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Value judgements

In my last few articles, I have discussed the fundamental issues which should be taken into account in determining whether a company, in which two or more individuals have more than a nominal holding of shares, might have need for what is commonly known as a director share-purchase arrangement.

So far, I have confirmed the need for a comprehensive fact-find to identify all shareholdings and, where possible, voting allegiances between shareholders.

I also discussed the need to establish the identity of the recipients of each shareholding on the death of each of the business owners (that is, the beneficiaries under each shareholder&#39s will or intestacy) and then to confirm with each shareholder individually – and with all the shareholders jointly – whether this would be their preferred outcome as opposed to, simply, the shares passing to the beneficiaries without any aforethought by the shareholders.

In particular, it is important to note any possible change in the overall balance of power within the shareholders, especially where the deceased&#39s shares are due to pass to one or more surviving shareholders.

Finally, where it is identified that, on the death of a shareholderm problems may be caused to the surviving shareholders and/or to the running of the company itself, then we can be pretty certain that there is a need for a share-purchase arrangement.

Typically, I would suggest that, in most cases, the general consensus within the company&#39s owners will be for a deceased&#39s shareholding to pass to the surviving shareholders. However, unless those survivors are members of the deceased&#39s close family, shareholders may be loathe to agree to their shares passing on in this way without financial compensation to their beneficiaries, in other words, the surviving shareholders get the shares but the deceased&#39s family get paid the value of the shares. This leads us to the next stages in establishing a share-purchase arrangement:

•Agreement as to the value of the company&#39s shares in general and, more specifically, the value of each shareholding.

•Provision of funds to enable purchase of the shares.

•Establishment of a suitable legal agreement for the transfer of shares and money on the death of a shareholder.

I want to concentrate on the valuation of the company&#39s shares. In this regard, I recall my days of being trained in this area of business, during which I was advised that the shareholders should be asked to estimate the value of their company and then, simply, to divide this valuation proportionately between the respective shareholdings. In this way, I was told that although the valuation may not necessarily be appropriate, reasonable or fair, at least it would be acceptable to the shareholders.

Although such an approach may be a reasonable first step in a valuation for share-purchase arrangements, it must not be relied upon. Such an arbitrary valuation may well cause problems on death, with taxation implications. The Inland Revenue takes a keen interest in the consideration paid for the transfer of shares in these circumstances, most particularly to determine potential liability to capital gains tax and inheritance tax.

Briefly, its interest in CGT is to prevent avoidance by, say, placing an artificially low or high valuation on the shares to reduce an immediate or future liability to CGT. More particularly, the Revenue seeks to prevent IHT avoidance where the shares are valued too low (to reduce the value of the deceased&#39s estate) or too high (if this valuation still leaves the deceased&#39s estate below the IHT threshold).

The Revenue has therefore produced acceptable valuation methods, so I would strongly suggest that the early and continuous involvement of the company&#39s accountant (or, less likely, some other person or organisation competent in share valuations for this purpose) is essential if the undesirable attentions of the Revenue are to be avoided on the death of a shareholder.

I have over the years met a number of IFAs who contend that this involvement by a third party is unnecessary where the IFA himself has an understanding of the valuation of a company&#39s shares. Varying suggestions as to methodology of valuation include a multiple of annual profits (broadly equivalent to the price/earnings ratios quoted for stockmarket companies), net asset value of the company (with or without allowance for goodwill) or a combination of these.

While these methods are almost invariably appropriate to some degree, in themselves they are unlikely to be acceptable to the Revenue and a more precise approach is needed. Not least, even having arrived at the valuation of the company as a whole, the valuation of each shareholding will not necessarily be proportionate. As an example, the owner of a 55 per cent shareholding in a company has almost total control over that company, not least in the voting of dividends. This shareholding will almost invariably be worth much more than 55 per cent of the value of the company as a whole where the company has only a small number of shareholders. Conversely, a 20 per cent shareholding in this same company (that is, with a single majority shareholder) would not usually be valued as highly as 20 per cent of the total company value although a 20 per cent shareholding in a company with four other 20 per cent shareholders might well be.

The way in which minority and majority shareholdings in these companies are valued – with particular regard to the sizes of the other shareholdings – is highly skilled and cannot be undertaken by a layman. Sure, any valuation – however amateurish – could be acceptable to the shareholders but I must stress again the future interest of the Revenue could cause unforeseen and very costly consequences on a shareholder&#39s death.

Some IFAs may be concerned that by involving the company&#39s accountant, he is inviting competition for the business. I strongly oppose that view, not only because it is my experience that the accountant will be only too pleased and impressed that the IFA is taking the proper steps in installing this share-purchase strategy but also because he should be impressed that the IFA is also recruiting the services of the company&#39s solicitors, as I will start to discuss in the next article. In other words, the IFA, far from being merely a life insurance salesperson, is now taking a pivotal role between the company&#39s professional advisers to ensure that the strategy works not only at the outset but also right up to and beyond the death of a shareholder.

The accountant should direct the methodology of the valuation of the shares, either as an initial value or by means of an agreed formula. I have also stressed that the ongoing involvement of the company&#39s accountant is essential as one would expect the value of the company to change over the years (if an initial cash value has been placed on the shares) and it may even be the case that a different formula may be needed.

If reviews of the shareholder&#39s values are not carried out, it can easily be seen that the amounts agreed at outset may become totally inappropriate by the date of a shareholder&#39s death.

Now, having professionally assisted the agreement as to the value of the company, the adviser must turn his attention to the way in which the transfer of the shares may be funded on a shareholder&#39s death. Here, it is essential to ensure that each shareholder has sufficient funds to buy out his or her share of a deceased&#39s holding. It may well be the case that one or more of the shareholders has sufficient funds for this purpose without recourse to outside assistance but this is quite unusual. The obvious answer lies with life insurance policies, as we will discuss in the next article.

Keith Popplewell is managing director of Professional Briefing

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