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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
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