Does the Choice of a Valuation Method Matter in the Judicial

DOES THE CHOICE OF A VALUATION METHOD MATTER IN THE JUDICIAL

VALUATION OF PRIVATE FIRMS?

Jani Saastamoinen* and Hanna Savolainen

University of Eastern Finland Business School

Abstract

In their study of dissenting shareholder litigation cases concerning public companies, Chen et al. (2010) find empirical support for the “rationality perspective” which means that the choice of a valuation method does not affect the outcome of judicial valuation. However, it is not yet known whether the same holds for private firms. We address this gap in the literature by investigating valuation approaches and fair value estimates presented in the Finnish arbitration tribunal between 1998 and 2014. Our statistical analyses suggest that a valuation method agreement is associated with the outcome of judicial valuation. We interpret this as evidence consistent with the “measurement perspective” which argues that the choice of a valuation method matters which information is incorporated into the valuation estimate. Further, our results point toward the redeemer attempting to exploit favorable information asymmetry in his or her fair price estimate by applying most frequently the valuation approach which has the greatest potential to underestimate the firm’s fundamental value. Our findings may result from differences in the availability of information that is relevant to business valuation between public and private companies.

Keywords: private company, judicial valuation, valuation methodology, fair value

* Corresponding author. Address: P.O. Box 111, FI-81101 Joensuu Finland. e-mail: [email protected]. Tel. : +358 50 442 3463. 1

1. Introduction

In a squeeze out, disputes between a redeeming entity and minority shareholders concerning the valuation of the target company’s shares are settled in court. According to Chen et al. (2010), there are two schools of thought on how valuation methods influence the appraisal outcome in litigation. “The rationality perspective” believes that the choice of a valuation method does not affect the outcome. That is, all available information pertaining to valuation is imputed into the valuation estimate, and the chosen valuation method is adjusted if needed. Conversely, “the measurement perspective” argues that the choice of a valuation method matters as the chosen method determines which information is incorporated into the valuation estimate. In their empirical investigation of judicial valuations of shareholder litigation cases of public companies, Chen et al. (2010) find empirical support for “the rationality perspective” in a sense that the appraisal outcome is insensitive to valuation methodology, and a valuation method agreement between the judge and either the plaintiff or the defendant, which means that the judge and the plaintiff or the defendant use the same valuation approach, does not affect the appraisal outcome.

However, research on the judicial valuation of private companies, most of which are small and medium- sized enterprises (SMEs), is scarce, and how valuation methodologies used in these cases are associated with the outcomes of the appraisal process has not been studied yet. This is a striking gap in knowledge because the economic importance of private firms cannot be underestimated (Ball and Shivakumar, 2005).

In particular, SMEs, which are rarely public companies, account for over 95 % of businesses in most industrialized economies (OECD, 2013). In addition, estimates suggest that the total value of private firm equity exceeds that of public companies (Anderson, 2009). Thus, how the applied valuation methodology in judicial appraisal is associated with the final redemption price is an important issue.

Compared to public firms, there are several difficulties in the valuation of private companies. First, there is no market which sets reliable prices for their shares. Therefore, establishing fair market value for a 2 private firm is challenging (Fama, 1970, Boatsman and Baskin, 1981; Gilson et al., 2000). Second, accounting methods pose another challenge because compared to public companies, requirements for reporting quality are less stringent for private firms (LeClair 1990; Ball and Shivakumar, 2005). Third, the level of disclosure is considerably lower in private firms than in public companies (LeClair, 1990), which increases asymmetric information between the firm’s insiders and outside stakeholders (Officer et al., 2009). Finally, valuation methods used in appraisal may be selected strategically to bias value toward a desired outcome (Beatty et al., 1999)1. Altogether, these issues imply that asymmetric information may play a significant role in the valuation of private firms. As Hirshleifer (2001, p. 1537) suggests, “people are likely to be more prone to bias in valuing securities for which information is sparse.”

This article contributes to the extant research by exploring the choices of valuation methods and their association with redemption prices in disputes concerning private company squeeze outs.

Methodologically, this paper builds on Chen et al. (2010). Our empirical results suggest that a valuation method agreement is associated with the outcome of judicial valuation. This implies that the measurement perspective as opposed to the rationality perspective is more relevant in the case of private companies.

Furthermore, our findings can be interpreted as consistent with the choice of a valuation approach being associated with how the appraiser’s incentives align with the characteristics of the chosen methodology.

More precisely, our results point toward the redeemer attempting to exploit insider information by applying strategically the valuation approaches which have a potential to provide low fair value estimates for the business. We argue that our findings, which appear to contradict Chen et al. (2010), can be explained by the context of private firms, in which asymmetric information is likely to play a more significant role in valuation than in the case of public firms.

1 This is not unique to private business valuation. 3

The empirical data consist of a comprehensive set of hand-collected cases of Finnish private companies subject to arbitration proceedings between 1998 and 2014. Although the data differ significantly from

Chen et al. (2010), the procedure followed in the Finnish arbitration tribunal, which can be regarded as the court, is ideologically akin to the one applied in Delaware courts (Pönkä, 2012). While the market for private company equities in Finland may not be directly comparable to larger markets, such as the UK or the USA, we are convinced that our results provide important insights into wider contexts because in terms of quality, the Finnish judicial system and domestic accounting standards are on par, for instance, with their British and American equivalents (La Porta et al., 1998; Houqe et al. 2012). Hence, we argue that that our results are generalizable and of interest to practitioners and scholars worldwide. As a practical implication, the entity responsible for passing the valuation judgement should pay attention to the valuation method choice and exhibit more willingness to apply income-based methods, because the objective of judicial valuation is to establish a fair value of a going-concern. In contrast, relying on valuation methodologies which are less suitable for this particular purpose may bias the appraisal outcome.

This paper is organized as follows. In Section 2, we describe the context of this study and develop testable hypotheses. Section 3 describes the data, variables and methods used in this study. Statistical analyses are carried out in Section 4. Finally, Section 5 concludes the paper by providing a discussion on the results and their implications together with limitations and guidelines for future research.

2. Judicial valuation, empirical context and hypothesis development

2.1 Basic premises of judicial valuation

The objective of judicial valuation is to determine the fair value of the minority shareholders’ remaining shares. While each party attempts to ascertain this value, the minority shareholder, the redeemer and the judge have different interests and incentives for presenting their appraisal of the true business valuation

(Harper and Rose, 1993). Obviously, a redeemer’s wishes to pay as little as possible in a squeeze-out, 4 whereas a minority shareholder seeks the maximum value for his or her minority interest in the firm

(DiGarbiele, 2006). Finally, the court’s task as an impartial body is to determine an objectively fair valuation for the firm (Chen et al., 2010). In a game-theoretic sense, it has been shown that while the court receives evidence supporting the true valuation, its ability to judge the signals presented in the process determines the accuracy of the final verdict (Yee, 2008). Nevertheless, presenting complex valuation models in a convincing way in judicial appraisal is challenging (Michel and Shaked, 1992).

In business valuation, fair market value is the most widely accepted and recognized standard of value

(Pratt and Niculita, 2008). In judicial valuation, determining an asset’s fair market value is instrumental; it has been a guideline instructed in the US (Boatsman and Baskin, 1981). According to the US Internal

Revenue Code 59-60, a formation of a fair market value requires a willing buyer and a willing seller engaging in a trade of an asset at arm’s length with reasonable endowment of information on the relevant facts affecting the transaction (Anderson, 2009). Consequently, a price does not represent a fair market value if it is influenced by special interests, an atypical buyer or seller (Pratt and Niculita, 2008), or insufficient information (Anderson, 2009) . Furthermore, empirical evidence suggests that the courts in the US have not always equated fair value with fair market value (Pratt and Niculita, 2008).

The traditional valuation approaches to private business valuation are the market-based approach, income- based approach and asset-based approach (e.g. Fodor and Mazza, 1992; Pratt et al., 1998; Hitchner, 2011).

Since all valuation approaches use accounting data as their inputs, they are associated with the quality of financial reporting which, according to FASB (2008), should provide information that is useful in investment, credit or other decisions. More specifically, the inputs of these valuation approaches can be argued to differ in relevance and reliability, because some are forward-looking intended to establish the current value of an asset and others are based on historical cost. FASB (2008) defines relevance as “the capacity of information to make a difference in a decision by helping users to form predictions about the 5 outcomes of past, present, and future events or to confirm or correct prior expectations.” FASB’s definition for reliability is “the quality of information that assures that information is reasonably free from error and bias and faithfully represents what it purports to represent.” In general, forward-looking methods exhibit more relevance, whereas historical cost is perceived reliable (Scott, 2009). Consequently, outputs of these valuation methods are related to their inputs, which, in turn, may lend themselves to be strategically used in judicial valuation.

In judicial valuation, a profound difference between the redeemer and the minority shareholder lies in the information available pertaining to business valuation. Since the redeemer has a controlling interest in the firm, he or she is presumably better informed on the value of the business (Ang, 1991). For example, the quality of data provided to stockholders may not be verifiable to outsiders (Ang, 1991). Due to information advantage resulting from insider information, it is reasonable to assume that the redeemer’s estimate of the firm’s fundamental value is more accurate than the minority shareholder’s estimate. By the same token, the minority shareholder’s and the judge’s valuation estimates are less accurate.

It is straightforward to see that the redeemer and the minority shareholder seek a profit-maximizing outcome for themselves in judicial valuation and make estimates which are subjective and consistent with their respective incentives (Beatty et al., 1999). To maximize profit, the redeemer’s incentive is to offer a redemption price below his or her fair value estimate because insider information allows him or her to make a more accurate estimate than either the minority shareholder or the court (Altamuro et al., 2013).

Due to the redeemer’s information advantage in valuation, the minority shareholder knows that the redeemer’s offer does not include the information rent and presents a claim that exceeds the redeemer’s offer by presenting evidence that inflates the fair value estimate above the one proposed by the redeemer.

Therefore, both litigants have incentives to select strategically valuation methods which bias the outcome toward a desired outcome (Beatty et al., 1999). 6

2.2 Empirical context: Judicial valuation procedure in Finland

Under the Finnish Limited Liability Companies Act (Limited Liability Companies Act 624/2006 henceforth referred to as LLCA 624/2006), an entity holding title to over 90 % of a company’s shares and votes has the right and the obligation to acquire the remaining shares at a fair price. If the redeeming entity or minority shareholders are unable to reach an agreement on the redemption price, either party may apply for a commencement of arbitration proceedings where the redemption price is settled. The arbitration proceedings in Finland correspond to traditional litigation as their decisions are treated as court rulings.

In an arbitration proceeding, the Redemption Committee of the Central Chamber of Commerce shall appoint a requisite number of impartial and independent arbitrators, which correspond to the court, with required expertise for the task. The committee may also appoint a trustee, who is required to be competent, to observe the interests of minority shareholders in the arbitration proceeding. The redeemer pays for the trustee’s costs regardless of the arbitration outcome (LLCA 624/2006)2. He or she has a right and an obligation to make a case on behalf of minority shareholders and to present evidence in support thereof in the arbitration proceedings.3

The arbitration proceedings set the final redemption price for the minority interest in a firm. LLCA

624/2006 states that “the redemption price shall be equal to the fair price of the share; in the absence of other evidence, the fair price of a share acquired for consideration shall be the price agreed for the share.”

In another court ruling (KKO 1993:31), the fair price - the fair value of shares paid in cash to minority shareholders - is the market price which is based on past transaction prices4. After reviewing the presented evidence, the arbitration tribunal announces the redemption price which is paid by the redeemer as a

2 It can be argued that the trustee’s incentives are aligned with the minority shareholders’ interests, because it is his or her duty to work for their benefit, and the trustee’s cost are borne by the redeemer. 3 While the description of the arbitration procedure focuses on the Finnish rules, we believe the basic premises and procedures do not differ markedly from other countries. 4 This concept of market value has also been a standard in the Delaware Block Method (Pratt and Niculita, 2008), in which it is one of the components in a linear weighted average of available valuation estimates (Yee, 2004). The Delaware Block Method has been an influential appraisal method in the US public company shareholder litigation cases (Chen et al., 2007). 7 settlement to minority shareholders for gaining title to their remaining stake in the company. The decision of the arbitration tribunal is bound by the redeemer’s original redemption price offer from below and by the highest redemption price claim made in the arbitration procedure. Hence, although individual minority shareholders may provide different fair price estimates, each shareholder receives the same redemption price regardless of their prior claims.

2.3 Valuation approaches

2.3.1 Market-based approach

In general there are two approaches to assess the market value of a company. Transaction prices can be used to observe the market value of a company if they are available, and in case they are absent, a comparable company can be used to estimate the market value of a firm (Anderson, 2009). To understand how the market value of private firms is established, it is important to contrast them to public companies.

The stock price of a public company is the best estimate for the present value of future benefits (e.g. dividends) an investor when he or she purchases minority interest in the company. In perfect and complete asset markets, market values are relevant (Barth and Landsman, 1995) and reliable (Ramanna, 2003). The standard finance theory assumes that the market price should correspond to the fundamental (intrinsic) value of the firm (Lee et al., 1999)5. However, a textbook definition for the fundamental value is “the value it would have in an efficient market if there is no inside information” which is a theoretical concept because information asymmetries are persistent (Scott 2009, p. 116). Nevertheless, since sufficient market liquidity implies information efficiency (e.g. Chordia et al., 2008; Chung and Hzardil, 2010), the stock price of a listed firm is usually a reliable benchmark of its fair value (Power, 2010), but it is difficult to

5 However, difficulties in the measurement of intrinsic value and/or significant trading costs cause the market price of a security to diverge from its fundamental value (Lee et al., 1999). 8 establish whether market value represents fundamental value because the latter lacks objective measurement (Milburn, 2008).

By contrast, the market value of a private company is a different concept. Although demand exists, it is difficult to establish market valuation for private firms (Pricer and Johnson, 1997). While public companies are continuously priced in stock exchanges, private companies are priced in a point in time

(Ang, 1991; Slee 2011). If prior transaction prices are used in valuation, their accuracy depends on the number of transactions, comparability, the time passed between transactions, and “the arm’s length nature” of these transactions (Harper and Rose, 1993). In light of this, Anderson (2009) argues that there are six reasons why the fair market value of a private company is rarely observable: 1) a lack of active markets for private equity, 2) possible restrictions on trading private firm shares, 3) the cost of obtaining information on a private firm, 4) transaction costs, 5) lack of pricing history, and 6) equity interest is often purchased in blocks which contributes to infrequency of trades and lack of transparency. Furthermore, in many cases, exchanges of private company shares concern a controlling interest, not a minority interest as in public markets, which has implications on valuation (Mellen and Evans, 2010). Slee (2011) argues that a private company has three market values at the same time, which depend on the buyer type. First, an asset-based market value is the expected selling price based on the net asset value. Second, a ‘financial’ market value is the value attached to a going concern by a nonstrategic buyer who discounts or capitalizes future benefits of the firm as a standalone enterprise. Third, a market value based on synergy is the value which a buyer who expects to accomplish benefits from combining two firms is willing to pay for a target company.

The markets for private business equity, and small businesses in particular, are inefficient compared to public firms. Transaction costs are substantial because there are no centralized exchanges with sufficient liquidity where to trade the shares of private firms (Ang, 1991), which also leads to a liquidity premium 9 demanded by the buyers of private equity (Slee, 2011). Also, information asymmetry is more prominent in private equity markets (Elnathan et al., 2010), which is exacerbated by lack of liquidity suggesting that transaction prices of private companies’ shares are likely to be highly distorted by private information

(e.g. Chordia et al., 2008; Chung and Hzardil, 2010)6. Even recently made transactions may be uninformative (Slee, 2011), which is compounded by the low disclosure requirements for private firms

(Ball and Shivakumar, 2005), unaudited financial reports (Slee, 2011) and a lack of competitive sources of information, such as securities analysts (Capron and Shen, 2007). In conclusion, these arguments suggest that company insiders have a substantial information advantage in assessing the fundamental value of a private firm.

Since market prices for private firms have limited relevance and reliability, the standard market valuation approach is to compare a private firm to sufficiently similar public companies (Pratt and Niculita, 2008).

The comparables method utilizes multiples obtained from the income statements and balance sheets of public firms to determine the market value of a private firm. More specifically, the guideline company method prescribes using value measures based on firms which have publicly traded assets and which are similar to a private company being valued (Dukes, 2001). However, it is often challenging to find public companies from which the obtained multiples can be realistically applied to private firms and to small businesses in particular (Pricer and Johnson, 1997).

Determining a comparable company requires ‘professional judgment’ (Anderson, 2009), which adds to the subjectivity in valuation. In fact, what is considered ‘comparable’ requires justification because the appraiser may use factors such as capital structure, product line, size, financial ratios and competition as measures of comparability (Dukes, 2001). According to Ang (1992), fundamental differences between

6 However, Fischel (2002) argues that isolated trades between parties that possess insider information could be informative. 10 public and private firms can be traced back to their objective functions: while a public firm maximizes the current market price, long term intrinsic value (if the two diverge) and a non-owner manager’s income from having control rights, private businesses have more diverse objective functions in which both the current and long term value maximization are weighted. Moreover, in the case of small private firms, the owner’s personal and business wealth are often integrated with respect to compensation, diversification, risk exposure and tax liability, the objective function is complex and distinctly different from the owner of a public firm (Ang, 1992). Mellen and Evans (2010) argue that differences between private companies, even large ones, and public companies can be attributed to various factors including “size, market share, access to capital, depth of management, breadth of product lines, brand names, and distribution systems.”

Further, Slee (2011) contends that differences in risk, liquidity and management involvement between public and private companies suggest that the former, in general, cannot be used as a substitute for the latter. As a result, the appraiser should not rely on single factor to assume comparability (Dukes, 2001).

In practice, appraisers appear to use qualitative judgment in the selection of relevant factors, which leads to potentially substantial differences in valuations presented in court (Beatty et al., 1999).

Even if information on a guideline public company were available a direct application of these data would yield biased estimates, because it has been demonstrated that private firms as opposed to comparable public firms are subject to a significant discount in valuation (Koeplin et al., 2000; Officer, 2007), referred to as the private company discount, which can be attributed to “the shareholder-level attribute of lack of marketability” for a minority interest (Pratt and Niculita, 2008, p. 268). For instance, survey-based evidence suggests that the private company discount for the US market is between 26 % and 50 % (Dukes et al., 1996) and for the Finnish market it is between 15% and 50% (PwC, 2015) though the latter survey is rather limited. These results conform to studies using archival data, which report discounts as high as

25% to 30 % for US firms (Beatty et al., 1999; Koeplin et al., 2000) and 54 % for non-US firms (Koeplin et al., 2000). 11

These arguments suggest that the market value of a private company exhibits limited relevance and reliability: it does not provide timely information which can be considered useful in rational investments or other decisions, and it is not sufficiently free of errors or bias and does not represent faithfully the value of the business. Further, given the information asymmetry which allows the redeemer estimate the fair value of the business more accurately, and the observed private company discounts, we propose that

H1: The redeemer applies market-based valuation methodology more frequently than the minority shareholder.

2.3.2 Asset-based approach

The asset-based approach is based on the net assets of a firm, and it relies primarily on accounting records of the items on the balance sheet. According to Gasson and Bertoli (2002), assed-based valuation should only be used if the value of the business is easily expressed in terms of its assets. Especially in litigation, a historical record of an asset, that is, its book value, is often regarded as credible due to its verifiability as opposed to projected benefits whose reliability is more difficult to establish (Pratt and Niculita, 2008).

As a valuation method, the asset-based valuation approach seeks to put fair values on items recorded in the balance sheet (Pratt and Niculita, 2008). A reason for its popularity is that an asset can be viewed as a store of value, which can be used to generate future benefits (Pricer and Johnson, 1997). On the other hand, it is a static figure which does not account for the varying future earnings power of assets making it a theoretically weak method (Pricer and Johnson, 1997; Andersson, 2009). Under ideal conditions, the use of fair values, which are perceived as value relevant for many asset classes (Barth, 2001), produces a realistic, value relevant balance sheet (Barlev and Haddad, 2003). In particular, fair values of financial instruments or other in-exchange assets are relevant and reliable in most cases (Carroll et al., 2003;

Botosan and Huffman, 2015). While appraising the fair value of marketable securities and some tangible 12 assets, such as investment property, is feasible, assessing the fair value of intangible assets, such as goodwill, is a more complex task and subject to a potential agency conflict resulting in unreliable valuations (e.g. Landsman, 2007; Ramanna and Watts, 2012). Furthermore, as an accounting amount is considered relevant if it exhibits a predictable association with public stock market values (Barth et al.,

2001), this is problematic for private firms because they lack this correspondence. However, historical costs for value in-use assets may still hold decision usefulness to investors for forecasting purposes

(Botosan and Huffman, 2015).

One problem may arise from the fact that historical cost accounting nests the concept of conservatism which means, loosely speaking, a preference for a lower (higher) equity (debt) value to a higher (lower) one (Barlev and Haddad, 2003). Under conservatism, recording gains are subject to a higher verifiability than recording losses (Ross, 2003a), which implies that reliability is preferred over relevance (Barlev and

Haddad, 2003). As a consequence, net assets tend to be understated due to higher requirements for verifiability of gains (Ross, 2003b), which leads to book values with limited relevance because they do not fully account for changes in price levels, depreciation, amortization, research and development capitalization, and opportunity costs (Harper and Rose, 1993; Barlev and Haddad, 2003). Further, since the purchaser of an asset expects that its value in-use exceeds its purchase price, the asset’s economic and book value tend to diverge (Benson, 1982). However, in some cases, such as real estate or marketable securities, asset values may appreciate over time (Harper and Rose, 1993). Indeed, Pratt and Niculita

(2008, p. 352) argue that “accounting book value is not a business valuation method at all”, because the values presented in a balance sheet based on historical cost “are usually not representative of a current economic value for business valuation purposes.”

While adopting accounting standards which incorporate fair value accounting, such as the International

Financial Reporting Standards (IFRS), may be a feasible option for some private firms in order to satisfy 13 the information needs of external stakeholders, small firms, in general, report using the local accounting principles which are based on historical costs. In addition, their financial reports are unaudited in many instances (Slee, 2011), which contributes to the lack of relevance. Moreover, if necessary, private firms are more likely to resolve problems emerging from asymmetric information by allowing company outsiders an insider’s access to the firm’s records (Ball and Shivakumar, 2005).

Based on the characteristics of accounting records which are reliable but exhibit limited relevance as they are unlikely to reflect the economic value of assets, it is proposed that

H2: The redeemer applies asset-based valuation methodology more frequently than the minority shareholder.

2.3.3 Income-based approach

The income-based approach uses discounted economic income to summarize the current value of the future income. This approach contains a measure for economic income, methods of projecting them into the future, and applications of the discount rate. The resulting value, if valuated as a standalone business, is fair market value (Pratt and Niculita, 2008). The income-based approach and the valuation methods relying on it, particularly the discounted cash flow (DCF) method, are widely accepted for valuing small businesses (Fodor and Mazza, 1992; Pratt et al., 1998; Fernández, 2002; Anderson, 2009). In the financial literature, the DCF method is advocated as the theoretically correct choice for business valuation, particularly in the case of going concerns (Pratt and Niculita, 2008). Indeed, empirical evidence suggests that the adoption of forward looking methods (including DCF) produce less biased estimates of fair value

(Kaplan and Ruback, 1995; Chen et al., 2007).

On the other hand, the weakness of this method is its dependency on forecasts (Pratt et al., 1998; Gasson and Bertoli, 2002; Martins, 2011). In addition, the validity of the valuation process depends on two 14 essential inputs – the expected economic income and the discount rate used (Dukes et al., 1996). Typically, projections involve specific values for economic benefits accruing in the immediate future, e.g., three to ten years, after which a terminal cash flow together with a terminal growth rate for this cash flow is assumed. In consequence, even small variations in the terminal growth rate may cause large fluctuations to the estimated value of the business (Martins, 2011). Moreover, selecting an appropriate discount rate which accounts for business risk is challenging (Lloyd, 2007). Thus, while the DCF method is theoretically sound in a world of perfect markets and no uncertainty (Yee, 2004), reliable estimates of fair value are much harder to produce in a market for small business equities, which does not satisfy these preconditions.

Although theoretically sound if applied correctly, the income-based approach lacks popularity in actual use (Lippitt and Mastracchio, 1993; Beatty et al., 1999). The most likely reason is, especially in judicial valuation, that projections of future economic benefits lack credibility and a discount rate may incorporate a great deal of subjectivity (Kantor, 2008). In addition, the method appears to be complex to use (Carland and White, 1980). Compared to public firms, earnings figures of private enterprises require several adjustments in order to make them usable in appraisal (LeClair, 1990). The empirical evidence from public companies also suggests that due to the agency conflict, inputs of valuation models may be manipulated to obtain desired valuations (Carlin and Finch, 2009; Avallone and Quagli, 2015). Indeed, estimates of fair value have been criticized on the grounds such as verifiability and management discretion (Barth,

2001). As a consequence, the income-based approach can be used to support different valuations for the same business depending on the assumptions used in the model which, in turn, may be a product of the appraiser’s incentives. Hence, the income-based approach can be used to produce the most accurate estimate of the enterprise value as well as valuations that either overestimate or underestimate the fundamental value of a business. However, Chen et al. (2007) find that the introduction of forward-looking valuation methods has improved fair value estimates in judicial valuation after.

Thus, the income-based valuation methods exhibit relevance because their predictive properties, but lack reliability due to subjectivity in the choice of inputs in valuation methods. Further, given that the market- based and asset-based valuation approaches exhibit properties which are likely to provide support to low fair value estimates, whereas the income-based methods provide more latitude to the appraiser, we propose the following hypothesis:

H3: The minority shareholder applies the income-based valuation approach more frequently than the redeemer.

2.4 Rationality perspective versus measurement perspective

The valuation methodology approaches described in Sections 2.3.1 to 2.3.3 and their subsequent applications in judicial valuation and their association with the outcome of the appraisal process is not well understood yet. As argued by Chen et al. (2010), valuation methods may or may not influence the appraisal outcome in litigation. They propose that under the rationality perspective the choice of a valuation method does not affect the outcome because all available information pertaining to valuation is imputed into the valuation estimate, and the chosen valuation method is adjusted if needed. In contrast, under the measurement perspective, the choice of a valuation method matters because it determines which information is incorporated into the valuation estimate. In their empirical investigation into litigation cases of public companies, Chen et al. (2010) find that 1) judicial valuation method does not produce a systematic bias on the appraisal outcome, 2) valuation method agreement between the judge and the plaintiff/the defendant does not bias the appraisal outcome, and 3) the judge takes into account contextual factors and the quality of litigants’ valuation analyses in the valuation analysis. As a result, they argue that these findings provide empirical support to the rationality perspective.

Other empirical studies related to judicial valuation have disclosed varying evidence on the potential influence exerted by claimants’ incentives. In a study of bankruptcy cases in which value is determined in 16 a negotiation process involving claimants, Gilson et al. (2000) provide evidence of a systematic strategic behavior which seeks to affect the negotiated outcome of firm valuation. In a related manner, Beatty et al.

(1999) find that valuation based on a testimony aligns with an expert’s incentives. The court, however, has been found to provide unbiased value estimates (Englebrecht and Jamison, 1977; Beatty et al., 1999).

The findings described above prompt us to test whether “the rationality perspective” holds in the judicial valuation of private firms using the following hypotheses:

H4: Valuation approach agreement between a) the judge and the minority shareholder and b) the judge and the redeemer does not bias the appraisal outcome.

In regard to individual valuation approaches, there are few studies which have addressed their application in private business valuation and in judicial valuation. In the case of private firms, LeClair (1990) argues that a valuation based on earnings provides better estimates than the adjusted book value method. Harper and Rose (1993) report that most valuation methods produce large estimation errors. However, Pricer and

Johnson (1997) do not find any valuation method commonly used in small business appraisal to be superior in predicting business value. As to judicial valuation, DiGabriele (2006) finds that courts in the

US exhibit preferences for valuation approaches, which depend on the type of litigation and the level of the court. He finds that courts prefer market value in dissenting shareholder cases. Further, Chen et al.

(2007) investigate shareholder litigation cases and suggest that the adoption of forward looking valuation methods as opposed to historical methods has not increased the manipulative nature of litigants’ valuations; instead, they argue that the use of forward looking methods has improved the quality of estimates. Since there is no unifying theme on how the adoption of an individual valuation approach influences judicial valuation and its outcome, we propose the following hypotheses:

H5: Valuation approach agreement between a) the judge and the minority shareholder and b) the judge and the redeemer when both use the market-based approach does not bias the appraisal outcome.

H6: Valuation approach agreement between a) the judge and the minority shareholder and b) the judge and the redeemer when both use the income-based approach does not bias the appraisal outcome.

H7: Valuation approach agreement between a) the judge and the minority shareholder b) the judge and the redeemer when both use the asset-based approach does not bias the appraisal outcome.

3. Data, variables and analysis methods

3.1 Data source

The data of this study were hand-collected from the trade registry of the Finnish Patent and Registration

Office. The resulting data set of 94 cases contains all registered private firm arbitration proceedings between 1998 and 20147. In over 90 % of the cases, the arbitration process was initiated by the redeemer which was an organization (as opposed to a private person) in 88 % of the cases. These data were amended by additional information from Voitto database which contains the public accounting records (income statements, balance sheets) of the Finnish private limited companies. As the unit of measurement for variables with monetary values was the Finnish Markka (FIM) between 1998 and 2001, these values were converted to the euro which has been the legal currency in Finland since January 1st, 2002, using the official exchange rate of one euro equaling 5.94573 FIM.

3.2 Variables

Several variables were constructed from the data extracted from the arbitration tribunal cases and accounting records. Key measures included (a) the valuation methodology employed and (b) the estimate of fair value by (i) the minority shareholder (MSH), (ii) the redeemer (RED) and (iii) the arbitrator (ARB), which is the judge in the Finnish litigation cases. We distinguished between three valuation approaches,

7 Although the sample size is small, it is, incidentally, equal to the sample size in Chen et al. (2010). 18 namely, market value (MV), asset value (AV) and income-based value (IV)8. It must be noted, however, that in many cases an estimate of the redemption price was not based on a single methodology. Thus, the measures employed here are the indicators of the valuation methodology mainly used in the fair value estimate.

While identifying the main valuation approach was straightforward in most cases, there were also some cases in which it was not clear which approach was ‘the main argument’. To illustrate, suppose, for example, that a minority shareholder argues that the firm’s asset value is 100 000 euros and the income- based value is 130 000 euros and then demands to be compensated by 12 000 euros for his or her minority interest in the firm. In this case, we would file the valuation approach under the income-based approach because its estimate is closer to the fair price demanded. Another case might involve a redeemer offering a positive fair price for a firm for which earnings and the book value of equity are negative. In this case, we would file this valuation under the income-based valuation approach because the redeemer’s offer implies that he or she has a positive expectation of the firm’s value suggesting a forward looking valuation being in use though not disclosed in the case filing. Furthermore, it must be emphasized that a marked difference to the business valuation literature is that the concept of market value in the empirical section is usually based on prior transaction prices. That is, it is not a market value based on multiples obtained from a comparable public entity used in the traditional business valuation (Pratt and Niculita 2008), which makes it a theoretically weak approximation of the fair market value as argued in Section 2.2.1.

These valuation methodologies together with information on the user of the methodology are applied to construct dummy variables:

MSH_MA takes the value 1 if the minority shareholder uses market value.

8 There were also seven cases in which a valuation approach could not be identified for either the minority shareholder (seven cases) or the redeemer (two cases). In the case of the redeemer, these cases overlapped with those of the minority shareholder.

RED_MA takes the value 1 if the redeemer uses market value.

MSH_AV takes the value 1 if the minority shareholder uses asset value.

RED_AV takes the value 1 if the redeemer uses asset value.

MSH_IV takes the value 1 if the minority shareholder uses income value.

RED_IV takes the value 1 if the redeemer uses income value.

Furthermore, we use dummy variables as indicators of the cases in which the arbitrator and the minority shareholder or the arbitrator and the redeemer base their valuation estimates on the same methodology.

We use two sets of these variables. The aggregated valuation agreement variables are9:

ARB_MSH takes the value 1 if the arbitrator and the minority shareholder use the same valuation

methodology.

ARB_RED takes the value 1 if the arbitrator and the redeemer use the same valuation methodology.

For a more fine-grained analysis, we use the ‘individual valuation methodology agreement variables’, which are:

MV_ARB_MSH takes the value 1 if the arbitrator and the minority shareholder use market value.

MV_ARB_RED takes the value 1 if the arbitrator and the redeemer use market value.

AV_ARB_MSH takes the value 1 if the arbitrator and the minority shareholder use asset value.

AV_ARB_RED takes the value 1 if the arbitrator and the redeemer use asset value.

IV_ARB_MSH takes the value 1 if the arbitrator and the minority shareholder use income value.

IV_ARB_RED takes the value 1 if the arbitrator and the redeemer use income value.

In the cases in which several minority shareholders presented different fair value estimates, we used the highest estimate because the arbitrator must award the same redemption price to every shareholder

9 Of course, it is possible that all parties involved use the same valuation approach. 20 irrespective of their individual claims, and the arbitration tribunal cannot award prices in excess of those claimed. Further, the trustee’s estimate of the fair value was used as a substitute for the minority shareholder’s valuation estimates if they were absent (16 cases).

Following Chen et al. (2010), the final redemption price announced by the arbitrator can be expressed as a weighted sum of the minority shareholder’s and the redeemer’s valuation estimates

ARB  RED  (1)MSH , (1)

in which  0,1 is the weight the arbitrator places on the argumentation presented by the minority shareholder and the redeemer in the appraisal outcome. If   1, the redemption price announced by the arbitrator equals the redeemer’s valuation estimate. Conversely, if   0 , the final price equals the minority shareholder’s estimate. If both parties receive equal weight in the final outcome, then   0.5.

This outcome corresponds to “splitting the difference” which, however, has no conceptual, intellectual or theoretical basis (DiGabriele, 2006).

For empirical testing purposes, Equation (1) can be rearranged as

ARB  MSH   . (2) RED  MSH

In the cases where the minority shareholder and the redeemer agreed on the redemption price (15 cases), and thus, the arbitrator confirms this value as the final price, the value of  cannot be determined because both the numerator and the denominator are equal to zero. In these cases, the value of  was set equal to

0.5 reflecting a neutral valuation. 21

The control variables used in regression analyses include dichotomous variables which control for potential industry differences and firm size. First, litigants and the court may exhibit industry-specific preferences for valuation approaches (DiGabriele, 2007). Second, firms of different sizes vary across factors such as business risk, capital structure and the source of funds (Ang 1991; 1992). The industry dummy variables (referred to as INDUSTRY in regression equations (A) to (F)) include retail and wholesale trade (TRADE), real estate (REALEST), services (SERVICES), industrial manufacturing

(MANUFACT) and communication services (COMMUNIC). A logarithmic transformation of total assets

(ASSETS) is a proxy for firm size. In addition, we use a dummy variable to control for the cases in which the litigants reached an agreement upon the redemption price during the arbitration process

(AGREEMENT).

3.3 Analysis methods

This study employs analytical archival research methodology. The proposed research hypotheses are analyzed using proportions tests and ordinary least squares (OLS) regression. The proportions test performs a test for equality of proportions in two groups. OLS regression models use  as the dependent variable and the variables for the used valuation methodologies and valuation agreements as predictors.

We control for the potential (unobservable) industry effects and firm size in the OLS models.

The regression models A, B and C are:

  0  1 ARB _ RED   2 ARB _ RED   (A)

7    0  1 ARB _ RED   2 ARB _ RED  3 AGREEMENT   i INDUSTRYi   (B) i4

7   0  1 ARB _ RED   2 ARB _ RED  3 AGREEMENT  i INDUSTRYi i4 (C)

 8 Ln(ASSETS)  

The variables of interest in the regression models A to C are ARB_RED and ARB_MSH. Model A omits all control variables. Model B includes industry dummies and the control for an agreement upon the redemption price. Since there was missing observations for the firm size proxy (84 observations versus 94 observations for other variables), a separate regression, Model C, includes the firm size variable.

The regression models D, E and F are:

     MV _ ARB _ RED   IV _ ARB _ RED   IV _ ARB _ RED 0 1 2 3 (D)   4 MV _ ARB _ MSH   5 IV _ ARB _ MSH   6 AV _ ARB _ MSH  

   0  1MV _ ARB _ RED   2 IV _ ARB _ RED  3 IV _ ARB _ RED   4 MV _ ARB _ MSH 11  5 IV _ ARB _ MSH   6 AV _ ARB _ MSH   7 AGREEMENT   i INDUSTRYi   (E) i8

   0  1MV _ ARB _ RED   2 IV _ ARB _ RED  3 IV _ ARB _ RED   4 MV _ ARB _ MSH 11  5 IV _ ARB _ MSH   6 AV _ ARB _ MSH   7 AGREEMENT   i INDUSTRYi (F) i8

 12Ln(ASSETS)  

These models include MV_ARB_RED, IV_ARB_RED, AV_ARB_RED, MV_ARB_MSH, IV_ARB_MSH and AV_ARB_MSH as explanatory variables. With respect to control variables, Models D to F follow a similar logic as Models A to C do.

4. Results

4.1 Descriptive statistics of empirical data

Table 1 reports the application frequencies of different valuation approaches across the parties involved in arbitration proceedings. The results indicate that market value is the most frequently applied valuation approach followed by the asset-based and income-based valuation approaches, in respective order. All parties exhibit a similar preference order for these valuation methods.

We also carry out a one-sample proportions test of the application frequency of a valuation methodology for each party. Since we have no prior empirical frequency to use as a benchmark, we assume that each valuation approach would exhibit 33.3 % application rate if selected randomly. The results indicate that redeemers apply market value (p < 0.01) significantly more often and the income-based valuation approach (p <0.01) less often than a random choice would imply. This pattern is also visible in the choices of arbitrators who use the market approach (p < 0.01) more and the income-based approach (p < 0.1) less frequently than the random choice would warrant. In contrast, minority shareholders, on aggregate, appear to select a valuation approach randomly because their choice patterns do not exhibit statistically significant differences from the random choice. These findings suggest that redeemers select valuation methods strategically, whereas minority shareholders’ choices may be more of a random kind, and the arbitrator may wish to follow the guideline of fair market value in his or her methodology choice. Furthermore, these results are consistent with DiGarbriele (2006) who finds that courts prefer market value in dissenting shareholder cases, and they provide additional empirical support to the notion that “the model advocated in the literature as being theoretically correct is seldom chosen in practice” in small business valuation

(Lippitt and Mastracchio, 1993, p. 52).

Table 1. Application frequencies of valuation approaches and results of proportions test.

Approach Arbitrator z-statistic Minority shareholder z-statistic Redeemer z-statistic Market 43 (46) 2.73*** 33 (35) 0.92 47 (51) 3.62*** Income 23 (24) -1.69* 25 (27) -0.90 19 (20) -2.57** Asset 26 (28) -1.02 29 (31) 0.01 25 (27) -1.25 Total 92 (100) 87 (100) 92 (100) Notes: Rounded percentages in parentheses. The proportions test assumes an equal (33.3 %) incidence for each valuation approach. There were 2 cases for the arbitrator, 7 cases for the minority shareholder and 2 cases for the redeemer, in which a valuation approach could not be identified in any of the three categories. Statistical significance (two-tailed): *** p-value < 0.01; ** p-value < 0.05; * p-value < 0.1.

Table 2 reports descriptive statistics for the variables used in regression analyses. Because the mean

(median) value of   0.619 (0.685) is over 0.5, it indicates that the arbitration tribunal, on average, places more weight on the redeemer’s valuation estimate in the final redemption price, because The aggregated valuation method agreement variables, ARB_RED = 0.628 and ARB_MSH = 0.564, suggest that the arbitrator shares the same valuation methodology with the redeemer than with the minority shareholder. The individual valuation approach agreement variables exhibit a pattern which is reminiscent of their application rates illustrated in Table 1. Market value, asset value and income-based value in that order are shared by the arbitrator and the redeemer and the arbitrator and the minority shareholder alike.

Table 2. Descriptive statistics.

Variable Mean S.D. Min. Max. Median α 0.619 0.364 0 1 0.685 ARB_RED 0.628 0.486 0 1 1 ARB_MSH 0.564 0.499 0 1 1 MV_ARB_RED 0.340 0.476 0 1 0 IV_ARB_RED 0.117 0.323 0 1 0 AV_ARB_RED 0.170 0.378 0 1 0 MV_ARB_MSH 0.277 0.450 0 1 0 IV_ARB_MSH 0.106 0.310 0 1 0 AV_ARB_MSH 0.181 0.387 0 1 0 AGREEMENT 0.160 0.368 0 1 0 MANUFACT 0.160 0.368 0 1 0 SERVICES 0.064 0.246 0 1 0 COMMUNIC 0.351 0.480 0 1 0 REALEST 0.170 0.378 0 1 0 TRADE 0.255 0.438 0 1 0 ASSETS (in Euros) 25 000 000 72 000 000 22 600 603 000 000 4 392 500 Notes: Obs. = 94 (84 for ASSETS).

As to the control variables, the industry dummies show that a third of cases concern communications firms, a quarter retail and wholesale trade enterprises, approximately a sixth manufacturing and real estate firms each and the rest services businesses. AGREEMENT indicates that the redeemer and minority shareholder(s) reach an agreement upon the redemption price during the arbitration process in 16 % of the cases. ASSETS suggests that approximately 90 % of the firms covered in this study can be classified as

SMEs by the European Union definition. It must be noted, however, that these figures indicate that the

25 sample is not representative of the distribution of firms in the economy by either industry composition or firm size.

The correlation matrix for the variables used in the regression analyses is reported in Table 4. They also imply that  is associated with the shared valuation methodology in a sense that the correlation coefficient between and ARB_RED is reasonably high (0.33). In a similar manner, the same coefficient between

and ARB_MSH (-0.28). In regard to correlations between and individual valuation methodologies, the highest correlation coefficients can be found in MV_ARB_RED (0.32), MV_ARB_MSH (-0.20) and

AV_ARB_MSH (-0.17). These results suggest that there may be associations between valuation method agreement concerning individual methods with the final price exhibiting bias toward the valuation estimate of the minority shareholder or the redeemer.

There are also some correlations between explanatory variables which are worth inspecting more carefully. Correlation coefficients in columns (2) and (3) are high but they are not concerning because the aggregated and individual valuation method agreement variables are not in the same regression equations.

However, the correlation coefficients between MV_ARB_RED and MV_ARB_MSH (0.56),

MV_ARB_RED and AV_ARB_MSH (-0.33), IV_ARB_RED and IV_ARB_MSH (0.41) and AV_ARB_RED and AV_ARB_MSH (0.67) as well as between some industry dummy variables may be concerning because they are a potential source of multicollinearity. We discuss how this problem was dealt with in Section

4.3.

Variable (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) α (1) 1.00 ARB_RED (2) 0.33 1.00 ARB_MSH (3) -0.28 0.17 1.00 MV_ARB_RED (4) 0.30 0.55 0.09 1.00 IV_ARB_RED (5) -0.01 0.28 -0.08 -0.26 1.00 AV_ARB_RED (6) 0.06 0.35 0.17 -0.33 -0.16 1.00 MV_ARB_MSH (7) -0.04 0.18 0.54 0.56 -0.23 -0.28 1.00 IV_ARB_MSH (8) -0.19 -0.09 0.30 -0.25 0.41 -0.16 -0.21 1.00 AV_ARB_MSH (9) -0.17 0.08 0.41 -0.34 -0.17 0.67 -0.29 -0.16 1.00 AGREEMENT (10) -0.14 0.28 0.27 0.05 0.02 0.27 0.06 0.04 0.25 1.00 MANUFACT (11) -0.03 0.04 -0.20 -0.13 0.11 0.11 -0.20 -0.06 0.02 -0.19 1.00 SERVICES (12) -0.09 0.02 -0.03 -0.19 0.18 0.11 -0.16 0.05 0.10 -0.11 -0.11 1.00 COMMUNIC(13) -0.14 -0.13 0.11 -0.20 -0.06 0.14 -0.06 0.11 0.12 0.29 -0.32 -0.19 1.00 REALEST (14) 0.08 0.11 0.17 0.33 -0.16 -0.13 0.29 0.03 -0.14 -0.04 -0.20 -0.12 -0.33 1.00 TRADE (15) 0.16 0.00 -0.08 0.15 0.01 -0.20 0.07 -0.12 -0.09 -0.06 -0.26 -0.15 -0.43 -0.27 1.00 Ln(ASSETS) (16) 0.07 0.14 -0.03 0.40 -0.14 -0.18 0.19 -0.20 -0.07 -0.11 0.13 -0.01 -0.13 0.07 -0.02 Notes: Obs. = 94 (84 for ASSETS). ASSETS logarithmized. Table 3. Correlations matrix.

4.2 Strategic choice of valuation methods by litigants in judicial valuation of private firms

Table 4 shows the two-sample proportions test for valuation methods applied to justify the fair price. In essence, we investigate whether the redeemer and the minority shareholder take advantage of the properties of a valuation method to bias their fair value estimates. We assume that the arbitrator aims for neutrality because he or she has no incentive to select valuation method strategically.

Table 4. Two-sample proportions tests of the applied valuation approaches. Variable Approach Mean S.E. Difference Prediction Proportion test MSH_MV Market 0.351 0.049 RED_MV – MSH_MV Positive 0.145 RED_MV Market 0.500 0.052 (2.07**) MSH_IV Income 0.266 0.046 MSH_IV – RED_IV Positive 0.064 RED_IV Income 0.202 0.041 (1.03) MSH_AV Asset 0.309 0.048 RED_AV – MSH_AV Positive -.021 RED_AV Asset 0.266 0.046 (-0.64) Notes: z-statistic in parentheses. Statistical significance (two-tailed): *** p-value < 0.01; ** p-value < 0.05; * p-value < 0.1.

The results provide some empirical support for the strategic choice of valuation methods. First, the redeemer uses market value more frequently (p < 0.05) than the minority shareholder. As a result, we cannot reject H1. Second, while the minority shareholder, on average, uses income-based valuation methodology more frequently than the redeemer, this difference is not statistically significant.

Consequently, we reject H2. Finally, the minority shareholder applies asset value more frequently than the redeemer, which is contrary to our hypothesis. Thus, we reject H3.

4.3 Rationality versus measurement perspective in judicial valuation of private firms

Estimated coefficients for the OLS regression models are reported in Table 5 and Table 6. All models tested negative for heteroscedasticity in White’s test. In addition, potential multicollinearity was assessed by computing variance inflation factors (VIFs) from the regressions. The highest VIF encountered was

5.26, which suggests that multicollinearity is unlikely to be a concern in the regression models (O’Brien,

2007).

The estimated coefficients for models A to C are reported in Table 5 estimate the overall association between the shared valuation methodology and  between the minority shareholder/the redeemer and the arbitrator when the other claimant applies a different valuation methodology. Model A suggests that in absence of control variables, the final redemption price announced by the arbitration tribunal appears to be tilted toward the redeemer (p < 0.01) or the minority shareholder (p < 0.01) if either of them applies the same valuation methodology as the arbitrator. With respect to the magnitude of the estimate, this result is slightly stronger for the redeemer. Models B and C indicate that this finding is robust to the inclusion of control variables as the magnitude, sign and statistical significance of the estimated coefficients for the variables of interest remains stable. The only marked difference between Model A and Models B and C is that the control variables absorb the explanatory power of the constant term rather effectively.

Consequently, we reject both H4a and H4b. This result is different from Chen et al. (2010) who do not report an association between a valuation method agreement and the outcome of judicial valuation of public companies.

Table 5. OLS regressions of  on valuation agreement variables. Model A B C Variable Coef. S.E. p-value Coef. S.E. p-value Coef. S.E. p-value CONSTANT 0.581*** 0.063 0.000 0.398*** 0.141 0.006 0.382 0.303 0.212 ARB_RED 0.288*** 0.070 0.000 0.330*** 0.073 0.000 0.345*** 0.078 0.000 ARB_MSH -0.254*** 0.068 0.000 -0.247*** 0.070 0.001 -0.237*** 0.075 0.002 AGREEMENT -0.206** 0.101 0.045 -0.234** 0.109 0.035 MANUFACT 0.056 0.153 0.717 0.092 0.165 0.578 SERVICES 0.191 0.144 0.189 0.244 0.156 0.122 COMMUNIC 0.249 0.152 0.105 0.284* 0.164 0.087 REALEST 0.263* 0.145 0.073 0.332** 0.163 0.045 Ln(ASSETS) -0.002 0.018 0.905 Obs. 94 94 84 F-Statistic 13.19*** 0.000 5.39*** 0.000 4.43*** 0.000 Adjusted R2 0.208 0.248 0.249 VIF Range 1.03 – 1.03 1.15 – 4.47 1.06 – 4.82 Notes: TRADE dropped in B and C. Statistical significance: *** p-value < 0.01; ** p-value < 0.05; * p-value < 0.1.

In regard to individual valuation methodologies, a more specific analysis is carried out in models D to F which are shown in Table 6. Again, the results of model D are robust to the inclusion of control variables

29 in Models E and F. When the redeemer and the arbitrator both use market value (p < 0.01) and asset value

(p < 0.01 and p < 0.05), the redemption price appears to be favorable to the redeemer, and the magnitude of this effect appears to be independent of a valuation methodology. Hence, we reject H5b and H7b.

However, when both use the income-based valuation method, the result is not statistically significant and we cannot reject H6a.

In the cases of a valuation agreement between the minority shareholder and the arbitrator, all valuation methodologies yield statistically significant both apply the asset-based approach, the redemption price exhibits bias toward the minority shareholder (with p-values ranging from p < 0.01 to p < 0.1). The magnitude of these estimates is somewhat higher for asset value than for either market or income-based value. Thus, we reject H5a, H6a and H7a.

Table 6. OLS regressions of  on valuation agreement variables. Model D E F Variable Coef. S.E. p-value Coef. S.E. p-value Coef. S.E. p-value CONSTANT 0.587*** 0.064 0.000 0.423*** 0.147 0.005 0.518 0.343 0.135 MV_ARB_RED 0.338*** 0.092 0.000 0.344*** 0.096 0.001 0.399*** 0.111 0.001 IV_ARB_RED 0.128 0.120 0.288 0.200 0.124 0.111 0.196 0.125 0.123 AV_ARB_RED 0.316** 0.123 0.012 0.421*** 0.127 0.001 0.420*** 0.138 0.003 MV_ARB_MSH -0.252*** 0.093 0.008 -0.256*** 0.094 0.008 -0.247** 0.104 0.020 IV_ARB_MSH -0.233* 0.124 0.064 -0.215* 0.127 0.093 -0.208 0.129 0.110 AV_ARB_MSH -0.320** 0.122 0.010 -0.296** 0.122 0.017 -0.284** 0.131 0.034 AGREEMENT -0.212** 0.104 0.045 -0.244** 0.111 0.031 MANUFACT 0.038 0.156 0.806 0.045 0.170 0.793 SERVICES 0.165 0.150 0.276 0.181 0.164 0.275 COMMUNIC 0.214 0.168 0.205 0.192 0.182 0.295 REAL_EST 0.253 0.154 0.104 0.291* 0.169 0.090 Ln(ASSETS) -0.007 0.020 0.716 Obs. 94 94 84 F-Statistic 4.96*** 0.000 3.55*** 0.000 3.10*** 0.001 Adjusted R2 0.204 0.232 0.233 VIF Range 1.30 – 1.95 1.34 – 4.73 1.32 – 5.26 Notes: TRADE dropped in E and F. Statistical significance: *** p-value < 0.01; ** p-value < 0.05; * p-value < 0.1.

As a note on the control variables, the regression models indicate that contextual factors may not play a significant role in private firm valuation. Since the intercept is positive, AGREEMENT (the redeemer and

30 the minority shareholder negotiate a redemption price and announce this to the arbitrator) is negative because it shifts  toward the neutral value. Statistically significant industry effects can only be observed in models B, C and F. Also, firm size lacks statistical significance in all models.

5. Conclusion

5.1 Discussion

This study explored how a valuation approach is associated with the outcome of the judicial valuation of private firms. Previous research has focused on shareholder litigation cases of public companies and provided empirical evidence for unbiased judicial appraisal (e.g. Chen et al., 2007; Chen et al., 2010).

However, private firms have not been studied empirically in a similar setting. To fill this gap in the literature, this paper used a comprehensive hand-collected sample of all arbitration proceedings carried out in Finland between 1998 and 2014, which were analyzed using proportions tests and OLS regression.

Perhaps the most important result in our paper is that in contrast to Chen et al (2010), our results imply that a valuation method agreement is associated with the outcome of the appraisal process. This is consistent with the measurement perspective as opposed to the rationality perspective being more relevant in the judicial appraisal of private firms. This contradictory result may be explained by the nature of private firms. Since functioning markets and competitive information sources (e.g., securities analysts), which are available for public companies, are rare or absent in the markets for private firm equities, the rationality perspective may be unattainable due to lack of information.

Overall, our data confirms the observation made in the literature (e.g. Lippitt and Mastracchio, 1993;

Beatty et al., 1999) that the income-based approach is the least popular valuation methodology even though it is advocated as the theoretically most sound alternative. In contrast, despite its shortcomings in the context of private firm valuation, market value is the most commonly used valuation approach (see also DiGabriele, 2006). This raises concerns because in our data, at least, market value is generally not 31 based on valuation metrics extracted from comparable public companies, but instead, ‘market values’ are based on transaction prices from previous exchanges of shares, which, in a purely theoretical sense, are very unlikely to reflect the fair price.

Based on our results, we argue that the choice of valuation methodology is associated with how the chosen approach is aligned with the appraiser’s incentives. More precisely, our findings suggest that the redeemer may seek to exploit his or her information advantage in estimation of the fair price. The redeemer favors market value which has a great potential to yield a low valuation estimate due to, for example, private company discount (e.g. Koeplin et al., 2000). Interestingly, the regression analyses suggest that the redeemer may not be ill-advised to follow this strategy. When the redeemer and the arbitrator both use either market value or asset value, the fair price, on average, is closer to the redeemer’s estimate. However, this is not the case if the redeemer uses income-based valuation methodology.

5.2 Implications

While our data source differs significantly from Chen et al. (2010), we argue that it is likely that our results are generalizable and of interest to practitioners and scholars worldwide because the procedure followed in the Finnish arbitration tribunal is ideologically akin to the Delaware method (Pönkä, 2012). Further, the quality of the Finnish judicial system and the domestic accounting standards are on par with major economies, such as the UK and the USA (La Porta et al., 1998; Houqe et al., 2012). Based on our empirical results, we argue that courts should pay attention to the choice of valuation methodology. Our results suggest that the arbitrator, the minority shareholder and the redeemer select most often market-based and asset-based valuation approaches, which are theoretically less likely to yield reliable fair value estimates.

One implication is that the arbitration tribunal at the very least should use forward looking valuation methods more frequently because its objective is to establish a fair value of a going concern, and these methods are both theoretically and empirically the most viable alternative (Chen et al., 2007). By contrast, 32 relying on valuation methodologies which may be inherently flawed for establishing fair value may bias the appraisal outcome. In addition, minority shareholders could also benefit from a more widespread use of the income-based approach as it is likely to provide the most reliable fair value estimate for a private firm.

5.3 Limitations and future research

Like all studies, also this one has some limitations. First, while the sample size does not differ from other studies exploring similar issues (e.g. Beatty et al., 1999; Chen et al., 2010), using a larger sample size would likely improve the reliability of results. Second, the data in this study are from a single country, and therefore, studies focusing on other countries in which judicial procedures and accounting principles may differ from the ones explored here might lead to different results. For instance, the market for private firm equities may differ between different countries and small economies and large economies. Third, we divided valuation methodologies into three broad categories. Thus, a more fine-grained classification might yield different results. Finally, the set of control variables/variables of interest in this study was rather limited which may affect results. These measures were crude and more research is warranted in this respect.

As a direction of future research, addressing the shortcomings described in the previous paragraph would be a natural way to increase our understanding of this matter. A possible avenue for future studies is to attempt a more fine-grained analysis of the judicial appraisal process. That is, one could, for instance, investigate how the parties involved and their characteristics are associated with the outcome of the process. For instance, the judge’s sophistication in performing valuation or expert opinions employed in valuation could be investigated.

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