‘We can see that the family court are moving further and further away from conventional valuation standards,’ says Luke Morris, the Scrutton Bland partner. Morris was presenting at last Wednesday’s ICAEW webinar Valuation in Divorce. Meanwhile, some of the leading family court judges appear to ‘hold a disparaging attitude toward business valuation,’ added Andrew Strickland, as the two reviewed recent decisions important to valuation. ‘We get a string of adjectives’ from the courts, he said, such as ‘arid,’ ‘abstruse,’ and (Strickland’s favourits, even if the meaning is unclear) ‘black letter.'

While judges increasingly understand the importance of business valuations in divorces involving couples with family companies, some valuation assumptions for quasi-partnerships and fiscal cases (the seller is anonymous, etc.) often do not hold. Others are intact; for instance, most (but not all) divorce decisions that end up in the courts still retain the quasi-partnership concepts that, if there’s no value leakage, and no problematic governance issues, no marketability discount is allowed.

Discounts are normally applied but not if there is no agency problem—for instance, when the people running the business are different from those owning the business. But if relationships are healthy, the courts have been loath to discount minority positions, says Morris.

A new case involved a company owned equally by the husband and wife. The judge did not allow a discount on the 50% share but discounted the value for selling costs and taxes. Other cases such as Sheffield United and UTB (2019) and George and McCarthy (2019) allow for discounts, so there are wide varieties of basis in various court decisions.

In fact, Morris and Strickland both note how many of the principles established by IVS’ ‘equitable value’ and previous case law are cast aside in the interest of meeting the needs of the separating parties. This results in standards of value not seen in any valuation textbook, such as the ‘marriage value’ standard outlined in the recent Estera Trust and Singh case, said Strickland. These new standards of value often sidestep the underlying assumptions of most contentious valuations.

The courts like to keep wide discretion for themselves about what is fair, so that means that some of the judiciary are likely to include ‘judicial caprice,’ says Strickland. First, the courts attempt to address financial need, and then they move to a ‘sharing principle.’ ‘You’d think that only high net worth cases would have anything left after 100% of the assets are applied to meet financial needs,’ says Strickland. It’s also resulted in more standards of value (and methods of valuation) unique to divorce valuation. Morris and Strickland highlighted a number of current trends, including:

• The matrimonial acquest—the asset initially brought into the marriage. This value is different than equitable value because it largely ignores the principle that valuations are conducted on the basis of what was known as of the valuation date.

• The springboard—Another concept introduced in the family courts is ‘the springboard,’ which is the ability of the company to rapidly increase in value in the future. ‘This appears to be the application of hindsight,’ says Andrew. He cites a case where Lady Justice Arden doubled the value the two experts agreed on due to an offer on the business made several years after the marriage date. Family courts struggle to quantify the fact that the momentum of the company was put into place before the marriage needs to be considered, even though the actual value at that time would be much less than the slippery slope of using future knowledge. Other courts dealt with this ‘vexed’ concept of the springboard, notably Judge Mostyn, in Martin and Martin 2018 EWCA Civ 2866.

• The first appearance of DCF models—DCF had not been widely used or accepted by UK courts, but we may be in the midst of a ‘veritable revolution.’ ‘More complex methods of valuation are having to be accepted by the courts since businesses are now using those complex methods.… So, the courts are having to accept the new models,’ Strickland believes.

‘There is little settled precedent in divorce valuation,’ Strickland concludes. ‘We have a role to play in changing these variances.… If we continue to think of, and continue to refer to, IVS 2020, we’ll at least be speaking in one voice.’

Business valuation experts in the UK often find little benefit from the academic literature about portfolio and investment theory. The prime example of the disconnect is the ongoing debate about the size premium. Do small stocks outperform larger ones over time?

Size is not alone as a value factor, however. Any BVWire—UK reader interested in this topic will enjoy the full list of factors (Bloomberg calls many of them ‘very abstruse’) contained in Campbell Harvey and Yan Liu’s updated list of identified value factors.

Harvey and Liu had some fun with this list in their 2019 article ‘A Census of the Factor Zoo.’

The Bloomberg article last week summarised:

Academics now claim to have identified more than 400 factors (which makes it a wonder that anyone ever failed to beat the market). Meanwhile, doubts over the ‘small is beautiful’ theory have reached such a point that many question whether it exists at all.

None of the 400 have drawn as much attention as the size premium, perhaps because that factor is a standard metric in building any risk model for business valuation—or investing. This new Bloomberg article summarises what many business valuers have come to accept when it concludes that ‘the small-company effect does not, after all, exist.’ The Russell indexes show that the factor is ‘muted at best,’ and sophisticated statistical work confirms it.

It also points to several recent papers, including one by Cliff Asness (AQR), who studied for his doctorate under Eugene Fama at the University of Chicago. One finding of that paper, ‘There Is No Size Effect,’ which we covered here, is that, since the size effect was originally identified in the early 1980s, a ‘series of cumulative challenges, many of which we have summarized …, all have reduced the historic “net of market beta” return to small vs. large, ultimately leaving nothing.’ The article also points to another recent paper, ‘Settling the Size Matter,’ that ‘nearly resurrects a narrower version of the small-company effect, before finding that it is close to impossible to exploit,’ the article says.

Is goodwill an asset on the balance sheet that reflects the difference between an acquisition price and the value of what was acquired? Most business valuers, citing IASB or other accounting standard, would agree. So it’s of some interest that, in the recently decided Primus International Holding Company and others vs Triumph Controls UK Limited and others [2020] EWCA Civ 1228 case, the court disagreed. Since the ‘lost goodwill’ warranties in the SPA were not clear, Primus’ argument that goodwill should have an accounting meaning, i.e., an intangible asset recorded when a company acquires another company, was rejected, and, with that, their claim that the projections their financial experts had created to support their goodwill claims were ‘honestly and carefully prepared.’

In the original case, the court disagreed:

[T]he plain and natural meaning of goodwill in a commercial contract is business reputation. The losses sustained by reasons of the breaches are lost revenues and increased costs, leading to reduced profitability and loss of share value.

Primus appealed to the Court of Appeal and was rejected a second time in this new ruling. Contrary to the expectations of most business valuers, the court said:

• The ordinary legal meaning of goodwill is the reputation, good name, or business connection of the business.

• This was not a claim for loss of share value: It was a claim for overpayment as a result of the careless financial projections.

• Any contract that contains a term to which the parties intend to give an unusual or technical or nonlegal meaning must spell out their specific intent.

• It should ordinarily be presumed that language is used ‘consistently within the four corners of an agreement.’ Primus had used the term to mean good business relations in other parts of the purchase agreement.

• Furthermore, claims for loss of (financial) goodwill are unusual, difficult to formulate, and hard to quantify (many business valuers would disagree with this last claim).

Listed company financial reports are supposed to be transparent, and often are not. This was the topic of a session at last week’s Annual General Meeting of the IVSC, during which the panellists brainstormed ways financial reporting could provide better information (particularly on the huge intangibles on their balance sheets) to investors.

The call for clarity descended into the private capital markets also, spurred on by the UK’s COVID-19 Brexit challenges. These financial actors should embrace an even greater sense of openness and responsibility, Baroness Jeannie Drake, British trade unionist and Labour Life peer, said during a British Private Equity and Venture Capital Association Ltd. Summit 7 October. Firms must embrace openness and responsibility, be more accountable in terms of what their contribution is to the economy and to the wider society, and how they demonstrate that. They may also need to have some ‘difficult discussions’ with the government, she added.

Of course, she was speaking at an event hosted by friends in private capital, so she also complimented her virtual audience for their growing importance globally, their central place in rebuilding Britain by securing the availability of capital, and the fact that the PE industry ‘already employs a million people and it has an important role out there.’

30 October: ICAEW Excel Modelling—Investment Appraisal, Valuation and Business Cases, virtual, 9:15-12:30 BST (repeated live 4 December)

1 December: ICAEW Practical Business Valuation, virtual, four-day course

9-10 December: EACVA 14th Annual Business Valuation Conference, virtual event

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David Foster at ukeditor@bvresources.com.