Business Valuations: How the sum of the parts can be less than the whole

Working out what a business is worth is one thing – but understanding what your share of it is actually worth can be a very different question, as Mark Smith, Corporate Finance Director explains.

Valuing ‘the whole’ business

As a Corporate Finance Director, the two most common questions I’m asked are:

• How much is my business worth?
• How much are my shares in the business worth?

The valuation of a business should never just be profits, or the number on the bottom of the balance sheet.

Of course, it’s more complicated than that.

Some will say ‘it’s an art not a science’. And in my opinion, if it’s done properly a valuation will have elements of both mixed in.

Every valuation for every business will be different. It’s dependent on so many things, such as stability of earnings, business sector, strength of the management team, dividend flows etc etc.

In the majority of cases a desk top valuation will give you a good indication of the value of the business.

However, the true test of a valuation is when the business goes to market for sale – and that will tell you the value, whether you like it or not.

Valuing ‘the parts’ of a business

Now this is where it gets interesting and more technical.

If I own 100% of Z Cars Limited – I have complete control. As long as I comply with the relevant legislation, including tax legislation, I can do as a wish – run the company entirely as I wish.

If I own 20% of Z Cars Limited I will have influence but certainly not significant influence. If all other shareholders own 5% then I will have the most influence of all the shareholders – or so you would think.

But if all the other shareholders are from the Jones family and I am the only shareholder from the Smith family then it may be that I have very little influence over the running of the company.

Because of the level of influence, which ordinarily diminishes at a greater rate than the percentage fall in shareholding, a discount factor is applied to the valuation of minority shareholdings – to take account of the diminishing level of influence.

So, let’s look at what this means in practical terms.

We’ll assume that Z Cars Limited has been valued at £5m and has 100 ordinary shares in issue.

Ordinarily – and this is precisely what I would have thought before I ever picked up a study manual – a 20% shareholding might be considered to have a value of £1m – because that’s the calculation of 20% of the £5m.

However, because this is a 20% shareholding a minority discount will be applied. There is no rule book or table as to what the appropriate discount rate would be, but for a minority holding of 20% I have seen discounts of 50% being applied, so in this instance a 20% holding in a company with a value of £5m, might be valued at £500,000.

You will see now how the sum of the parts can be less than the whole.

Taking the above example, there could be 5 unrelated shareholders each owning 20% of  Z Cars Limited – with the sum of the individual parts equating to £2.5m.

I appreciate that on the face of it this makes little sense – I’ve just said that Z Cars Limited is worth £5m – but then the 5 shareholding pots are only worth £500,000 each.

But…think it through

This is because a 20% holding only gives you some influence but not significant influence.

You cannot dictate dividend flow, whether the company should be sold, or whether to appoint new directors  – all things you can do with a 100% shareholding.

It’s also worth noting that the minority discount reflects the fact that a minority shareholding is less marketable – because not all shareholders will be aligned on matters such as a company sale.

And finally…

The Company’s Articles or a Shareholders Agreement might stipulate how minority shareholdings should be valued, though different ‘rules’ might apply depending on the reason for the valuation.

These legal documents can be complex – certainly internally we will always get a second opinion on any provisions set out in either.

So the advice as always with these things is to come in and see us.

Google the answer if you so wish – but you’ll not get the answer to your precise circumstances, relying only on Google won’t give you certainty (we all want to be able to sleep at night). But importantly of course, Google doesn’t make you a coffee.

To discuss your business valuation with Mark or one of the team, call us on 0330 058 6559 or email hello@scruttonbland.co.uk