Growth Shares and Management Incentives - Getting the valuation right

Issues with the Current Value Model 

The above approach – which in simple terms looks at the current valuation of a business and apportions that value across the share classes in issue in line with what they would receive on an imminent sale of the business – is often referred to as a Current Value Model (CVM).

Inherently, this approach is not forward-looking, and so is considered limited owing to its inability to capture potential future outcomes, in particular business growth expectations ahead of  a targeted exit. Going back to the example above, under a CVM you would assess the growth shares to be basically worthless as at the date they were issued, with the equity in the business currently valued at £40m and the hurdle threshold at £50m. However, getting from £40m to £65m cited in my example over a period of, say, four years would require annual growth of c.13% - which is clearly not a wildly unfeasible outcome – returning the growth shares (as a class) the £1.5m. If I was personally awarded those growth shares, I wouldn’t say that I would be happy to let them go at the date of their issue for next to nothing given this potential upside!

It is for this reason that the CVM should only be used in certain situations. The International Valuation Standards (IVS, as published by the International Valuation Standards Council) states that the CVM should only be used in very limited circumstances, such as when a “liquidity event” is imminent or there is no reasonable basis for estimating the amount and timing of any future benefit (more on this below).

This view is almost certainly one that would be shared by HMRC when it comes to the assessment of tax liabilities around growth shares and any other management incentive schemes. The Share Valuation Worked Examples Group (which is a committee of share valuation specialists that has been pulled together to collaborate with HMRC on specific employee share scheme valuation issues, and which also comprises senior representation from HMRC) has issued an Exposure Draft document that reiterates the wording contained in the IVS. Anecdotally, I have also heard HMRC challenging nil or nominal valuations by questioning why the shares are being issued at all (and all the associated costs being incurred in drafting the documents) if they are genuinely considered to be worthless? Which is a pretty good point, to be fair.

Risks of flawed approaches

Unlike awards being made under the Enterprise Management Incentive Scheme (EMI), or one or two other approved schemes, it is not possible to approach HMRC to ask for prior approval for growth share or sweet equity schemes. The obvious risk therefore is that HMRC issue a retrospective challenge against the values that have been determined at the date of issue, with the possibility not only of the company incurring additional liability (along with the potential for fines) but also the potential additional cost of fighting the challenge. 

An additional risk however – with a greater likelihood – arises on the exit event that is generally envisaged in such scenarios: an acquirer would most likely, through their due diligence processes, uncover the potential for such a challenge, and seek to cover themselves during negotiations either through indemnities or chipping at the provisionally agreed deal value.

What approaches are applicable?

Economically speaking, growth shares often act in very much the same way as share options in terms of how their payoffs are structured – albeit in a slightly more passive way, as there is no need for the holders of growth shares to actively exercise their holding. As such, option pricing models (OPM, such as the Black-Scholes approach or Monte-Carlo simulation) are commonly used. An obvious advantage of OPM is that such approaches are inherently forward-looking, unlike the CVM.

Another frequently adopted  approach is the probability-weighted expected return method (PWERM). This is a more manual approach, which in short entails a number of future outcome scenarios being estimated (with the associated payoffs, and appropriately adjusted for timing), and then a probability being assigned to each: the sum of the time-adjusted, probability-weighted outcomes forming the assessed valuation.

Each approach outlined above does come with a degree of complexity and subjectivity – such as how to make an assessment of ‘price volatility’ under an OPM, how to determine probabilities to drive the PWERM, or reflecting the impact of the timing of assumed exits under either approach. But, in the absence of perfect 100% foresight or a very powerful crystal ball, a number of assumptions as to future outcomes and the associated risks will always need to be made by the valuer. 

The key to valuing growth shares, however, is to ensure that such assumptions are reasonable and supportable, and crucially, that the methodology the valuer adopts captures the impact of reasonably foreseeable potential upsides from holding the shares in the first place.