Share Sales and Valuations

Corporate/Commercial

Share Sales and Valuations

New Guidance and the potential end of "fair value" estimates - Richard Gray examines the key issues.

Share Sales and Valuations

The Articles of Association or Shareholders' Agreements of many private companies, particularly family owned companies, contain pre-emption provisions requiring a selling shareholder to offer his shares first to the existing shareholders at a price, reflecting the market or "fair" value, to be determined by the auditors.

Only after the shares have been offered to the existing shareholders at the price determined by the auditors can any shares not taken up be offered to outsiders. The purpose of this clause is obviously to give the shareholders an element of control over the membership of the company. The logic for having the auditors determine the price of the shares is that they are familiar with the financial position of the company and therefore can carry out a valuation relatively quickly and cheaply.

Unworkable

It will therefore come to a shock to many that recent changes in the professional rules governing accountants may make such share valuation provisions unworkable. New ethical standards for auditors introduced by the Auditing Practices Board with effect from 6th April, 2005 prohibit auditors from providing valuation services to audit clients where the valuation would involve a high degree of subjectivity, and would have a material effect on the financial statements.

As a result, auditors may be obliged to decline to provide valuations to audit
clients in many situations where the Articles or a Shareholders Agreement provide for them to do so.

Exemption

There is an exemption for small entities covering unlisted companies having two or more of the following criteria:

• not more than £5.6m turnover;


• not more than £2.8m balance sheet total; and
• not more than 50 employees.

If, in the light of the APB's new guidance, the auditors do decline to provide a valuation, unless the articles provide an alternative valuation mechanism, there may be no procedure for determining the price at which the selling shareholder's shares are to be offered.

The Courts

In these circumstances, a sensible approach would be for the parties to agree on a price, or on an alternative valuer, but if they are unwilling to do so, a selling shareholder may find himself prevented from offering his shares to outsiders. In such a situation a seller might be left with no prospect but to
apply to the court for assistance. Unfortunately the courts may not feel themselves able to intervene. The trend of judicial decisions suggests that a pre-emption clause, which provides for a valuation to be carried out by the auditors, may well be considered an essential and indispensable provision in the Articles, with the result that, if the auditors decline to act, the court may be unwilling to substitute its own alternative valuation machinery.

Options

There does not appear to be an actual authority on where this leaves the parties in such circumstances, but the possibilities would seem to be that, on the one hand the shares are regarded as untransferable unless a price can be agreed by the shareholders or, alternatively, the pre-emption provisions are void and the shareholder may ignore them and sell his shares to an outsider unwanted by the other shareholders.

This is unlikely to be commercially desirable for most shareholders in private companies. It is therefore suggested that companies which have valuation provisions such as those described above should amend them by providing for an alternative valuation mechanism, for example, for the price to be determined by an experienced valuer appointed by a third party, if the auditors decline to act. Unless they take steps to implement this type of change, companies that have valuation provisions such as those described above risk problems every time a shareholder wants to sell his shares.

Richard Gray is a Partner in the firm's Corporate Department. Richard can be contacted at richard.gray@lestrangeandbrett.com

Quote: ..... shareholder..... prevented from selling