Small and medium-size business owners can always benefit from entering into a shareholder agreement. The agreement makes it possible to regulate the internal functioning of the company far beyond what is generally found in the internal regulations.
The shareholders’ agreement also provides a mechanism for the sale, purchase or redemption of shares in various circumstances.
It is important to plan how the value of these shares will be set. Several options are available to shareholders and it is appropriate to adopt a formula that is most suited to the reality of the company.
The shareholder agreement should make it possible to achieve the following objectives:
1. Establish value as fair as possible;
2. As soon as possible;
3. At the lowest possible cost; and
4. As objectively as possible.
This minimizes the risk of litigation and protects the value of the shareholders’ investment. Of course, in reality the formula adopted often represents a compromise between these different objectives.
Among the most common approaches, the par value is probably the simplest and least expensive: it is enough to decree in the convention, a value in dollars for each share. At the time of sale, simply multiply this value by the number of shares to be traded. However, this value is essentially arbitrary, and it rarely represents a fair assessment of the value of the business.
The book value is based on the financial statements of the company. Generally, reliance is placed on the latest available annual financial statements. This method is applicable to companies whose main assets are tangible, and whose book value is not lessened by accounting techniques such as depreciation. It is also better for companies whose ridership is not too likely to be affected by the departure of a shareholder.
Another popular technique is the use of a multiple, applied to the profits of the company. This technique is particularly suitable for companies that have reached their cruising speed, in a field where there are transaction statistics for shares of comparable companies. This can be based on a reliable estimate of likely future profits and an objective basis for establishing the multiplier.
Of course, there are other formulas and it is possible to combine various evaluation techniques. Whatever the formula, establishing rules accepted by all shareholders generally reduces the risk of litigation at the time of sale. Such litigation can be disastrous for maintaining the value of the business. That’s why we recommend that our clients include an evaluation clause in their shareholder agreements.