1. Overview

Most companies create economic value for their stakeholders by investing their capital efficiently in a manner that generates return in excess of the cost of capital deployed. For companies to generate high ROCE and maintain consistent growth, there must be certain inherent competitive advantages which in turn depends upon industry structure and market trends. However, the competitive advantages of today may not remain unique for a selected group of companies or industries for a very long period with a continuously evolving regulatory, technological and demographic environment. Beyond a point to remain competitive, companies need to look at inorganic growth that can take them to the next level. M&A is an important tool in this respect.

Valuation of a business, asset or liability is critical for strategic Corporate Transactions including M&A, Restructuring, Fund Raising, internal management decisions and for applicable Regulatory, Tax or Financial reporting requirements.

While certain markets provide a price for shares of companies or their assets at which buy and sale transactions can take place, the Intrinsic (Fair) value of shares of these companies or their assets can be materially different. Business valuation is thus undertaken to ascertain the Fair Value and Market value to understand and then attempt at reducing the gap between intrinsic and market value for value creation of companies before taking appropriate corporate actions.

2. Special Scenario Valuations

a) Valuation of Start-Up Companies

Valuation of start-up companies is challenging as they have no past history, negligible revenues with high operational losses, negative cash flows, limited promoter’s capital and high dependence on external sources of funds often leading to speculative/aggressive financial projections for early-stage start-ups. Start-up valuation is more about understanding promoters and management background, experience and vision, future potential of the business, people, technology, competitive landscape, traction and the probability of success and failure attached. It can be said that while valuating a start-up, the experience of a valuer plays a major role in value conclusion.

The Valuation of Investor funded start-ups requires experience in the valuation of complex securities as they have series of capital with different levels of preferred rights in the distribution of the company’s value over other investors in the event of a sale or liquidation of the company besides participation in profits of the company. Such rights include liquidation preferences, tag along, drag along rights and other terms which have an impact on the Valuation for common shareholders of Companies.

The stronger the preferences assigned to investors, the lower would be the value of the equity shareholders. Option pricing (Back Solve) model is applied in practice to derive the value of common stock based on the Price of Recent Investment of Preferred Stock.

Valuation Methodology for Early Stage start-ups

• Venture Capitalist/Exit Multiple Method

-Venture capitalist method is majorly used by VC Investors looking for making investments in start-up companies.

-As start-ups are high-risk companies, investors expect higher returns.

-The exit method takes into account the current investment, the expected return, and the valuation at the time of exit to determine the current value of the company.

• First Chicago Method

-The First Chicago method entails projections under three different scenario – success, failure and survival cases – and profitability estimates are assigned to each.

-This method results in a separate valuation and pricing for each outcome.

-These are then averaged and the weighted average valuation is determined (weights being the profitability assigned to each case).

• Scorecard Method

-The scorecard valuation method is a more elaborate approach to the subject company valuation. It starts the same way as the First Chicago Method, i.e. by determination of a base valuation for the subject company and then adjusting the same value for the qualitative scores of management, traction, competitors, etc. The weighted average value is recommended as the value through scorecard methodology.

b) Valuation of Distress Companies

Distressed businesses often face Operational issues (Production issues, Supply chain mismanagement, Working capital blockage, Loss of key customers etc.), Financial constraints (High debt, Limited sources of funds, Overdue liabilities etc.), Loss of key people etc.

IBBI Regulations require Fair Value and Liquidation Value of the Assets of the Corporate Debtor. The stakeholders may unjustly liquidate a company if they use an inflated reference value for comparison with the value offered under resolution plans. Such decisions arising from use of inappropriate values, in addition to causing unfair gain or loss to parties, has the potential to distort market and misallocate resources which may impinge upon economic growth in a market economy.

Valuation Challenges

• High level of uncertainty (Risk) in sustaining business operations
• Non-availability of reliable data
• Requires greater due diligence of available data and underlying assumptions
• Quantification of Contingent Liabilities
• Premise of Valuation – Going Concern / Liquidation

Choice of Valuation Methodologies

• Distressed companies typically earn less than their cost of capital; thus, sale of their assets might earn more than the value of business.
• Cost of capital increases for distressed companies as the companies are seldom able to take tax benefits due to accumulated and recurring losses.
• The applicability of terminal value in a distress scenario is a question in itself as with negligible growth rate and high cost of capital, the terminal value comes insignificant.
• Non-availability of comparable companies.
• Enterprise Value is determined for distressed Companies rather than Equity Value as Value of Debt could be at significant discount to its book value.

The above factors lead to the asset approach being the preferred choice for the valuation of distressed companies. The value of inventory, debtors and unbilled revenue needs detailed verification as there are high chances of obsolete inventory and bad debts which can reduce the value significantly.

c) Valuations for Private Equity

Valuation for private equity purposes has inherent control characteristics as investors enter into private agreements with the companies and get special information and rights including liquidation rights, Board seats, Veto powers etc.

Private equity Investors are required to carry out periodic valuations of their portfolio Investments as part of their reporting process. International Private Equity and Venture Capital (IPEV) Valuation guidelines represent current best practice, on the valuation of private equity Investments in Debt and Equity instruments and their reporting at ‘Fair Value’ assisting the Investors to make better informed decisions.

IPEV Valuation Guidelines are applicable to Alternative Investment Funds (seed and start-up venture capital, buyouts, growth/development capital, credit etc.; hereafter collectively referred to as Private Capital Funds) and financial instruments commonly held by such Funds. They also provide a basis for valuing Investments by other entities, including Fund-of-Funds, in such Private Equity Funds.

These valuation guidelines are in sync with the Fair Value principles in IFRS and US GAAP as followed in financial reporting. It is further clarified that other jurisdictions that use a similar definition of Fair Value, such as “willing buyer and willing seller” may also find these Valuation Guidelines applicable.

d) Merger Valuations

In case of valuation for merger or amalgamation, the emphasis is on arriving at the “relative” values of the shares of the transferor and transferee companies to facilitate determination of the “Equity Share Swap ratio”. Hence, the purpose is not to arrive at absolute values of the shares of the companies. Real challenge in merger valuation is to have fairness to all shareholders, particularly where the shareholding pattern and shareholders vary between the transferor and transferee companies.

Capital Market Regulator SEBI through NSE and BSE has mandated that the valuation reports of Scheme of Arrangement shall display the workings, relative fair value per share and fair exchange ratio in the following format:

Note: Where any valuation approach has not been considered or applied by valuer, its reasons for not adopting a particular approach also need be provided for in the valuation report.

Swap Ratio:

x (xxx) equity share of XYZ Ltd of Rs 10 each fully paid up for every y (yyy) equity shares of PQR Ltd of Rs 10 each fully paid up.

Fairness Opinion on Merger or Amalgamation Valuations

In accordance with applicable SEBI Circulars and SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, the listed as well as the unlisted company getting merged shall each be required to obtain a ‘fairness opinion’ on the valuation of assets/equity shares done by the valuers from an independent merchant banker.

e) Acquisitions Valuations

The acquisition of shares of a listed company requires compliance with the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 and that of unlisted company with Income Tax Law and RBI Regulations.

SEBI Regulations on Acquisition of Shares

Under the SEBI Takeover Code, the shares are segregated based on their Trading volume into Frequently and Infrequently Traded shares.

Valuation of Frequently Traded Shares is done based on the volume-weighted average market price of such shares for a period of 60 trading days immediately preceding the date of the public announcement as traded on the stock exchange where the maximum volume of trading in the shares of the target company are recorded during such period.

Valuation for Infrequently Traded Shares is determined by the acquirer and the manager to the open offer taking into account valuation parameters including, book value, comparable trading multiples, and such other parameters as are customary for valuation of shares of such companies

Income Tax Law on Acquisition of Shares

Valuation Methodologies prescribed-

Quoted Shares: Market price on recognised stock exchange on the valuation date or on a date immediately preceding the valuation date where on the valuation date there is no trading in such shares and securities on any recognised stock exchange.

Unquoted Equity Shares:

For Transfer of Shares of a closely held company, the rules have prescribed Adjusted Book Value method. The fair value of Land & Building, Jewellery, Shares & Securities and Artistic property needs to be undertaken for this purpose. In this methodology, the value of investments in shares is to be undertaken based on Net Assets Value in all underlying companies, down the line which makes it a detailed process, specifically for Investment/Finance companies.

For Issue of Shares of a closely held company, the valuation of business is to be done as per Discounted Free Cash Flow (DCF) or Net Asset Value (NAV) method or value as may be substantiated by the company to the satisfaction of the AO based on the value of its assets including intangible assets. The valuation is to be done exclusively by SEBI-registered category I merchant banker in case of application of DCF method.

Unquoted Shares (other than equity shares): Price it would fetch if sold in the open market as per any valuation methodology can be applied which can be substantiated.

Company Law on Acquisition of Shares

In case of Fresh Issue of Shares, Valuation shall be done by an IBBI Registered Valuer in accordance with the Companies (Registered Valuers and Valuation) Rules, 2017.

However, for preferential allotment of shares of listed companies, Preferential issue guidelines of SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 need to be followed.

f) Purchase Price Allocation Accounting for Financial Reporting

In Purchase price allocation (“PPA”) exercise, the acquirer allocates the consideration paid to the acquired assets and liabilities of the target company. PPA is thus carried out for accounting and financial reporting under Ind AS 103 which requires all business combinations (except group consolidation) to report the Fair Value of assets (tangible and intangible assets) and liabilities acquired in their financial statements. PPA is a complex process and involve identification, measurement and valuation of intangible assets requiring an in-depth knowledge of the acquired business and its key value drives as well as knowledge and experience in the application of various valuation approach and methodologies.

There are five major types of intangible assets and valuation methodologies vary for each of these methods. The remaining amount which cannot be apportioned to the respective Tangible and Intangible Assets forms part of Goodwill.

The most commonly applied valuation methods for Intangibles are Royalty Relief method (for Brands and Trademarks), Multi-period excess earning method (for Customer relationships), Assembled Workforce (Cost method) and With or Without DCF methods for Intangibles in general.

Conclusion:

Even though it is accepted that divergent views are possible in the field of valuation, the purpose is defeated if the value is not authentic and genuine. Decisions arising from the use of inappropriate values, in addition to causing unfair gain or loss to the parties, has the potential to distort the market and misallocate National resources which may affect the economic growth of a country as well. The seriousness of the Valuation profession in India at this point of time can well be understood as the government is in the process of bringing in a new law to set up a National Institute of valuers (NIV) to regulate and develop a special cadre of valuers and an institutional framework for them. The central government is also working on the preparation of Indian valuation standards while will lead to the standardisation of Valuation practices in India. The Draft Valuers Bill, 2020 is already in the public domain.

Valuation is thus an integral part of any transaction. The depth of analysis is most important in any Valuation engagement and the ability of the Valuer to follow the complete valuation process right from understanding the purpose of valuation, seeking relevant information requisition (and follow on questions) from the company, performing financial analysis and normalization adjustments, understanding industry characteristics and trends, forecasting and reviewing company performance, considering and applying appropriate valuation methodologies to performing scenario analysis, value adjustments, documentation and reporting. Needless to say that the experience of the valuer plays a crucial role in reviewing the company’s financial model, selection and application of appropriate valuation methodologies and value conclusion after suitable discounts and premiums. Independent valuations are thus essential for the efficient working of the markets, businesses, government and all its stakeholders.