About Valuation

Before we go into the importance of valuation, we need to know what is valuation and why a company requires to be valued. Valuation is the process of determining the “Economic Wealth” of an “Asset” or “Company” under certain “Assumptions” and “Limiting Condition” and subject to the “Data” available on the “Valuation Date”.

Valuation determines the economic value of a business, asset or company. Typically, it depends on various factors including industry, economic conditions, sector, valuation approach and methodology. There are high chances that, if you have your business valued by two professionals, you will come up with two different answers.

Gaining importance of valuation

Valuations, whether of financial, tangible or intangible assets play an important role in investment decisions, risk assessments and recognition in books of accounts. Thus, valuation requires the valuer to have the right mix of experience and professional judgement.

Valuation approach and judgement changes with objective

It is important to start with a clear goal. Why are you valuing? It could be mergers, acquisitions, sales, buy-sell agreements, financing, shareholder disputes, tax purpose or gifting of interests, and purchase price allocation. What are you trying to accomplish with this valuation? You need to assess what the purpose of this valuation is.

There are several reasons due to which you might want to determine the value of a business, including:

A. Financial Reporting Purposes

Nowadays Indian Accounting Standards (“IND AS) sometimes require companies to record assets at fair value. For example, where the company has complex derivative instrument having equity and debt component, for example Optionally convertible instruments or Compulsory convertible instruments. In such cases the company needs to recognise equity and debt component separately through its fair value, valuation of such complex derivatives is needed for fair recognition of equity and liability. Often valuation of such complex instruments is outside the comfort zone of in-house accounting personnel, so it pays off to hire an outside expert who will get it right.

B. Buy and Sell Transaction

Valuation plays a key role in different areas of finance such as buy/sell, mergers and acquisitions. It’s important that the parties agree on the value of the business when drafting a buy-sell agreement. Every business should incorporate a buy-sell agreement to avoid potential litigation if the shareholders suddenly disagree or want to exit the business. By involving an external valuer in the creation of buy-sell, the parties can ensure the agreement covers all relevant valuation issues, including the:

• Appropriate standard of value,
• Relevant valuation methods,
• Application of valuation discounts for lack of control and marketability, and
• Buyout terms and timeline.

These parameters may differ depending on the size of an ownership interest or any other triggering event. 

When company owners look for selling business, they have certain beliefs about the market value of the business. The owner most often has a conclusion that does not consider the procedure required to adjust certain company specific factors. Without a professional valuation, this number can potentially create a lot of problems in future. If there is no professional valuation done, they arrive at the market value without considering the full picture and end up making decisions only on their belief towards the market value of the business. This can create undesirable results for the seller.

Like sellers, infrequent buyers also make significant valuation mistakes. For example, one mistake is to not apply discounts for lack of marketability for private companies. Such discounts can result in a substantial adjustment in the value of an asset, security or business.

Both buyer and seller, if they do not use a multiple comparable with each method, they will not reach the best conclusion in valuation. Further if they do not adjust the target for the purpose of the valuation, that is, an acquisition, they will end up getting a value that is not economically correct for market the valuation range and for their transaction.

Many companies engaged in M&A transactions, whether it is sell-side or buy-side, erroneously employ oversimplifyed valuation techniques in their transaction. As a result, they miss out on the discount/ premium on valuation resulting in biased outcomes and a never-ending process due to unrealistic, doubtful and unmet expectations.

C. Mergers and Acquisition (‘M&A’) Transaction

M&A transactions are ones in which one company merges with another company or one company acquires the other company. These transactions require transfer of assets and liabilities from one company to the other in consideration of shares or any other form. The consideration will be determined by share swap ratio which requires fair valuation of the shares of the companies involved.

The Independent professional valuer plays an important role in these kind of transactions for determination of consideration by evaluating swap ratio. Here the purpose is to assess the fair value of companies involved. To determine the fair value, the valuer will consider the company specific factors and rationale of the transaction which needs to be adjusted in determing the value of the company.

D. Tax Purposes

It is compulsory for companies in some tax transactions to be valued by an independent valuer. In many cases various business transactions are required to be reported by self-assessment by the owner itself, however the tax authorities have given the statutory right to of valuing certain transactions to expert professionals and thus valuation professionals provide an important input in such cases. A business valuation professional is uniquely suited to prepare a qualified appraisal for tax purposes. Here, fair market value is always the appropriate standard of value. Discounts may be available for lack of control and marketability when valuing minority interests.

E. Litigation and Restructuring Needs

Litigation involving the business or its shareholders may necessitate valuation. Examples include a shareholder’s stake being affected from various business decisions or loss of minority interest, etc. The appropriate standard of value in these assignments is often defined by statute or legal precedent, which varies from jurisdiction to jurisdiction. For example, valuation discounts may sometimes be considered inequitable while valuing a business interest for minority shareholders under cases of oppression. It is important for your valuation expert to define the assignments’ parameters and purpose to prevent the valuer recommendation and conclusion from being misused for any other purpose.

F. Internal Assessment for Business Planning

The first time a valuation need arises is often for general business planning purposes. The business owner might be interested in knowing the business worth, its investment in the market and how it can be increased to gain a competitive edge; Or maybe he’s evaluating capital investment options and wants to rely on more than his instincts to determine each alternative’s long-term impact on cash flows and, ultimately, the value of the business.

When valuing a business for internal purposes, you may be interested in how your business would be perceived by hypothetical buyers. If so, fair market value might be relevant. But if you’re interested in what it’s worth to you or a specific “strategic” buyer, investment value is more relevant. Often strategic buyers are willing to pay a premium above fair market value due to synergies.

Unfortunately, many business owners rely on a do-it-yourself assessment for internal decision-making purposes. Often in-house estimates are biased estimates which lead to incorrect assessment of value. An independent business valuation professional can help in building business models that can be used to evaluate how changes in various assumptions affect the ultimate value. An independent valuation professional can also estimate the company’s cost of capital, which can be used to perform discounted cash flow analyses or as an internal rate of return for analysis of various investment alternatives.

What are the approaches of valuation?

Valuation can be a very complex process. There are multiple valuation approaches, including Income, Assets, and Market approach. There is no one way to value a business. In order to price the assets right, one needs to figure out which approach will best work based on the objectives of the valuation

There are three primary valuation theories falling into the following groups:

• Income Approach – generally used in going concern
• Asset Approach –  the asset theory considers a liquidation approach
• Market Approach – considers values attributable to other companies and/or M&A transactions in a similar line of business.

 

• Income Approach

The basic premise is that the current value of any business is a function of the future value that an investor can expect to receive from purchasing all or part of the business.

• Asset Approach

In comparison, the asset approach determines business value based on the assets of the company. This is where you might engage an appraiser to discuss value of assets based on market value and possible liquidation.

• Market Approach

The market approach decides the value by comparing similar companies or M&A transactions. A valuation professional will focus on the comparative transaction method. Then, they will appraise competitive sales of comparable businesses to estimate the economic performance of revenue or profits. This works well with publicly traded companies where earnings information is readily available. 

Before Companies act, 2013 and Adoption of IND AS

Until the Company’s act, 2013, There was no provision in the earlier version of Company law that provide for any valuation nor it has specified the person who can conduct the valuation of companies, shares, etc. Earlier, the valuation of shares, assets, business etc. was conducted by chartered accountants or as prescribed by the relevant law under which valuation was needed such as Foreign Exchange Management Act, 1999 and the regulations thereunder or the Income Tax Act, 1961. And thus, there was a need for consistent, uniform, strict and transparent valuation policies.

Valuation in The New Regime

Investors along with investment characteristics are more concerned about transparency and compatibility in valuation of asset so that it can be comparable with the similar characteristics investment opportunity.

Independence and transparency is a must in the following areas –

• Issue of Shares & Securities
• Fairness opinion for Scheme of Amalgamation & Arrangement
• Fair Value Determination as per IND-AS / IFRS
• Valuation of Goodwill and Intangibles
• Related Party Transactions
• Tax Issues/Litigation
• Issue of Shares for Non-cash consideration
• ESOP Valuation
• Valuations for special purposes such as disputes, exits, etc.

The Companies Act, 2013 has encompassed the concept of Registered Valuers by incorporating a separate chapter in the act, which leads to the formalisation and regulation of the Registered valuers under the Act. 

Section 247 of the Companies Act provides that “where a valuation is required to be made in respect of any property, stocks, shares, debentures, securities or goodwill or any other asset or net worth of a company or its liabilities under the provisions of this Act, it shall be valued by a person having such qualifications and experience and registered as a valuer in such manner and on such terms and conditions as maybe prescribed and appointed by the audit committee or in its absence by the Board of Directors of that company”.

It does not apply to valuations required under other laws, unless the other laws mandate valuation by a registered valuer.

Following sections of Companies act, 2013 require valuation of securities to be conducted by Register valuer only:

Section/Rule	Description
Section 39(4)	Valuation of consideration shall be determined by register valuer in case of allotment of securities for consideration other than cash.
Section 62(1)C	Valuation for Further Issue of Share Capital
Section 67(3)(b)	Valuation by registered valuer needed for provision of money by company for purchase of its own shares by employees or by trustees for the benefits of employees.
Section 192(2)	Valuing Assets involved in Arrangement of Non-Cash transactions involving directors
Section 230/232	Valuation under Scheme of Compromise/Arrangement or Scheme of Corporate Debt Restructuring
Section 236(2)	Valuation for Purchase of Minority Shareholding
Section 260(2)(c)	Valuation in respect of Shares and Assets to arrive at the Reserve Price for Company Administrator
Section 281(1)	Valuing assets for submission of report by Company Liquidator
Section 305(2)(d)	Report on Assets for declaration of solvency in case of proposal to wind up voluntarily
Section 319(3)(b)	Valuing interest of any dissenting member under Power of Company Liquidator to accept shares etc., as consideration for sale of property of company
Rule 2 –  Companies (Acceptance of deposit) Rules, 2014	Deposit includes any receipt by way of deposit or loan or in any other form by a company but does not include, among other things, money raised by issue of debentures secured by a charge on company’s assets. The amount of such debentures shall not exceed the market value of the assets as determined by a registered valuer.
Rule 8 of Companies (Share capital and Debentures) Rules, 2014	Valuation in various cases of issue of sweat equity shares

 

Further Valuation plays an important role in the Insolvency Resolution regime where Liquidation value must be determined by Resolution professional through the Registered Valuers. Below is some valuation requirement where register valuer plays an important role for determination of liquidation value of the business.

Section/Regulation	Description
Section CIRP 27/35	The 2-register valuer appointed under section 27 need to submit an estimate of the liquidated value.
Section VLR 3(2)/59(3)	In case of voluntarily liquidation, the declaration shall be accompanied by the report of valuation of assets prepared by registered valuer
Section VLR 38(1)	The liquidator shall prepare a sale statement of assets showing the value realized lesser than the value assigned by the registered valuer.

 

SEBI ICDR Regulations, 2018 and SEBI (REIT and Inv IT) Regulations have also defined Valuer as a person who is registered under section 247 of the Companies Act, 2013.

As per SEBI regulations, in many cases where valuation is needed, the merchant bankers are authorised to conduct the valuation. However, in some cases, the registered valuer is referred for determination of value of securities. Following are some illustrative SEBI regulations where authority can refer the registered valuer for fair valuation of securities.

Regulation	Description
SEBI Delisting regulations-23	At the time of delisting of equity shares by stock exchange, the stock exchange shall appoint an independent valuer for determination of fair value of delisted equity shares from out of its penal of expert.
SEBI ICDR – 70	Conversion price shall be certified by two independent qualified valuers.
SEBI ICDR – 73	In case of preferential issue of shares where consideration is received other than cash, valuation shall be done by independent qualified valuer, if the stock exchange is not satisfied with the appropriateness of the valuation, it may get the valuation done by any other valuer.
SEBI SAST regulations – 8	The value of the IP or technical know-how to be received from employees, along with the valuation report to be attached to the notice to shareholders for approval of sweat equity shares.

The Ministry of Corporate Affairs (MCA) has notified the Valuation Rules and opened a new area for a Registered Valuer professional. It offers opportunities to the existing professionals including Chartered Accountants, Company Secretaries, Cost Accountants and MBA/ PGDBM in finance.

Valuation field is gaining importance now and is considered as one of the most critical areas in finance. To harmonise the diverse practices in use in India, the Council of the Institute of Chartered Accountants of India (ICAI) has issued “The ICAI Valuation Standards 2018” which are 1st of its kind. The importance of valuation in India has increased by introduction and adoption of the Ind AS by many Indian Companies in a phased manner. These will help ICAI members in maintaining high level of transparency and consistency in performing valuation services and issuing Valuation reports.