How to value growth shares

Growth shares are a fantastic mechanism that enables a business to incentivise senior management to drive growth in return for receiving some of the value of a company over and above set valuation hurdles. The shares granted through a growth shares scheme have specific economic rights attached to them, which means that, in the event of a sale, the shareholder only benefits if the value of the company exceeds the predetermined hurdle. Typically, this hurdle is set as a premium over and above the market value for the company’s shares on the date that the growth shares are granted.

One of the key appeals of growth shares is that, in contrast to EMI options or other option-based incentive schemes, shares are issued to employees immediately, and the economic or structure limits that constrain EMI do not apply. Growth shares are particularly useful in circumstances where options schemes (such as EMI) are not suitable for the business, but they can also be used in conjunction with EMI options too.

Some key characteristics of growth shares:

• Growth shares are typically used by private limited companies and are particularly popular among high potential, early-stage (and often Private Equity or Venture Capital backed) businesses, given the high growth expectations characteristic of those businesses.
• Growth shareholders only share in any capital value growth from the date that they were issued – meaning that current value for existing shareholders is ring-fenced and protected from dilution.
• They are governed by the company’s Articles of Association, which will likely be amended as part of the issuing process, and, therefore, subject to the same treatment and requirements as other share classes on the sale of the business.
• Any gains on growth shares are subject to capital gains tax (CGT) charged at the standard rate of 20% (or 10% if the conditions for lower tax reliefs are met).
• They are not limited to incentivising key members of staff; growth shares can also be used for inheritance or succession planning through awarding growth shares to family members. This allows existing owner managers to transfer the future growth in value of the company to their family while they retain the current value.
• Due to the lack of economic rights of growth shares, their market value tends to be relatively low, as the current value of those shares reflect “hope value” only. The cost (or initial tax charge) to employees acquiring their growth shares is, therefore, usually lower than existing ordinary shares. It is important that this point is understood by both the acquiring employees and your existing shareholders.

Valuing growth shares

There are a number of methods for calculating valuations for growth shares. The Black-Scholes model is the most common and popular mechanism used. However, alternatives relating to Discounted Cash Flow and Hybrids also exist. These are evaluated in turn:

Black-Scholes model

The Black-Scholes method of valuation was once most commonly used as a pricing model for valuing call options on a stock exchange. Today, it is also used to determine the value of growth shares due to the similarities between both mechanisms; if share price does not hit the strike price level, then there will be no payoff on the options, but if the share price goes beyond the strike price level then any payoff increases linearly.

In simple terms, the model works by considering the various potential future scenarios for business performance, applying a probability weighting to each of those scenarios and then discounting the outcomes from them back to get today’s present value. In order to calculate this, a valuer will require the following inputs: current share price, the exercise price/ valuation hurdle, the risk-free rate, the expert term (i.e. time before exercise), the volatility and dividend yield (if applicable).

People generally get nervous about using the Black-Scholes model for valuing growth shares for a few reasons, including:

• A general fear of the model as it appears confusing and the inputs, outputs, and workings are not intuitive;
• Confusing a model which includes vs excludes dividends;
• Not intuitively understanding how a business’ plans for growth relate to the inputs;
• Misunderstanding over what acceptable inputs are, and;
• Not knowing the extent to which the valuation ‘answer’ or output is acceptable.

The critical step for any valuer using the Black-Scholes method to value growth shares is to make sure they understand how the planned choices around growth connect to commercially justifiable inputs (which may include adapting the formula or structure of the inputs into the model itself) in order to form an answer.

For example, volatility is a critical input that can be at risk of being poorly appraised and can lead to erroneous or commercially suspect valuation outputs. What this means is that the actual understanding of the different scenarios that could or could not lead to growth in value, and how those different scenarios relate to one another (i.e. it is possible that more than one scenario, or aspects of different scenarios, could occur) is often quite limited, which could subsequently expose the shareholders and company to unexpected risks.

To use the Black-Scholes method effectively, a valuer needs to be able to understand:

• The growth plan and the key drivers of growth;
• The reasoning behind the resultant performance increases in your model and the evidence sitting behind those assumptions;
• The identified challenges to this plan and where other, similar businesses have gone wrong previously;
• Alternative growth scenarios in the event that these challenges are realised; and,
• Finally, taking this all together, they will need to be able to step back and assess what all of this means for the true risk factor to growth.

 Discounted cash flow

In one sense, all a Black-Scholes model is a complex Discounted Cash Flow model. If you do not have the relevant information to do a Black-Scholes calculation, other methods can be used, such as a more traditional Discounted Cash Flow (DCF) with scenario planning covered by an accompanying method. The accompanying method can take many forms, but the most robust might be a real options analysis.

The real options approach is, simply put, the cost of doing vs not doing something based on assumptions on how a market will operate. However, it forces both the company and the valuer to think strategically about the things that a company could or could not do, or that the competition is like or not likely to do, and then use this to generate ideas on how any of these occurrences could impact future performance and, ultimately, overall value. This methodology is particularly relevant for a business where the possible growth scenarios are either completely perverse to one another and/or completely binary (because of things not under their control that could blow a plan completely in or out of water), or when the business exists in a dynamic market with competition that could create polar opposite outcomes. A great example of these sorts of market conditions exists for rights-based businesses, such as film, sports, 5G networks and music rights businesses.

Hybrid

For robustness, it can also be comforting to undertake both approaches and consider if the answers broadly align, or, if they do not, then what the commercial and economic reasons for the difference might be.

Given that at the time of writing, it is not possible to seek statutory clearance for Growth Shares valuations and that the Revenue are quite rightly pursuing cases where growth shares have been undervalued, an additional level of comfort may be desirable.

The right methodology and structure for a growth shares scheme will depend on the particular circumstance and whether there are other interactive tax reliefs or dilutive instruments, such preference shares.

It is our experience, however, that these alternative methods are rarely considered or used on their own, and sadly, we often find the Black-Scholes model is used ineffectively – resulting in potentially significant value disadvantages to both the company issuing the growth shares and those set to benefit from them.

However, by combining strategic awareness with technical robustness, a credible Growth Shares valuation can be formed by a valuer.

This article was written by Chand Chudasama, Strategic Corporate Finance Partner at Price Bailey. If you have any questions about anything in this article or would like to discuss a growth shares valuation with us, please get in touch with the team using the form below, and we will be in touch.