When it comes to key issues in unfair prejudice petitions, there is little which is more important to petitioners and respondents alike than whether a buy out order is likely to be made by the court, and if so what price will be ordered to be paid for the shares. The issue of valuation, whether dealt with by agreement in accordance with the principles set out in O’Neill v Phillips or determined by the court lies at the heart of the process in almost all cases.
In this article, Hugh Jory KC and Matthew Bradley explore the art of share valuation and the different approaches that can be taken.
One of the wide powers of the court, once it is satisfied that unfair prejudice has been established, is that it may “provide for the purchase of the shares of any members of the company by other members or by the company itself and, in the case of a purchase by the company itself, the reduction of the company’s capital accordingly”. Since this remedy provides the only chance for many minority shareholders to realise the value of their capital and since it offers the continuing shareholder a clean break (albeit at a cost), it is the remedy most often ordered by the court and most frequently sought by the petitioner.
It is therefore of considerable importance to petitioners and respondents alike in unfair prejudice petitions to get a good grasp of the likely range of valuations of the minority shareholding in question. Only then can they consider on an informed basis whether or not the way forward is through the out-of-court procedure set out by Lord Hoffmann in O’Neill v Phillips  1 WLR 1092, or instead the pursuit of the petition to a valuation by the court.
In this article we:
- Consider briefly what “fair value” means in the context of a court valuation;
- Examine some of the differing valuation approaches which may be adopted by a court (noting here that often more than one approach is considered by way of a sense-check);
- Look a little more closely at the price/earnings multiple, an under-examined factor which is key to the most commonly adopted earnings-based valuation approach;
- Undertake a short study of a decision in a recent case where the earnings were too uncertain to apply a valuation based on a P/E multiple;
- Conclude by considering O’Neill v Phillips out of court offers.
The essence of the valuation by the court is to establish a value which is fair to the parties. That value may not be ‘market value’, a term which in any event sits uncomfortably in the context of private companies where no market exists for their shares. That reality was reflected in Eurofinance v Parkinson  BCC 551, in which Pumfrey J pointed out that the value of the shares should be on the basis that the sale was taking place between the actual participants (not a putative willing buyer and seller) “since the whole purpose of the valuation is to be fair between the parties”.
The fact that it is the other shareholder who is acquiring the shares can be a very relevant consideration affecting their value. A buyer may wish to see a lower valuation placed upon the seller’s shares because the buyer contends that he is key to the continuing success of the company, whereas the seller was not. However, the considerations can extend wider; in Re Edwardian Hotel Group  EWHC 1715 (Ch), Fancourt J referred to the concept of “marriage value” in uniting the shareholdings as something which the particular shareholders involved were likely to have in contemplation, in assessing what price would attach to the shares. This case is considered in more detail by Helen Evans and Anthony Jones in their article in this series titled “Creative remedies in unfair prejudice petitions”.
Typical approaches to valuation of shares
If the valuation issue comes to court for determination, then that process inevitably begins with an assessment of the value of the company with the assistance of expert accountants/share valuers. As Paul Mitchell QC and Nigel Burroughs explore in more detail in their article in this series titled “Expert evidence on share valuations: when to use hot tubbing in unfair prejudice petitions” there are different ways in which expert evidence can be given in court.
There are three main approaches that can be adopted to valuing businesses: assets, earnings and cashflow. Typically, the valuation is based on earnings, and the other bases if relevant in the particular circumstances of the case provide cross-checks against the earnings-based valuation.
Valuations other than on an earnings basis
Some companies are more appropriately valued by reference not to the profits they actually earn, but to the assets they own. Typically, they may be assets such as real estate or intellectual property, from which the business generates its earnings. The valuation of such companies will involve expert evidence from a valuer experienced in the relevant area of property.
Discounted cash flow basis
In some situations, company valuations can be achieved by discounting cashflows going forward. The gist of that approach is to value the company on the basis of the cash its business will generate rather than on the basis of the assets it uses to generate it. Alternatively, valuers may try to estimate a future maintainable dividend stream and discount that figure to arrive at a present value. That approach is unlikely to be apt in the context of private companies which are not accountable to institutional shareholders and where there is usually no history of paying a particular level of dividend.
The particular difficulties with applying a cashflow method to private companies are two-fold. First, the lack of accurate profit forecasts for the forthcoming 3 to 5 years often risks making the model too uncertain. Second is the problem of establishing an appropriate discount factor.
There are however situations in which those difficulties may be less pronounced, for example the hotel sector where sale prices can be established on the basis of discounted cashflows as well as land values, rather than earnings. The valuation in the claim for breach of contract in ESO Capital Luxembourg Holdings II v GAS Invest Management SA  EWHC 1351 was premised on such an approach.
There may be other situations where a judge has recourse to a discounted cashflow valulation because of the difficulties with other methods of valuation on the particular facts before the court. The court may well be supported for having done that in the event of an appeal. In Chilukuri v RP Explorer Master Fund  EWCA Civ 1307 Briggs LJ expressed the extent of the leeway afforded to a judge at first instance in this way:
“The valuation at a historic date of a miniorty shareholding in an overseas company, the principal asset of which is a bare majority stake in another overseas company which owns an unexploited mining concession in the DRC, is as obvious an example of a judicial task requiring an assessment and weighing the competing considerations as it is possible to imagine. I therefore approach this appeal with a ready disposition to respect the judge’s overall conclusion unless satisfied that it lies outside the bounds within which reasonable disagreement is possible”.
Of course, if the parties’ experts are agreed that a discounted cashflow basis is the appropriate one in the circumstances of a particular case then that will be a powerful influence on approach the court adopts. Blair J said of the claim and counterclaim ariding in the case of breach of warranty before him in The Hut Group Ltd v Nobahar-Cookson  EWHC 3842:
“This case is an example of two different methodologies within the same case. Both claim and counterclaim involved shares in private companies, but in the case of the claim, the shares comprised the whole issued capital, whereas in the case of the counterclaim, the shares comprised a minority interest. It was common ground at the end of the trial that whereas the quantum of the claim was to be calculated by reference to the effect of the adjustments on the company’s EBITDA, the quantum of the counterclaim was to be calculated by applying a discounted cash flow method.”
Such agreements aside, however, discounted cashflow valuations are unlikely to become a prominent valuation method in the context of unfair prejudice petitions at any time soon: the typical valuation method is likely to remain the earnings basis.
Valuation on an earnings basis
In simplistic terms, the earnings-based valuation usually involves a process along the following lines:
- Identifying cash which is surplus to the operational needs of the company and making allowance for those monies outside the earnings valuation process, on the hypothesis that on a putative sale the sellers would be expected to have withdrawn those monies by way of a dividend.
- Establishing maintainable earnings by making adjustments to stated profits, typically to directors’ emoluments to strip out ‘lifestyle’ and other costs which would not be expected to be faced by a purchaser.
- Making adjustments for any payments which were not within the ordinary business of the company (which may include those identified by the Petitioner as having been made wrongfully so as to adjust for the unfair prejudice), or for one off costs or payments which do not reflect the company’s usual business operation.
- Consideration of accounting policies and realities in relation to matters such as stock and depreciation, to test whether or not the reported figures distort the actual value that a purchaser would pay.
- Considering an appropriate way of averaging and weighting historic, current and predicted further profits on that basis to arrive at a figure for maintainable earnings.
- Considering how many times the maintainable earnings a willing buyer would pay for the shares in that business. Once applied to the maintainable earnings, this produces the price, hence the names for this figure – the Price Earnings Multiple or Price Earnings Ratio).
- Cross checking the price arrived at by this method by reference to the value of the company’s assets (eg. land) and adjusting for any additional value which is not reflected in the earnings-based valuation.
This sort of approach accords with the guidance set out by Nourse J, as long ago as In Re Bird Precision Bellows  Ch 419.
The P/E Multiple is a vital aspect of an earnings based valuation approach, but is one which receives relatively little attention in practitioners’ works.
Experts’ reports are little different. Expert valuation reports usually consider the adjustments to the maintainable earnings to establish the maintaniable earnings very fully, but frequently the issue of the appropriate multiple is addressed very shortly. However, the reality is that the usual “game-changer” in determining the value of the shares is the level of the multiple, rather than that of the earnings figure to which it is applied. Whilst the level of the multiple is a matter for expert evidence, in practice cogent evidence to support the chosen multiplier is often wanting.
What the multiple tells us
Why is it that one company in the stock market may trade on a multiple of say 30 x earnings (a P/E mutiple of 30) when another trades at 8 x earnings (a P/E multiple of 8)? At its simplest the multiple is telling the purchaser how many years at current profit levels it will take to generate the equivalent of his investment on a straight line basis. Straight line in this context means that its earnings remain at the same level as they were at the time of calculating the P/E multiple. So, if investors expect the profits to increase rapidly they may be prepared to pay a higher P/E multiple, not because they want to wait longer to be repaid their investment, but because they assume that there will be growth in profity that will realised their return in a shorter time. In broad terms, the greater the confidence in profit growth and the higher that growth is expected to be, the higher the P/E multiple that the investor would be prepared to pay. Other factors which may have an impact on the P/E multiple of a quoted company include matters such as dividend yield, as well as market behaviour such as following the herd and not wanting to be left behind, which by ignoring fundamentals of the stock sometimes lead to spectacular crashes.
Because of such factors, when considering what the appropriate multiple would be in the context of a private company, there is often little guidance to be drawn from larger listed companies dealing in similar business areas.
In Re Planet Organic Ltd , Jacob J, in the context of a company operating a single organic supermarket in London, referred to the PER as “the near undecidable problem”:
“[The expert] selected three companies out of the list, Budgen, Iceland and Somerfield on the basis that their shops were much smaller than those of Sainsbury and the like, and were food-only shops. The truth is however that these companies are nothing like Planet Organic, a little shop with a big name. These companies are what Mr Clemence described as ‘in a depressed state in a depressed sector’, On the other hand I do not think taking the average P/E ratio of quoted companies in the FT is any more helpful. None of the companies selected are like this company. They are metaphorically on a different planet. I cannot imagine any potential investor in Planet Organic considering his investment as in any shape the same sort of investment as in one of the quoted companies.”
There are indices which relate only to private companies such as the PCPI. Such indices were characterised by Jacob J as a “somewhat flimsy guide”, including as they do “good and bad companies”. He nonetheless determined the appropriate multiple to be a figure which was slightly more than the average in the PCPI, on the basis that he recognised that a buyer might pay more for a profit making shop with the potential to have its name expoited.
In Southern Counties Fresh Farm Foods Ltd  EWHC 3334 (Ch) Warren J contrasted the PCPI with the FTSE All Share Price Index, and notwithstanding the fact that the PCPI was not sector specific, said:
“I am persuaded that the PCPI provides a more reliable indicator, in spite of all the shortcomings identified by Mr Joffe (not all of which I have mentioned), than the FTSE All Share Price Index to the movement in private company shares. The market there is more stable than in the quoted share market; and the FTSE Index is not, as I see it, at all a reliable guide to the value of this specialist company…”
However, there can be situations where the particular business of the company may make reference to similar quoted companies a proper starting point for valuation; see for example the stockbroking company which the court was valuing in Blue Index Ltd  EWHC 2680.
Another source of relevant multiple can be founded on an expert’s ability to point to particular deals in the relevant sector.
The issue of the multiple is quintessentially a matter of expert evidence, which can vary significantly. What is important is how the expert justifies the multiple to be applied by way of objective analysis, given the lack of comparables. To that end it is always useful to bear in mind what the multiple is actually saying, in particular as regards growth prospects and to step back and consider whether it appears defensible in that respect.
Where maintainable earnings are too uncertain – a case study from a football club
In VB Football Assets v Blackpool Football Club (Properties) Ltd  EWHC 2676 (Ch) Marcus Smith J found that the 20% interest in Blackpool FC owned by the petitioner should be treated not as a 20% interest but as one equivalent to that of Segesta, another shareholder (holding 76.29% of the shares) with whom the judge held that there had been a gentleman’s agreement that they would exercise control. That equivalence he found to be represented by a 48.145% interest, namely half of the combined shareholdings of the petitioner and Segesta.
Notwithstanding the fact that the shares constituted a minority holding, the judge decided that a minority discount was not appropriate because of his finding that the petitioner had “had a legitimate expectation to be treated as a equal partner in the governance of Blackpool FC” which expectation the respondent had breached. He relied on what Jonathan Parker J said in Re Guidezone  2BCLC 321 to identify the situation as one of quasi-partnership namely “in the case of a quasi-partnership company, exclusion of the minority from participation in the management of the company contrary to the agreement or understanding on the basis of which the company was formed provides a clear example of conduct by the majority which equity regards as contrary to good faith.”
This case therefore followed the general rule that minority discounts will not apply in cases of quasi-partnership companies. The judge then took the conventional route to valuation, holding that “the starting point in assessing the buy out price is to approach matters as if the Oyston Side had behaved in a non-discriminatory way and to pay to VB Football Assets what the Oyston Side paid to itself [by way of disguised dividends].”
However, thereafter the process he adopted was tailored to the particular features of that football club:
“I consider the key to valuing VB Football Assets interest in Blackpool FC is to recognise that Mr Belokon did not put money into the club as an investment, but because he wanted to support the club. It seems to me that his aim of supporting the club having come to naught, he would be able to unwind the transaction and receive back what he paid. I therefore consider that Belokon should be repaid the money he paid to acquire his shareholding in Blackpool FC.”
That totalled £4.5m. He also made orders for payment of £26.77m, being the amount of the payments wrongfully made to the respondent by way of disguised dividends, making a total of £31.27m.
The judge went on to acknowledge that whilst his approach took full account of what VB Football Assets paid for its interest in Blackpool FC and ensured that it shared in Blackpool FC’s success in reaching the Premier League;
“I recognise that it gives no weight to the potential for Blackpool FC’s possible future success. That is deliberate. As I have described, the difficulty in valuation a club like Blackpool FC is that its future is inherently improbable. It might – as it has done – achieve great success and reach the Premier League again; or it might – as it also has – sink to League 2, or worse. It is impossible to say what will happen: for that reason, I have declined to make any prediction at all, and simply make provision for VB Football Assets to receive back what was paid – £4.5 million”.
This case illustrates how important it is to have some visibility with regard to future earnings when applying an earnings based valuation model, even if that visibility is less reliable than that which would be required to justify a discounted cashflow valuation.
Along with other sports-related cases, the Blackpool FC case is considered in more detail by Hugh Jory KC and Richard Liddell in their article in this series titled “Shareholder disputes in Sport”.
Out of court valuations – O’Neill v Phillips offers
In O’Neill v Phillips  1 WLR 1092 Lord Hoffmann set out guidance on the sort of offer that a respondent to a petition could make which, if the petitioner refused to accept, would enable him to apply to court to have the petition struck out. The gist of the reasoning was that the offer would provide the respondent with the relief which he could expect at trial if he won, and would avoid the costs and other consequences of prolonged proceedings. The essential characteristics of such an offer are:
- An offer to purchase the shares at fair value and ordinarily without a discount for it being a minority (i.e. at the equivalent proportion of the total value of company that the petitioner’s shareholding constitutes of the total shareholding in the company).
- If not agreed, the value is to be determined by a competent expert (acting as expert and not as an arbitrator, and not giving reasons for his valuation), whose identity the parties should attempt to agree, and in default should be nominated by the President of the Institute of Chartered Accountants. The costs of the expert should ordinarily be shared by the parties, but the expert should have the power to decide if they should be borne in some different way.
- Equality of arms – the parties should have the same right of access to information about the company which bears on the value of the shares and both should have the right to make submissions to the expert, though the form of those submissions, written or oral, should be left to the discretion of the expert.
- Costs – the mere fact that a petitioner has presented his petition should not mean that the respondent has to offer to pay costs. The respondent must be given a reasonable time once he is aware of the claim in unfair prejudice to make the offer.
The first point to note about the O’Neill v Phillips offer is that it was formulated in the context of a quasi-partnership case. In O’Neill v Phillips the House of Lords rejected the submission that there was any right to a no-fault divorce (i.e. it held that a minority shareholder had to establish unfair prejudice and not just some breakdown in relations before he could obtain an order for the purchase of his shares). In the circumstances where a company was a quasi-partnership (a concept explored in more detail by Tom Ogden and John Williams in their article in this series titled “Recent Developments in Quasi Partnerships”) Lord Hoffmann said “As I have said, the unfairness does not usually consist merely in the fact of the breakdown but in a failure to make a suitable offer, and the majority shareholder should usually have a reasonable time to make the offer before his conduct is treated as unfair…”.
The condition in the offer that the fair value of the shares is be determined on the basis that there is no discount for a minority holding follows from the fact that he was dealing with a quasi-partnership and even in those circumstances he said “This is not to say that there may not be cases in which it will be fair to take a discounted value. But such cases will be based upon special circumstances and it will seldom be possible for a court to say that an offer to buy on a discounted basis is plainly reasonable, so that the petition should be struck out.”
In the non-quasi partnership situation, where the parties are likely to argue about whether to apply a minority discount or not, there is a similar difficulty to that which Lord Hoffmann identified in the context of the ”special circumstances”cases, where a minority discount can be applied in a quasi partnership situation.
However, where it is likely that a minority discount should apply then it may still be appropriate for a respondent to make an offer along the same lines as the O’Neill v Phillips offer, though leaving the extent of the discount to the expert valuer. Whilst it will probably not justify strike-out of the petition if it is not accepted by the petitioner, such an offer can have an impact on costs and if the respondent wants a valuation date which is earlier than the finding of unfair prejudice, form the basis for that submission in due course, given that unfair prejudice petitions are as a general rule dealt with by way of split trial with issues of valuation being reserved to the second trial, see Re Tobian Properties Ltd  2 BCLC 567 at .
The reason why such an offer providing for a minority discount would probably not found a successful application to strike out the petition but could still amount to a fair and reasonable offer was explained in Potamianos v Prescott  EWHC 1924 (Ch), in which the deputy judge said: “Lord Hoffman said what he did in the context of discussing whether the respondent to a petition had made an offer which was so plainly reasonable that the respondent would be entitled to have the petition struck out…” and pointed out that “…that does not mean that any offer which does not comply with those requirements is necessarily unfair or unreasonable…”
Whilst there are many virtues in the process of agreeing remedies out of court, there are drawbacks too. Lord Hoffman himself pointed out that “the objective should be economy and expedition even if this carries the possibility of a rough edge for one side of the other (and both parties in this respect take the same risk) compared with a more elaborate procedure”. Accordingly, for example, the basis the expert chooses to adopt is entirely a matter for that expert as is the matter of what adjustments, if any, need to be made to a typical accountancy style valuation to make it a fair one as between the parties.
The O’Neill v Phillips offer is a substitute for the remedy that a successful petitioner could expect to receive where he is a quasi-partner against the fairly typical background circumstances of having been excluded from management without a fair offer for his shares. Once other elements are introduced, such as whether or not there have been breaches of fiduciary duties, and whether or not the company is a quasi-partnership, it fairly soon becomes less appropriate for the value to be determined by an expert rather than the court.
The question of valuation is one which parties are well advised to consider at an early stage. The petitioner is required under the standard directions given in unfair prejudice petitions to provide a non-binding valuation of its shares at the same time as presenting its petition, which is a useful reminder of the importance of the issue of valuation. Whilst this helps the court to consider proportionality in relation to costs, from the point of view of the parties, what value a court or a single expert would put on a minority shareholding remains at the forefront of the considerations they should be considering when deciding what strategy to adopt in relation to a petition.
We have given consideration to the impact of minority discounts and the recent cases in that area in a separate article in this series titled “Where does the law now stand on discounts for minority holdings in non-quasi-partnership companies?”. Where the minority interest is less than 50% then that issue, together with the issue of the appropriate price earnings multiple (which applies to valuations of all sizes of shareholdings) are in the vast majority of cases key factors in determining the value of the shareholding. Those issues are often the key determinants in the risks facing parties in notoriously expensive proceedings, and a keen assessment of them is usually the key to giving the best advice on how they should proceed, whether as petitioner or respondent.
Hugh Jory KC and Matthew Bradley
4 New Square
© Hugh Jory KC and Matthew Bradley. The authors assume no responsibility to any party in respect of this article. Specific legal advice tailored to specific problems should always be obtained.
About the Authors
Hugh Jory KC specialises in commercial and commercial chancery litigation and company and insolvency law. He is ranked in the legal directories as a leading silk and has acted in shareholder disputes for over 20 years. Prior to that he worked as an investment analyst with an investment bank in the City focussing on the valuation of shares. He has been involved in shareholder disputes ranging from companies which are listed to those which are private including those which are family run, and he has acted for and against shareholders ranging from private equity funds to private individuals.
Matthew Bradley specialises in commercial and commercial chancery litigation & arbitration. He is ranked by the legal directories as a leading junior in the fields of commercial disputes and company law and regularly acts and advises on unfair prejudice petitions and related company law matters.
 S.996(2)(e) Companies Act 2006
 For a recent case where the majority was ordered to sell to the minority see, Goodchild v Taylor  EWHC 2964 (Ch), Barling J.
 On the facts of the case, the Court of Appeal allowed the appeal on the basis that it could not imagine any reasonable purchaser paying anything for the shares and substituted nominal damages for the judge’s award of $5.6m.
 See for example Bennett v Bennett  WLUK 244
 Private Company Price Index
 Profinance v Gladstone  1 BCLC 141, 161b