already have little or no foreseeable prospect of saleability is, to my mind, a little like placing one security box inside another. At most these are partial or diluted restrictions which can readily be distinguished from transfer restrictions attaching to quoted shares.
Some companies operate a limited internal market for their shares, but often only employees can take advantage of these facilities. If persons in the open market are unable to use them then they give no enhancement to an estimate of fiscal market value.
Dependent upon the degree of inherent marketability and demand, if any, for the shares in question I suggest a transfer restriction should carry a discount of 2% to 4% per annum up to an aggregate maximum of about 20% of IUMV. Adjustments above 15% should be relatively uncommon.
There is a slight paradox in that transfer restrictions imposed on shares in fast expanding companies seeking a sale or flotation may not have such a substantial effect on IUMV as they might where shares in less interesting companies are involved. After all, who would want to sell the former shares before a sale or flotation is achieved?
Forfeiture restrictions
So far as I am aware, there is no empirical method by which to allow for forfeiture restrictions. These are some of my thoughts.
* In an unsuccessful company, a short term restriction of one to three years operating on repayment of cost would not have a substantial effect. If the company's performance does not pick up, a restriction of this nature might even start to look like a modest advantage to an employee who later thinks of leaving.
* The longer the term and the more successful the company, the more significant the restriction becomes.
* Restrictions operating on repayment at less than cost would have a substantial effect, but the shares would probably not be taken up in the first place.
* Necessarily, the more IUMV exceeds cost, the greater will be the percentage adjustment to IUMV.
In the absence of setting out and working through a number of examples using differing assumptions, intuition tells me that adjustments of 10% to 20% to IUMV are probably of the right order in all but very unusual circumstances.
Voting restrictions
Based on historical analysis of the prices of non-voting quoted shares, a discount of up to about 10% from the value of an equivalent voting interest may be made when valuing insignificant holdings of permanently non-voting unquoted shares. I suggest a temporary restriction should carry a discount of 1% to 2% per annum up to an aggregate maximum of certainly not more than 10% of IUMV.
Dividend restrictions
Dividend restrictions are relatively straightforward.
Where there is no dividend paying record and no immediate prospect or hope of a dividend, the adjustment is negligible.
Where there are prospective dividends, their total should be estimated over the term of the restriction, discounted to net present value and then a deduction for risk applied (albeit dividends could increase, the open market is, in the main, risk averse).
The deduction for risk should reflect the security afforded by the company to the investor as well as the term of the restriction. This is judgmental.
This net value may then be expressed as a percentage of IUMV as shown in the Illustration below.
Illustration
Assume an IUMV of £10 per share, a current prospective dividend of 50p per share and a three-year restriction.
Prospective total dividends over the term = £1.50 or, say, £1.20 discounted to net present value.
Risk, say, 25% reduces £1.20 to 90p.
90p as a percentage of an IUMV of £10 is 9%.
Finally
Given that underlying the restricted securities régime there are no new share valuation issues lurking, I believe that in twelve or eighteen months we might be asking what all the initial fuss was about. In the meantime this article — albeit no substitute for a proper and full discourse — might dispel some uncertainties.
On the other hand you could try to make all your clients enter into only approved share schemes!
Mick Ruse is in practice at 140 Tabernacle Street, London EC2A 4SD and can be contacted by e-mail at mhruse@aol.com or by telephone: 020 7300 7345.
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