International valuation standards gain traction at crucial moment
12 November 2020: At a time of economic uncertainty, the ability to create trusted valuations of assets is more important than ever. Valuations expert Andrew Strickland describes the development of valuation standards and how IVS2020 aims to provide clearer valuations of certain equity securities.
The accurate valuation of businesses and assets underpins confidence in markets and is relevant to many finance roles. Valuations are vital not only in mergers, acquisitions and sales, but also for financial reporting, tax purposes and in a variety of legal proceedings.
Understandably, there has been an increasing desire for more confidence in how such valuations are created. The first standards for undertaking valuations were created by the Royal Institution of Chartered Surveyors and focused on real estate assets.
Demand for a framework for the valuation of a wider range of assets has increased and in the past 10 years, the International Valuation Standards Committee (IVSC) and the global standards it publishes have grown in prominence.
The independent standard-setting body is a non-profit that has more than 150 member organisations from around the world, including valuation professional bodies, corporates and other related institutes, including ICAEW.
“There has been a very rapid revolution of the IVSC standards,” explains Andrew Strickland, a consultant at Scrutton Bland with 30 years’ experience in business valuations. “The 2017 edition marked a significant ramp-up of the standards and was seen as a major step forward.”
Strickland, who is also a director of the International Institute of Business Valuers, says the standards have been gaining traction within the valuation profession as a common way of working. One of the reasons is simple: valuers have been seeking a source of definitions, such as the meaning of market value and other commonly used terms.
“It is increasingly recognised in reports as a framework for approaching valuations,” he says. “We’re getting to the point that if a valuation report does not use the terminology of the IVSC standards, clients can be left wondering why.”
IVS2020: modest changes but key developments
A new edition of the standard came into force on 31 January 2020 (IVS2020) and while overall the changes appear modest there has been a key development in the valuation of shares in complex capital structures.
“While 95% of the 2020 edition remained unchanged from the 2017 version, what the standards did for the first time was to set down three methods for the valuation of different share classes and when they should be used,” says Strickland.
The valuation methods that IVS2020 outlines are:
- Current value method (CVM) – which values assets at their immediate sale value
- Option pricing method (OPM) – which values different share classes by treating each class as an option on the cashflows from the enterprise
- Probability-weighted expected return method (PWERM) – which estimates value of equity assets based on an analysis of future values assuming various outcomes.
The standard is clear that CVM should only be used in specific circumstances as it is not forward-looking and doesn’t consider option-like payoffs of many share classes. Meanwhile, PWERM is described as typically only used when a company is “close to exit and does not plan on raising additional capital”.
The OPM, meanwhile, is suited to circumstances where future liquidity events are “difficult to forecast” or the company is an early stage of development – so particularly useful for valuing employment-related securities in a young business, for example.
The OPM is based upon a Nobel-prize winning mathematical formula, known as the Black-Scholes formula. This was devised as an option pricing model; it can be used to stratify the current value of equity over different layers of value.
For example, a company with a current value of £20m may offer its management team shares which only participate in value above £30m. Such a structure can achieve the twin objectives of providing a real incentive of equity participation with a relatively modest up-front tax cost for the management team. The OPM can readily provide a value to such shares.
“This is where business valuation gets interesting,” says Strickland. “While it’s a more rarefied subject, it is one that every business valuation professional should know because such share structures are commonly encountered in fiscal valuations, shareholder disputes and even in divorce cases.”
“While the OPM is already used by many valuation professionals, inclusion in the IVS2020 has given the method more credibility,” says Strickland. “It says that this is the method you should be using in these circumstances and is an indicator that it will become mainstream for all accounting firms in the future.”
Hear more about the latest development in valuations
Andrew Strickland will be discussing the valuation of complex share classes in more detail and providing an update on recent legal cases at ICAEW’s Forensic Accounting and Expert Witness Conference on 26 November.
This full-day virtual event includes sessions on changes to legal proceedings in the pandemic, as well as updates on criminal, matrimonial and civil law.