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The Joy of Enterprise Management Incentives
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5 min read

When would you want a low business valuation?

When would you want a low business valuation?
When would you want a low business valuation?

Last updated: 29 April 2024.

There are numerous reasons why you might want to determine the value of your business, and in each scenario, there will be a different outcome that you are hoping for. 

We can all recall startup valuations that have gone through the roof, and for many founders growing their business to be worth as much as possible is a motivating factor behind why they do what they do.

But you would always want your business to be valued as highly as possible, right? Wrong. 

In some situations, a high valuation will be exactly the opposite of what you are looking for.

A valuation for options in an employee share scheme, such as the Enterprise Management Incentive (EMI) scheme, is one example.

In this article, we will explore why you would want a low business valuation, to help founders to understand why this shouldn’t be a cause for concern. 

Low business valuations: What they do and don’t imply

When we begin the valuation process for our clients, one of the questions that our team will ask is whether you would like us to try to get the valuation of your business as low as possible.

As you can imagine, this raises a few eyebrows, and there is often a misconception of what this really means. 

Here, we will look at what getting a low EMI valuation does and doesn’t imply: 

What it doesn’t imply

It may seem counterintuitive to try to get a low valuation, especially if you’ve been through investment and put in work to make sure your business was appraised fairly. 

To put your mind at ease: a low valuation for EMI options doesn’t imply a low perceived value of your shares at the next investment round

Similarly, while investment (if there has been any) is certainly a good starting point for the calculation, it is not necessarily the final number. There are a few reasons for this:

1. Illiquidity of the options

EMI options themselves are illiquid, in that they can’t be sold. Even once the options are exercised, there is still no guarantee that there will be a market for those shares, partly because of the small percentages that EMI recipients usually receive, and partly because a shareholder resolution is usually needed to permit a Stock Transfer.

2. Voting rights

EMI options often effectively lack voting rights, even if they are issued over a voting class of share. This can be for one of two reasons:

  • Because of the small percentages that are usually issued through EMI, the recipient is easily outvoted
  • If the EMI options are made Exit Only (rather than ‘exercisable’), the recipient is never actually a shareholder until immediately prior to an exit, and so never get to use their voting rights.
3. Risk of Forfeiture

This is the term used by HMRC to describe, in simple terms, the risk of the recipients not getting to the point of exercise of their options, and therefore not becoming a shareholder, i.e. losing or forfeiting their options.

4. Scope

An EMI valuation is very different in scope, and therefore methodology, to that of an investment. A big reason for this is that an investment valuation will tend to look into the future, taking into account the business’ growth potential.

An EMI valuation, on the other hand, will look almost entirely at the present day, which tends to look less optimistic than the forward-facing view.

5. “Full Risk” nature

A “Full Risk” investment is one where all of the money you are putting at stake is actually at risk. This is as opposed to an investment under EIS or SEIS for example, where you can claim some of the money you invest back through tax breaks if your investment is a loss. 

Investors often use schemes like this to protect themselves in case the business doesn’t perform as expected, which suggests that the price they pay might be higher than what someone would pay if fully at risk of losing their capital.

While receiving shares through EMI is certainly tax efficient, the money recipients pay to exercise their options is fully at risk.

6. Share class

The class of share you have taken investment over isn’t necessarily the same class that you are issuing options over, so we might be comparing apples and oranges. 

The shares over which options are being issued will not carry any preferred rights to capital or dividends, like a Preferred share class might. If options are being issued over something other than an ordinary share, their rights are usually inferior to those of the other classes.

They might not have voting rights for example, or could sit at the bottom of the waterfall, meaning that they are the last investors to be paid in the event of a sale.

What it does imply

Broadly speaking, a lower EMI valuation means a greater upside for recipients.

To understand why, we will need to look at what we are actually getting approved by HMRC, and what other numbers come into play.

In total, there are three values to consider. Here’s an outline of what they stand for, what they mean, and who decides what they are:

1. Exercise Price

Not approved by HMRC

This is the price the recipient will pay to exercise each option. Other than it needing to be at least nominal value (usually less than £1), there are no restrictions on where this is set, and therefore it is a purely commercial decision.

What it means

Apart from the obvious implication that recipients need to have that money to hand in order to exercise their options (with some exceptions, like the options being exercisable only at Exit), where the Exercise Price is set dictates how much (if any) Income Tax recipients will need to pay when they exercise.

No Income Tax will be due if the Exercise Price is at or above the Actual Market Value (AMV) of the options. AMV is explained below.

2. Unrestricted Market Value (UMV)

Approved by HMRC

UMV appraises the shares as if they had no restrictions and could easily be bought and sold at the prevailing worth of the company at the time.

The prices paid at the latest investment round are a good starting point for this calculation, but because of the reasons listed above (and a few others) the UMV can come in orders of magnitude lower than these market prices.

What it means

This figure is used to calculate the maximum amount of options allowable to be granted to an individual (£250,000 within a three year period) or by the company (£3m unexercised at any time).

3. Actual Market Value (AMV)

Approved by HMRC

This will not be higher than the UMV, but is instead usually up to 30% lower to reflect the illiquidity of options, restrictions imposed on the shares by the company’s Articles of Association, and the Risk of Forfeiture.

What it means

The AMV is used to set the tax point for the shares when they are exercised, and is one of the two numbers that dictate how much tax an EMI recipient will have to pay on exercise.

If the Exercise Price (explained above) is below AMV, the recipients will owe income tax on the difference between the two.

The tax benefits of EMI

AMV and Exercise Price dictate how much Income Tax will be due on exercise, but there are other caveats to EMI’s beneficial tax treatment. Read our article on the tax benefits of EMI to learn more.

A low business valuation might be just what you need

Therefore, while it might seem counterintuitive or scary, a low business valuation can in fact make all the difference when it comes to getting the most out of your EMI scheme. 

We understand that this can get a bit complicated, so if it would be helpful for you to speak with one of our equity experts, feel free to book a free discovery call today to discuss EMI valuations.

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