Introduction

2. The subject of shareholder valuation is often viewed through the lens of finance; however, there are meaningful insights to be had by viewing the subject through a legal lens too. This article seeks to explain how shareholder valuations are impacted by the prevailing laws, regulations, and contracts, which have a bearing on an enterprise.
3. In the interest of ensuring that discourse is corralled in the direction of legal matters, one can assume that the enterprise value has been arrived at using one of the many accepted methods of valuation, and what one seeks to now achieve is arriving at the shareholding value of an interest or holding in the enterprise.

Standard of Value

3. After having arrived at their enterprise value, two broad valuation standards will be relevant to our understanding – Fair Market Value (FMV) and Fair Value (FV). FMV has been described as –

“the highest price available in an open and unrestricted market between informed and prudent parties, acting at arms’ length and under no compulsion to act, expressed in terms of cash.”[1]

4. Relevant for our further analysis, is appreciating that generally discounts/premiums are considered in this form of valuation. In the case of FV, which is defined as –

  “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date…”[2],

The converse also holds true, i.e. no discounts/premiums are considered in FV valuation generally.

Concept of Shares and Shareholder Rights

5. Given that the underlying object of valuation is the equity interest in an enterprise, it would be useful to elaborate on some elemental aspects of shares and it their legal relevance in a company. Firstly, a share can be conceived as a right to a specified amount of share capital in a company which comes attached with certain rights and liabilities during the life of the company and after its winding up.[3] Shares are regarded as movable and transferable property in accordance with the Articles of the company[4]. They are part of the personal estate of the shareholder and not in the nature of one’s real assets, and they may be transferred in like manner to transferable property. The financial benefits accruing from one’s shareholding are usually in the form of dividend distributions, liquidation of assets, as well as the outright sale of one’s ownership interest.

Shareholders’ Agreement

6. A Shareholder Agreement is a contract between the various shareholders of a company in which they all have an equity interest in. It is not necessary that the company be a party to such agreement. The legal purpose of the SHA is to serve as a contractual regime that binds the parties together. A SHA is not mandated by the Companies Act[5], 2013, that said, if an SHA is incorporated into the company’s Articles it does put third parties to notice, thus conferring a modicum of legal protection. Further, Section 6 of the Companies Act, 2013 states that the Act shall have overriding effect over any other agreement between shareholders, in addition to placing certain legal fetters on the terms of an SHA. The contractual rights one enjoys in respect of the SHA are available in addition to certain statutory rights as well.
7. Generally, the broad aspects covered by an SHA are ownership, management, and control of the company. Under these broad areas, certain bespoke terms are then framed in accordance with the needs and concerns unique to the parties or the company. For example, ownership aspects may include clauses pertaining to buyback of shares, the company’s rights upon the death of a shareholder, right of first refusal (ROFR) issues etc. Operational and management terms may be concerned with board representation, appointments to key management positions, reporting procedures and requirements both statutory and internal etc. Lastly, control aspects included in a SHA deal with such matters as minority protection rights, dividend policy, the procedure in case of a deadlock amongst shareholders, forced sale provisions etc.

Interplay between the SHA, Articles, and the Applicable Law

8. Per Section 10 of the Companies Act, 2013, the provisions of the MOA and AOA are binding on both the company and its members. Articles commonly contain provisions giving directors the power to refuse a share transfer, provided it is in the interest of the company/shareholders and not done arbitrarily or for personal benefit.
9. AOA’s also commonly contain provisions outlining the pre-emptive rights of shareholders i.e. their first option over shares to the exclusion of outside third parties. As mentioned earlier, rights enshrined in an SHA gain greater legal enforceability when they are incorporated into the AOA of the company.
10. The Shanti Prasad and Rangaraj cases better elaborate the above position in the prevailing law. In Shanti Prasad Jain vs Kalinga Tubes Ltd.[6], the court held that no company can be bound by a private shareholders agreement, in this case the SHA was not incorporated into the AOA either and therefore not binding on the company and thus, there were no transferability restrictions of the company in its power to dispose of the shares.
11. In B. Rangaraj vs V.B. Gopalakrishnan and Ors.[7] it was held that regulations contained within the AOA were binding upon the company and its shareholders. Shares are movable property and their transfer could be regulated only in accordance with provisions of the AOA, Companies Act, and Transfer of Property Act. Any restriction on transferability of shares which is not in the AOA of the company would not be binding on the company or its shareholders.
12. The prevailing judicial approach suggests that provisions of the AOA override the provisions of any private agreement between shareholders, all within the overall supremacy of the Companies Act. Having said that, even in a situation where the terms of the SHA are not incorporated into the AOA, it may be enforced between the parties in the same manner as a claim for specific performance or damages under contract law. Thus, a private agreement for pre-emptive rights which does not bind the company because the agreement has no place in the AOA of the company may still be the subject matter of a civil suit between the parties to the agreement and the party committing breach may be liable to damages.

Equity interest Valuation

13. In the context of valuation of a company, shareholder rights involving transferability, marketability, and control become paramount. In addition, the concept of discounts/premiums in ascertaining shareholding value also requires assessment.
14. While ‘Discounts’ reduce the value of interests in closely held companies (usually minority interests) ‘Premiums’ increase the value of the interest. Typically, discounts and premiums are applied at the end of the valuation exercise, arising from the concepts of control and marketability.
15. In a larger sense, a discount or premium may be at an entity level or a shareholder level, however for the purposes of this article, our emphasis remains on the shareholder or internal level.

Marketability of Equity Interest and DLOM (Discount for Lack of Marketability)

16. Marketability refers to the ease and speed with which a security can be sold when so desired. If the marketability of an equity interest is good, one will be able to sell their equity interest for cash relatively quickly and without any significant loss of value. This conception may cause one to liken the concept to that of liquidity, indeed the terms are used interchangeably at times, but it is important to note that while anything liquid is marketable, the reverse is not always true.
17. It is moot that an investor cannot withdraw money from the company, but only convert their investment into cash through sale of their shares. Thus, from the very inception of public companies, free transferability of shares has been well recognized.
18. Marketability of shares is also influenced by the provisions of the Companies Act, 2013, in Section 56 which deals with the transfer of shares, Section 2 (68) allows for a private company to restrict share transfer rights, and section 58(2) lays down that securities held by members of a public company are freely transferable. Companies may however place reasonable restrictions on transferability, say in case of private family-owned companies where there is an interest in safeguarding the family character of the business, or by public companies seeking to prevent an unscrupulous takeover being effected through market manipulations.
19. One’s ownership interest can be considered ‘marketable’ so long as it is reasonably liquid. Enhanced marketability generally increases the value of a security. One arrives at a valuation for non-marketable equity interest by application of discount for lack of marketability (DLOM). Of course, such an assessment would also be dependent on various factors such as the terms of the AOA- whether it contains any restrictive terms pertaining to transferability, the position of the prevailing contractual regime expressed in the SHA also through other agreements like pooling agreements or JVAs etc., and other laws governing pricing such as FEMA pricing guidelines.  Other factors such as the presence of put options could have the effect of reducing or eliminating the DLOM. Similarly, the value of dividend payments – higher dividends lead to higher marketability reducing DLOM or prospect of an IPO (reduces DLOM) etc.

Control by Shareholders and DLOC (Discount for Lack Of Control)

20. Much like marketability has a bearing on shareholder valuation, so too does the degree of control shareholders have over the future of the company. This control, or lack thereof, is expressed in shareholder meetings, board meetings, and management meetings etc.
21. ‘Discount for lack of control’ or DLOC shares an inverse relationship with control premiums. Equity held with those shareholders having legal rights that grant them a degree of control over the company, will command higher premiums. For the purpose of valuation, it is necessary to quantify the elements of control, generally through the concept of control premiums.
22. Like in case of DLOM, before one explores the factors that influence DLOC, it is useful to examine what elements, in general, suggest a degree of control. These include – the power to appoint or replace management and board members, frame company policy/strategy, acquire or dispose of assets of the business, negotiate mergers and acquisitions, and to sell/dissolve the company, amongst others.  Also, the amount of the shareholding block indicates the degree of their control. In the case of 100% shareholding, it can be said one has full control, 76% denotes a super majority (as per Section 114 of the Companies Act, 2013 some acts require a 3/4ths super majority), 51% denotes a simple majority, anything below 50% begins to invite the possibility of a deadlock. This does not mean that a smaller percentage of shareholding does not connote meaningful control. A 26% shareholding is sufficient to block the actions of a Super Majority, at minimum a 10% shareholding has been observed as a threshold for asserting certain legal rights for example under Section 244 of the Companies Act, 2013 – an oppression and mismanagement action requires one to have at least a 10% shareholding.
23. These amounts are indicative of a shareholder’s blocking power, power to effect a swing vote, or even effect a successful vote on any issue in general. The possibility remains open for smaller shareholders to club their interest together to achieve any of the aforementioned actions.
24. The application of DLOC depends upon the degree of value, legal and contractual diktats regarding the rights and restrictions of the interest holder, and the ultimate rate of return produced for the interest. The factors impacting the applicability of DLOC can include certain legal/statutory requirements, the terms of the AOA, and share dilution, amongst others.  For example, as mentioned, there is a statutory right under Section 244 of the CA 2013 allowing members with a minimum 10% shareholding to apply to the tribunal in cases of oppression and mismanagement.
25. Within such factors, one may take several approaches to arrive at the value of non-controlling interest. Namely, the ‘discount approach’, ‘direct comparison approach’, and the ‘income approach’. Under the discount approach, DLOC is applied to Enterprise Value (EV) and in Direct Comparison one arrives at a valuation for non-controlling interest by gauging other comparable firms non-controlling interest value. Lastly, per the Income Approach method, one makes an assessment based on economic benefit that the minority shareholder expects to realize over an expected holding period, this is then discounted at the appropriate rate of return.

DLOC vis a vis DLOM

26. While on the face of it DLOC and DLOM may appear to be largely disparate concepts, with the DLOM approach requiring greater empirical evidence than DLOC, there is an interrelation between the two that merits recognition. The base from which DLOC is subtracted is a proportionate share of the value of equity that is taken as a whole. Conversely, the base from which DLOM is subtracted is the value of an entity of interest (generally the minority interest), this is otherwise comparable but does enjoy higher liquidity.
27. Another manner in which the two are connected is that a lack of control (the prime concern of DLOC) can at times be manifested through projected cash flows (an aspect of a business typically analysed for the DLOM approach), i.e. whether or not control adjustments are made to the cash flows.

Indian Law on Shareholders Valuation

28. To begin with, one may refer to the opinion of the SC in the Hindustan Lever case (1995)[8]. Therein, in a challenge to a company’s merger by its employee’s union, certain restrictive covenants attached to shares part of the proposed amalgamation became a site of contention. The valuation and exchange ratio of the shares was upheld by the SC as it was done by a reputed valuer applying a combination of three generally accepted methods (i.e. the net-worth, market-value, and earning method). The SC also stated that a shareholder has no interest in the assets of a company while it is in existence, only when it is in liquidation. The right to surplus of assets upon liquidation was regarded as one of the rights of shareholders. Additionally, other rights that were acknowledged in this judgement were the right to elect directors, vote on resolutions in meetings, and enjoy profits in the dividends declared.
29. The Bombay HC explored the position of valuation, control, and interplay between the MOA/AOA and SHA in the Western Maharashtra Development Corporation case. During a dispute, the value of shares became a point of contention between the parties and the issue was placed before an arbitrator. The arbitrator rendered their opinion as to what the correct price of shares should be as well as what the relevant date of valuation should be. The Arbitral Award was assailed under the Arbitration and Conciliation Act,1996 before the Bombay HC, who set aside the award on the grounds that an earlier agreement between the parties granted the appellant ROFR to purchase the shareholding of the respondent. On appeal, a subsequent bench of the HC opined that the 30% DLOC that was included in the valuation was reasonably arrived at, and the Companies Act overrides any MOA/AOA/SHA[9]. Any terms in the MOA/AOA or any other agreement that run contra to any provision of the Companies Act, are to the extent of their incongruity, void. Therefore, any pre-emptive rights provision be it in the MOA/AOA or any other agreement would have to satisfy all relevant provisions of the Act. Per section 111 A of the Companies Act, 1956[10] shares of public companies (like those of the appellant) are regarded as freely transferable. Thus, the pre-emptive rights provision was found to be bad in law.
30. Moving on now to the judgement in Renuka Datla Vs. Solvay Pharmaceutical[11] wherein the position of the law regarding the circumstances in which a premium for controlling interest could be added in a valuation and the circumstances in which the value of certain brands could be added, became clearer. In this case the respondent sought to purchase 4.91% of shares held by the petitioners in two companies. Both these companies met the criteria for a going concern under three generally accepted methods of valuation (asset, earning, and market-based methods). It was decided that the intrinsic value of a share would be premised on the asset and earnings based valuation, further greater emphasis was placed on the earnings value as it was opined that this would have a stronger bearing on the value of company business. It was also decided that due to various discrepancies the DCF (discounted cash flow) valuation would be disregarded. There was also no weightage given to control premiums as no value was assigned to the controlling interest given that the parties merely owned 4.91% of the share capital. Further the valuer also chose not include in their assessment a drugs brand which had been transferred to the respondent.  The method of valuation as well as its validity were subsequently challenged before the SC. The bench opined that the valuer’s reasoning behind the exclusion of the drugs was correct, as they were not the existing assets of the companies being valued. Further, according to the SC the petitioners had no grounds to assail the validity of transfer, given that as per relevant records all pertinent assets had been accounted for by the valuer.
31. On the subject of the proper use of the DCF method for valuation, the SC said that when adopting DCF valuation, it is key that the appropriate rate of discount be determined. Determining this rate appropriately depends upon reliable date and projections being provided, which was not the case in the present matter. When considering questions pertaining to control premiums, it was decided that a claim for control premiums could not stand, as a shareholding of just 4.9% could not be seen to carry with it any special rights.
32. Questions surrounding valuation methods and the judgement applied by a valuer as well as control premiums were further explored by the SC in the GL Sultania case (2007) which referred to the Renuka Datla In this matter it was the contention of the appellants that both SEBI as well as the concerned merchant bank had improperly valued the shares of the target company, then SEBI appointed an independent valuer who compared previous valuation reports, and offered a revised share value in conformity with one of the preceding assessments. It was this valuation that by the SEBI-appointed valuer that was challenged before the SC. While deciding the matter the SC posited that determining the correct principle of valuation to be applied in a particular case is a question of law and not a question of fact. The implication being that in question of law the principles being assessed may be applied to other cases, while a question of fact requires an assessment of the facts and circumstances unique to the case at hand to be made. Parties, the SC said, may agree upon a principle that is recognised and is permissible under the law. In a situation where there are multiple principles, all equally valid, then parties may agree among themselves to prefer one mode over the other.
33. On control premiums, the SC said that the premium values would be different in the case of a majority of shareholding and at 76% shareholding. On the broader question of whose determination as to reasonability of share valuation counts (in this case there was the opinion of the parties, the merchant bank, and the SEBI valuer for example). It was seen that as per SEBI regulations the offer price is to be determined by the acquirer and merchant banker. SEBI is not however bound to accept this assessment if they suspect the offer price does not truly represent the FV of the shares. If the valuation of the acquirer/their merchant banker is largely in conformity with the assessment of SEBI’s valuer (or vice-versa), then the Board has no option but to accept the acquirer’s offer price.
34. The court stated that the correct principles of valuation applicable to a given case are a mix of principles of law and of facts, in addition to complex and technical aspects. It is not feasible that absolute mathematical precision and exactitude be attributes of share valuation, given this, the aforementioned approach is the most feasible way forward.

International Authority on Shareholders Valuation and Discounts

35. The New Jersey Supreme Court’s judgement in Lawson Mardon[12] dealt with determination of fair value of shares by dissenting shareholders. The issue at hand was whether a court should apply a “marketability discount” in determining the “fair value” of shares of stock held by dissenting shareholders in a family-held corporation in the context of a statutory appraisal action. Herein, to further restrict public sales of the company stock, controlling family members approved a plan to restructure the corporation they controlled. A demand was made by shareholders holding approximately 15% of the stock and the company offered to buy the stock using a non-marketability discount of 25% theorising that there was a limited supply of potential buyers.
36. Such a rule would penalize the minority for taking advantage of the protection afforded by the appraisal statute. Barring extraordinary circumstances, a marketability discount should not be applied to the value of the shares being tendered by a dissenting shareholder in the context of a statutory appraisal action. The New Jersey Supreme Court did not find an “extraordinary circumstance” and refused to diminish the value of the shares. Even controlling interest in non-public companies may be eligible for marketing discounts thus inability to convert stock interest in cash applies irrespective of control. FV entails fairness and equity in deciding whether to apply a discount in value of shareholder’s stock. Under the FV standard dissenting shareholders are entitled to their proportionate share of FMV without any discount for lack of liquidity or marketability. That said, in the United States this is far from a settled position of law and there are dissenting judicial views on this aspect.
37. In 2001 the New Jersey Supreme Court weighed in on the valuation process once again in the matter of Casey v Brennan[13]. When a bank with over 400 shareholders seeking Subchapter S designation under federal tax law (affording it the benefit of limited liability protection) sought to reduce its number of shareholders (the required threshold is 100). The bank engaged an “independent financial advisor” to make a “Cash Fair Market Evaluation” of approximately 20% of the bank’s stock. However, not all of the shareholders approved the plan. The Court held that “marketability discounts should not be applied in determining the ‘fair value’ of a dissenting shareholder’s share in an appraisal action,” in the absence of “extraordinary circumstances.” Therefore, it concluded that the lower court “correctly declined to apply marketability discounts or minority discounts to the value of the shares.” The lower court also declined to consider including a “control premium” within the “fair value” of the shares.
38. The Court distinguished between the “control premium” and the inclusion of value for anticipated future effects of a merger. Because the lower court determined that a control premium was prohibited as a matter of law, the Appellate Court concluded that the lower court erred in disregarding valuations offered to the lower court that had an inherent control premium thereby reversing and remanding to permit the lower court to consider what, if any, impact, the control premium should have on the valuation of the stock.
39. While the above two judgements serve to give a flavour of how valuation issues are dealt with in the United States, it would also be worthwhile to mention what factors are generally of prime importance in the assessment of DLOM. These include an analysis of financial statements, dividend policy, outlook of company management, as well as the nature of the company and its history. Additionally, an emphasis is placed on the control passed in transferred shares, restrictions on transferability, holding period requirements, base value, and the expected growth rate of value.

Conclusion

40. It has been the aim of this article to lay out the broad contours of the concept of valuation and some of the methodologies behind it from a legal perspective, as well as connected challenges.
41. In this attempt, certain key takeaways that become apparent after assessing the prevailing landscape. Firstly, there is an element of interconnectedness between marketability and lack of control. Secondly, Non-controlling interest is worth less than its proportionate value (and vice versa) conversely, the market would be willing to pay a premium for liquidity.
42. Lastly, one should be cognizant of the unique facts and circumstances both within and without the entity that may have a bearing on valuation. The legal and contractual paradigm of the subject entity becomes very relevant in this light, pertinent laws, the AOA, SHA etc. all must be given due appreciation. Lastly, the valuation results are not limited to the test of mandating parties only, valuation may be tested by third parties and forums as well like FEMA, Authorities, Courts etc.
43. Hence the fiduciary obligations of the valuer are ever increasing, and the consequences of default and negligence are getting more severe. So, there is an growing need to exercise diligence, prudence, and legal compliance in valuation analysis exercises.

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[1] Cost Accounting Standards I

[2] Cost Accounting Standards I

[3] Palmer, Halsbury, and Pennington

[4] Section 44, Companies Act of 2013

[5] Except proviso to Section 58(2)

[6] AIR 1965 SC 1535

[7]  AIR 1992 SC 453

[8]   1994 SUPPL. (4) SCR 723

[9] Provided for in Section 6 of the CA 2013

[10] Replaced by Section 6 of the CA 2013

[11] Dr. Renuka Datla Vs. Solvay Pharmaceutical B.V. and Ors. (2004) 1 SCC 149)

[12] 734 A.2d 738 (1999)

[13] 780 A.2d 553 (2001)