Provisions of Companies Act

 THEINTACTFRONT23 APR 2018 1 COMMENT

A business may grow over time as the utility of its products and services is recognized. It may
also grow through an inorganic process, symbolized by an instantaneous expansion in work
force, customers, infrastructure resources and thereby an overall increase in the revenues and
profits of the entity. Mergers and acquisitions are manifestations of an inorganic growth process.
While mergers can be defined to mean unification of two players into a single entity, acquisitions
are situations where one player buys out the other to combine the bought entity with itself. It may
be in form of a purchase, where one business buys another or a management buy out, where the
management buys the business from its owners. Further, de-mergers, i.e., division of a single
entity into two or more entities also require being recognized and treated on par with mergers
and acquisitions regime as recommended below, and accordingly references below to mergers
and acquisitions also is intended to cover de-mergers (with the law & Rules as framed duly
catering to the same).

Mergers and acquisitions are used as instruments of momentous growth and are increasingly
getting accepted by Indian businesses as critical tool of business strategy. They are widely used
in a wide array of fields such as information technology, telecommunications, and business
process outsourcing as well as in traditional business to gain strength, expand the customer base,
cut competition or enter into a new market or product segment. Mergers and acquisitions may be
undertaken to access the market through an established brand, to get a market share, to eliminate
competition, to reduce tax liabilities or to acquire competence or to set off accumulated losses of
one entity against the profits of other entity.

The process of mergers and acquisitions in India is court driven, long drawn and hence
problematic. The process may be initiated through common agreements between the two parties,
but that is not sufficient to provide a legal cover to it. The sanction of the High Court is required
for bringing it into effect. The Companies Act, 1956 consolidates provisions relating to mergers
and acquisitions and other related issues of compromises, arrangements and reconstructions,
however other provisions of the Companies Act get attracted at different times and in each case
of merger and acquisition and the procedure remains far from simple. The Central Government
has a role to play in this process and it acts through an Official Liquidator (OL) or the Regional
Director of the Ministry of Company Affairs. The entire process has to be to the satisfaction of
the Court. This sometimes results in delays.

Needless to say, in the context of increasing competitiveness in the market, speed is of the
essence, especially in an expanding and vibrant economy like ours. A sign of corporate
readiness, skill and stratagem is the ability to do such mergers and acquisitions with ‘digital’
speed. E-governance could provide a helpful tool in achieving the objective of speed with
provisions for online registration, approvals etc.

The Committee was of the view that contractual mergers may be given statutory recognition in
the Company Law in India as is the practice in many other countries. Such mergers and
acquisitions through contract form (i.e. without court intervention), could be made subject to
subsequent approval of shareholders by ordinary majority. This would eliminate obstructions to
mergers and acquisitions, ex-post facto protection and ability to rectify would be available.

There has been a steady increase in cross-border mergers with the increase in global trade. Such
mergers and acquisitions can bring long-term benefits when they are accompanied by policies to
facilitate competition and improved corporate governance.

The Committee went into several aspects of the provisions in the existing law constituting a
separate code in themselves and regulating a very important aspect of restructuring and
consolidation of business in response to the economic environment. An effort was made to
identify the areas of concern under the present law and to recommend means of addressing them.

At present, in case of a proposed scheme for amalgamation of company which is being dissolved
without winding up, the law requires a report from the Official Liquidator (OL) or Registrar of
Companies (ROC) that the affairs of company have not been conducted in a manner prejudicial
to the interest of its members or to public interest. The Act also requires that no order for
dissolution of any transferor company shall be made by the Court unless the OL makes a report
to the Court that the affairs of the company have not been conducted in a manner prejudicial to
the interest of its members or to public interest. The Committee felt that the above two
requirements under the present law can be covered by issuing notices to ROC and OL
respectively; who may file before the Court, information that may have a bearing on the
proposed merger. There is no requirement of a separate information in response to the notice to
be filed for the purpose. Filing of such report may be time-bound, beyond which it may be
presumed that ROC/OL concerned have no comments to offer.

The Companies Act, 2013 (2013 Act) has seen the light of day and replaced the 1956 Act with
some sweeping changes including those in relation to mergers and acquisitions (M&A).

The new Act has been lauded by corporate organizations for its business-friendly corporate
regulations, enhanced disclosure norms and providing protection to investors and minorities,
among other factors, thereby making M&A smooth and efficient. Its recognition of interse
shareholder rights takes the law one step forward to an investor-friendly regime. The 2013 Act
seeks to simplify the overall process of acquisitions, mergers and restructuring, facilitate
 domestic and cross-border mergers and acquisitions, and thereby, make Indian firms relatively
more attractive to PE investors.

The term ‘merger’ is not defined under the Companies Act, 1956 (“CA 1956”), and under
Income Tax Act, 1961 (“ITA”). However, the Companies Act, 2013 (“CA 2013”) without
strictly defining the term explains the concept. A ‘merger’ is a combination of two or more
entities into one; the desired effect being not just the accumulation of assets and liabilities of the
distinct entities, but organization of such entity into one business.

On 7th November, 2016 Central Government issued a notification for enforcement of section 230-
233, 235-240, 270-288 etc w.e.f. 15th December, 2016. But still rules were not available till date
for CAA.

MCA vide notification dated 14th Dec, 2016 has issued rules i.e. The Companies
(Compromises, Arrangements and Amalgamations) Rules, 2016. These rules will be
effective from 15th December, 2016. Consequently, w.e.f. 15.12.2016 all the matters relating
to Compromises, Arrangements, and Amalgamations (hereafter read as “CAA”) will be dealt
as per provisions of Companies Act, 2013 and The Companies (Compromises,
Arrangements, and Amalgamations) Rules, 2016.

Where a compromise or arrangement is proposed for the purposes of or in connection with

scheme for the reconstruction of any company or companies, or for the amalgamation of
any two or more companies, the petition shall pray for appropriate orders and directions
under section 230 read with section 232 of the Act.

Section relating to Merger & Amalgamation Section 230 & 232.

In this article COMPROMISE & ARRANGEMENT (C&A) will be read in relation to Merger &
Amalgamation only.

In Case of application filing u/s 230 for Compromise & Arrangement in relation to
reconstruction of the Company or companies involving merger or the amalgamation of any
two or more companies should specify the purpose of the scheme.

REASON OF M&A TERMS

·        Expansion and Diversification·        Optimum  
Economic Benefit·        De-risking Strategy
Amalgamation – means combination of two or
more independent business corporations into a
 
single enterprise
·        Scaling up of operation for competitive advantages
Demerger– means transfer and vesting of an
undertaking of a company into another company
·        Increase the Market capitalization
Reconstruction- means re-organization of share
·        Cost reduction by reducing overheads
capital in any manner; varying the rights of
shareholders and/or creditors
·        Increasing the efficiencies of operations

Arrangement- All modes of reorganizing the share

·        Tax benefits
capital, including interference with preferential and
other special rights attached to shares
·        Access foreign markets

Who can file the application for Merger & Amalgamation  propose: Section 230(1)

An application for Merger & Amalgamation can be file with Tribunal (NCLT). Both
the transferor and the transferee company shall make an application in the form of petition
to the Tribunal under section 230-232 of the Companies Act, 2013 for the puspose of
sanctioning the scheme of amalgamation.

Joint Application

Where more than one company is involved in a scheme, such application may, at the
discretion of such companies, be filed as a joint-application.

However, where the registered office of the Companies are in different states, there will be
two Tribunals having the jurisdiction over those, companies, hence separate petition will
have to be filed.

Regulations by SEBI, Scheme of

Amalgamation, Approval from Court
Companies Act, 1956

Sections 390 to 394 of the Companies Act govern a merger of two or more companies
under Indian law. The Merger Provisions are in fact worded so widely, that they would
provide for and regulate all kinds of corporate restructuring that a company may possibly
undertake; such as mergers, amalgamations, demergers, spin-off / hive off, and every other
compromise, settlement, agreement or arrangement between a company and its members
and / or its creditors.

Scheme of Mergers and Acquisitions

Procedure for merger and amalgamation is different from takeover. Mergers and
amalgamations are regulated under the provisions of the Companies Act, 1956 whereas
takeovers are regulated under the SEBI (Substantial Acquisition of Shares and Takeovers)
Regulations.

Although chapter V of the Companies Act, 1956 comprising sections 389 to 396-A deals
with the issue and related aspects covering arbitration, compromises, arrangements and
reconstructions but at different times and under different circumstances in each case of
merger and amalgamation application of other provisions of the Companies Act, 1956 and
ruled made there-under may necessarily be attracted. 

A scheme of compromise or arrangement must be approved by a resolution passed by not

less than three-fourths in value of the total creditors (or class of creditors) or members (or
class of members), as the case may be, present and voting either in person or through
proxies. There is no rigid formula for determining a class of creditors or members. It is the
discretionary power of the court to determine these classes. Essentially, ‘class’ means
persons whose rights are so similar that they can be combined together with a view to
achieve a common interest. Generally, secured creditors and unsecured creditors could
form distinct classes of creditors and members can be categorized into preference
shareholders and common equity shareholders.

Subsequent to the scheme being approved by the members and/or creditors, a petition for
sanctioning of the scheme is filed with the appropriate court within whose jurisdiction the
registered office of the transferor and the transferee company is situated. The approved
arrangement is, unless prejudicial to public interest or interest of the creditors, sanctioned
by the court and a certified copy of the order is required to be filed with the Registrar of
Companies.

Procedure under the Merger Provisions

Since a merger essentially involves an arrangement between the merging companies and
their respective shareholders, each of the companies proposing to merge with the other
must make an application tothe Company Court having jurisdiction over such company for
calling meetings of its respective shareholders and/or creditors. The Court may then order a
meeting of the creditors/shareholders of the company. If the majority in number
representing 3/4th in value of the creditors/shareholders present and voting at such meeting
agreesto the merger, then the merger, if sanctioned by the Court, is binding on all creditors/
shareholders of the company. The Court will not approve a merger or any other corporate
restructuring, unless it is satisfied that the company has disclosed all material facts. The
order of the Court approving a merger does not take effect until the company with the
Registrar of Companies files a certified copy of the same.

The Merger Provisions constitute a comprehensive code in themselves, and under these
provisions Courts have full power to sanction any alterations in the corporate structure of a
company that may be necessary to effect the corporate restructuring that is proposed. For
example, in ordinary circumstances a company must seek the approval of the Court for
effecting a reduction of its share capital. However, if a reduction of share capital forms part
 of the corporate restructuring proposed by the company under the Merger Provisions, then
the Court has the power to approve and sanction such reduction in share capital and
separate proceedings for reduction of share capital would not be necessary.

Applicability of Merger Provisions to Foreign Companies.

Section 394 vests the Court with certain powers to facilitate the reconstruction or
amalgamation of companies, i.e. in cases where an application is made for sanctioning an
arrangement that is:

 For the reconstruction of any company or companies or the amalgamation of any two
or more companies; and
 Under the scheme the whole or part of the undertaking, property or liabilities of any
company concerned in the scheme (referred to as the ‘transferor company’) is to be
transferred to another company (referred to as the transferee company’). Section 394 (4) (b)
makes it clear that:

 Securities Laws

As per the ICDR Regulations, if the acquisition of an Indian listed company involvesthe
issue of new equity shares or securities convertible into equity shares by the target to the
acquirer, the provisions of Chapter VII contained in ICDR Regulations will be applicable in
addition to the provisions of the Companies Act mentioned above. We have highlighted
below some of the relevant provisions of the Preferential Allotment Regulations.

Approvals for the Scheme

The scheme of merger / amalgamation is governed by the provisions of Section 391-394 of

the Companies Act. The legal process requires approval to the schemes as detailed below.

Approvals from Shareholders

In terms of Section 391, shareholders of both the amalgamating and the amalgamated
companies should hold their respective meetings under the directions of the respective high
courts and consider the scheme of amalgamation. A separate meeting of both preference
and equity shareholders should be convened for this purpose. Further, in terms of Section
81(1A), the shareholders of the amalgamated company are required to pass a special
resolution for issue of shares to the shareholders of the amalgamating company in terms of
the scheme of amalgamation.

Approval from Creditors / Financial Institutions / Banks

Approvals are required from the creditors, banks and financial institutions to the scheme of
amalgamation in terms of their respective agreements / arrangements with each of the
amalgamating and the amalgamated companies as also under Section 391.
 Approval from Respective High Court

Approvals of the respective high court(s) in terms of Section 391-394, confirming the
scheme of amalgamation are required. The courts issue orders for dissolving the
amalgamating company without winding-up on receipt of the reports from the official
liquidator and the regional director, Company Law Board, that the affairs of the
amalgamating company have not been conducted in a manner prejudicial to the interests of
its members or to public interests.

Report of Chairman to the Court

The chairman of the meeting must within the time fixed by the court or where no time is
fixed within 7 days of the date of the meeting, report the result of the meeting to the court.
The report should state accurately the number of creditors or class of creditors or the
numbers of members or class of members, as the case may be, who were present and who
voted at the meeting either in person or by proxy, their individual values and the way the
voted.

Takeover Code
 THEINTACTFRONT23 APR 2018 1 COMMENT

The concept of Takeover

Although, the term ‘Takeover’ has not been defined under the said Regulations, the term
basically envisages the concept of an acquirer taking over the control  or management of the
target company . When an acquirer, acquires substantial quantity of shares or voting rights of the
target company, it results in the Substantial acquisition of Shares.

For the purposes of understanding the implications arising from the aforementioned paragraph, it
is necessary for us to dwell into what is the actual meaning of substantial quantity of shares or
voting rights

1. Meaning of substantial quantity of shares or voting rights

The said Regulations have discussed this aspect of ‘substantial quantity of shares or voting
rights’ separately for two different purposes:

 For the purpose of disclosures to be made by acquirer(s)

 5% or more shares or voting rights

A person who, along with ‘persons acting in concert’  (“PAC”), if any, acquires shares or voting
rights (which when taken together with his existing holding) would entitle him to more than 5%
or 10% or 14% shares or voting rights of target company, is required to disclose the aggregate of
his shareholding or voting rights to the target company and the Stock Exchanges where the
shares of the target company are traded within 2 days of receipt of intimation of allotment of
shares or acquisition of shares.

2. More than 15% shares or voting rights

An acquirer who holds more than 15% shares or voting rights of the target company, shall within
21 days from the financial year ending March 31 make yearly disclosures to the company in
respect of his holdings as on the mentioned date.

The target company is, in turn, required to pass on such information to all stock exchanges where
the shares of target company are listed, within 30 days from the financial year ending March 31
as well as the record date fixed for the purpose of dividend declaration.

For the purpose of making an open offer by the acquirer

(a) 15% shares or voting rights

An acquirer who intends to acquire shares which along with his existing shareholding would
entitle him to more than 15% voting rights, can acquire such additional shares only after making
a public announcement (“PA”) to acquire at least additional 20% of the voting capital of the
target company from the shareholders through an open offer [ix].

(b) Creeping limit of 5%

An acquirer who is having 15% or more but less than 75% of shares or voting rights of a target
company, can consolidate his holding up to 5% of the voting rights in any financial year ending
31st March. However, any additional acquisition over and above 5% can be made only after
making a public announcement [x]. However in pursuance of Reg. 7(1A) any purchase or sale
aggregating to 2% or more of the share capital of the target company are to be disclosed to the
Target Company and the Stock Exchange where the shares of the Target company are listed
within 2 days of such purchase or sale along with the aggregate shareholding after such
acquisition /sale. An acquirer who has made a public offer and seeks to acquire further shares
under Reg. 11(1) shall not acquire such shares during the period of 6 months from the date of
closure of the public offer at a price higher than the offer price.

(c) Consolidation of holding:

An acquirer who is having 75% shares or voting rights of target company, can acquire further
shares or voting rights only after making a public announcement specifying the number of shares
to be acquired through open offer from the shareholders of a target company.

In order to appreciate the implications arising here from, it is pertinent for us to consider the
meaning of the term ‘public announcement’.
 3. Public Announcement

A Public announcement is generally an announcement given in the newspapers by the acquirer,

primarily to disclose his intention to acquire a minimum of 20% of the voting capital of the
target company from the existing shareholders by means of an open offer.

However, an Acquirer may also make an offer for less than 20% of shares of target company in
case the acquirer is already holding 75% or more of voting rights/ shareholding in the target
company and has deposited in the escrow account in cash a sum of 50% of the consideration
payable under the public offer.

The Acquirer is required to appoint a Merchant Banker registered with SEBI before making a PA
and is also required to make the PA within four working days of the entering into an agreement
to acquire shares, which has led to the triggering of the takeover, through such Merchant Banker.

 The other disclosures in this announcement would inter alia include

 The offer price,
 The number of shares to be acquired from the public,
 The identity of the acquirer,
 The purposes of acquisition,
 The future plans of the acquirer, if any, regarding the target company,
 The change in control over the target company, if any
 The procedure to be followed by acquirer in accepting the shares tendered by the shareholders
and the period within which all the formalities pertaining to the offer would be completed.

The basic objective behind the PA being made is to ensure that the shareholders of the target
company are aware of the exit opportunity available to them in case of a takeover / substantial
acquisition of shares of the target company. They may, on the basis of the disclosures contained
therein and in the letter of offer, either continue with the target company or decide to exit from it.

4. Procedure to be followed after the Public Announcement

In pursuance of the provisions of Reg. 18 of the said Regulations, the Acquirer is required to file
a draft Offer Document with SEBI within 14 days of the PA through its Merchant Banker, along
with filing fees of Rs.50,000/- per offer Document (payable by Banker’s Cheque / Demand
Draft). Along with the draft offer document, the Merchant Banker also has to submit a due
diligence certificate as well as certain registration details.

The filing of the draft offer document is a joint responsibility of both the Acquirer as well as the
Merchant Banker

Thereafter, the acquirer through its Merchant Banker sends the offer document as well as the
blank acceptance form within 45 days from the date of PA, to all the shareholders whose names
appear in the register of the company on a particular date.
 The offer remains open for 30 days. The shareholders are required to send their Share
certificate(s) / related documents to the Registrar or Merchant Banker as specified in the PA and
offer document.

The acquirer is obligated to offer a minimum offer price as is required to be paid by him to all
those shareholders whose shares are accepted under the offer, within 30 days from the closure of
offer.

5. Exemptions

The following transactions are however exempted from making an offer and are not required to
be reported to SEBI:

 Allotment to underwriter pursuant to any underwriting agreement;

 Acquisition of shares in ordinary course of business by;
 Regd. Stock brokers on behalf of clients;
 Regd. Market makers;
 Public financial institutions on their own account;
 Banks & FIs as pledges;
 Acquisition of shares by way of transmission on succession or by inheritance;
 Aquisition of shares by Govt. companies;
 Acquisition pursuant to a scheme framed under section 18 of SICA 1985;
 Of arrangement/ restructuring including amalgamation or merger or de-merger under any law
or Regulation Indian or Foreign;
 Acquisition of shares in companies whose shares are not listed;
 However, if by virtue of acquisition of shares of unlisted company, the acquirer acquires shares
or voting rights (over the limits specified) in the listed company, acquirer is required to make an open
offer in accordance with the Regulations.

6. Minimum Offer Price and Payments made

It is not the duty of SEBI to approve the offer price, however it ensures that all the relevant
parameters are taken in to consideration for fixing the offer price and that the justification for the
same is disclosed in the offer document. The offer price shall be the highest of:

 Negotiated price under the agreement, which triggered the open offer.
 Price paid by the acquirer or PAC with him for acquisition if any, including by way of public
rights/ preferential issue during the 26-week period prior to the date of the PA.
 Average of weekly high & low of the closing prices of shares as quoted on the Stock exchanges,
where shares of Target company are most frequently traded during 26 weeks prior to the date of the
Public Announcement

 In case the shares of target company are not frequently traded, then the offer price shall be
determined by reliance on the following parameters, viz: the negotiated price under the
agreement, highest price paid by the acquirer or PAC with him for acquisition if any, including
by way of public rights/ preferential issue during the 26-week period prior to the date of the PA
 and other parameters including return on net worth, book value of the shares of the target
company, earning per share, price earning multiple vis a vis the industry average.

Acquirers are required to complete the payment of consideration to shareholders who have
accepted the offer within 30 days from the date of closure of the offer. In case the delay in
payment is on account of non-receipt of statutory approvals and if the same is not due to willful
default or neglect on part of the acquirer, the acquirers would be liable to pay interest to the
shareholders for the delayed period in accordance with Regulations. Acquirer(s) are however not
to be made accountable for postal delays.

If the delay in payment of consideration is not due to the above reasons, it would be treated as a
violation of the Regulations.

7. Safeguards incorporated so as to ensure that the Shareholders get their payments

Before making the Public Announcement the acquirer has to create an escrow account having
25% of total consideration payable under the offer of size Rs. 100 crores (Additional 10% if
offer size more than 100 crores). The Escrow could be in the form of cash deposited with a
scheduled commercial bank, bank guarantee in favor of the Merchant Banker or deposit of
acceptable securities with appropriate margin with the Merchant Banker. The Merchant Banker
is also required to confirm that firm financial arrangements are in place for fulfilling the offer
obligations. In case, the acquirer fails to make payment, Merchant Banker has a right to forfeit
the escrow account and distribute the proceeds in the following way.

 1/3 of amount to target company

 1/3 to regional Stock Exchanges, for credit to investor protection fund etc.
 1/3 to be distributed on pro rata basis among the shareholders who have accepted the offer.

 The Merchant Banker advised by SEBI is required to ensure that the rejected documents which
are kept in the custody of the Registrar / Merchant Banker are sent back to the shareholder
through Registered Post.

Besides forfeiture of escrow account, SEBI can take separate action against the acquirer which
may include prosecution / barring the acquirer from entering the capital market for a period etc.

8. Penalties

The Regulations have laid down the general obligations of the acquirer, target company and the
Merchant Banker. For failure to carry out these obligations as well as for failure / non-
compliance of other provisions of the Regulations, Reg. 45 provides for penalties. Any person
violating any provisions of the Regulations shall be liable for action in terms of the Regulations
and the SEBI Act.

If the acquirer or any person acting in concert with him, fails to carry out the obligations under
the Regulations, the entire or part of the sum in the escrow amount shall be liable to be forfeited
 and the acquirer or such a person shall also be liable for action in terms of the Regulations and
the Act.

The board of directors of the target company failing to carry out the obligations under the
Regulations shall be liable for action in terms of the Regulations and SEBI Act.

The Board may, for failure to carry out the requirements of the Regulations by an intermediary,
initiate action for suspension or cancellation of registration of an intermediary holding a
certificate of registration under section 12 of the Act. Provided that no such certificate of
registration shall be suspended or cancelled unless the procedure specified in the Regulations
applicable to such intermediary is complied with.

For any mis-statement to the shareholders or for concealment of material information required to
be disclosed to the shareholders, the acquirers or the directors where he acquirer is a body
corporate, the directors of the target company, the merchant banker to the public offer and the
merchant banker engaged by the target company for independent advice would be liable for
action in terms of the Regulations and the SEBI Act.

The penalties referred to in sub-regulation (1) to (5) may include

 Criminal prosecution under section 24 of the SEBI Act;

 Monetary penalties under section 15 H of the SEBI Act;
 Directions under the provisions of Section 11B of the SEBI Act.

Regulations have laid down the penalties for non-compliance. These penalties may include
forfeiture of the escrow account, directing the person concerned to sell the shares acquired in
violation of the regulations, directing the person concerned not to further deal in securities,
monetary penalties, prosecution etc., which may even extend to the barring of the acquirer from
entering and participating in the Capital Market. Action can also be initiated for suspension,
cancellation of registration against an intermediary such as the Merchant Banker to the offer.

The provisions dealt with in this paper are some of the important provisions, which are required
to be complied with when dealing with the procedure to be complied with in order to take over a
company.
 Valuation of a Business
 THEINTACTFRONT23 APR 2018 1 COMMENT

There are many reasons to have an up-to-date business valuation. For example:

 You may need to sell the business due to retirement, health, divorce, or for family reasons.
 You may need debt or equity financing for expansion or due to cash flow problems. Potential
financiers or investors will want to see that the business has sufficient worth.
 You may be adding shareholders (or one or more shareholders may wish a buyout). In this case,
share value will need to be determined.

Regardless of the reason, how much your business is worth depends on many factors, from the
current state of the economy through your business’s balance sheet. If for example, similar
businesses in your area have recently sold, the value of your business will be determined in large
part by the selling price of the previous sales.

Get It Done Right

Business owners should not do their own business valuation. This is too much like asking a
mother how talented her child is. Neither the business owner nor the mother has the necessary
distance to step back and answer the question objectively.

So to ensure that you set and get the best price when you’re selling a business, get a business
valuation done by a professional, such as a Chartered Business Valuator (CBV). In the U.S., you
can find Business Valuators through the website of the American Society of Appraisers
(ASA) while in Canada you can find them through the Canadian Institute of Chartered Business
Valuators.

A Business Valuator (or anyone valuating your business such as an accountant) will use a variety
of business valuation methods to determine a fair price for your business, such as:

Three Business Valuation Methods

1. Asset-Based Approaches

Basically, these business valuation methods total up all the investments in the business.
 Asset-based business valuations can be done on a going concern or on a liquidation basis.

 A going concern asset-based approach lists the business’s net balance sheet value of
its assets and subtracts the value of its liabilities.

 A liquidation asset-based approach determines the net cash that would be received if all assets

were sold and liabilities paid off.

Using the asset-based approach to value a sole proprietorship is more difficult. In a corporation,
all assets are owned by the company and would normally be included in a sale of the business.
Assets in a sole proprietorship exist in the name of the owner and separating assets from business
and personal use can be difficult.

For instance, a sole proprietor in a lawn care business may use various pieces of lawn care
equipment for both business and personal use. A potential purchaser of the business would need
to sort out which assets the owner intends to sell as part of the business.

2. Earning Value Approaches

These business valuation methods are predicated on the idea that a business’s true value lies in
its ability to produce wealth in the future. The most common earning value approach is
Capitalizing Past Earning.

With this approach, a valuator determines an expected level of cash flow for the company using
a company’s record of past earnings, normalizes them for unusual revenue or expenses, and
multiplies the expected normalized cash flows by a capitalization factor.

The capitalization factor is a reflection of what rate of return a reasonable purchaser would
expect on the investment, as well as a measure of the risk that the expected earnings will not be
achieved.

Discounted Future Earnings is another earning value approach to business valuation where
instead of an average of past earnings, an average of the trend of predicted future earnings is
used and divided by the capitalization factor.

What might such capitalization rates be? In a Management Issues paper discussing “How Much
Is Your Business Worth?”, law firm Grant Thornton LLP suggests:

“Well established businesses with a history of strong earnings and good market share might
often trade with a capitalization rate of, say 12% to 20%. Unproven businesses in a fluctuating
and  volatile market tend to trade at much higher capitalization rates, say 25% to 50%.”

Valuation of a sole proprietorship in terms of past earnings can be tricky, as customer loyalty is
directly tied to the identity of the business owner. Whether the business involves plumbing
 or management consulting, will existing customers automatically expect that a new owner
delivers the same degree of service and professionalism?

Any valuation of a service oriented sole proprietorship needs to involve an estimate of the
percentage of business that might be lost under a change of ownership. Note that this can be
mitigated in many cases, such as when a trusted family member (who may already be familiar
with the client list) takes over the business.

3. Market Value Approaches

Market value approaches to business valuation attempt to establish the value of your business by
comparing your business to similar businesses that have recently sold. Obviously, this method is
only going to work well if there are a sufficient number of similar businesses to compare.

Assigning a value to a sole proprietorship based on market value is particularly difficult. By

definition, sole proprietorships are individually owned so attempting to find public information
on prior sales of like businesses is not an easy task.

Although the Earning Value Approach is the most popular business valuation method, for most
businesses, some combination of business valuation methods will be the fairest way to set a
selling price.

Non-Competition Clauses Can Affect Valuation

Non-competition clauses are frequently included in agreements for the sale of a business,

particularly in cases where goodwill forms a significant part of the valuation. No one wants to
purchase a business on the assumption that current customers will continue to patronize the
business only to have the previous owner immediately join a competitor or open a similar
business in the same area.

Non-competition clauses typically contain restrictions such as:

 Forbidding the seller from opening up a competing business in the same geographical area
 Attaching a time limit to competing activity – for example the buyer may request that the seller
not engage in direct competition for a period of five years

Non-competition agreements can be a thorny legal issue and are often the subject of court cases
between buyers and sellers after a business is sold. From a legal standpoint, to be enforceable the
restrictions placed in a non-competition clause must be clearly defined and ‘reasonable’. Non-
competition covenants can be nullified by the courts if it is determined that enforcement places
overly broad and/or unreasonable restrictions on the seller’s ability to continue his/her trade and
earn a living. Non-competition clauses should be reviewed by the legal representatives of the
buyer and seller prior to the sale of the business.

What About Franchise Businesses?

Franchise agreements generally define how a franchise can be sold, and these vary by franchise
vendor — check your franchise contract. Some contracts stipulate that the franchisors will buy
back your franchise directly for a fixed price. Others provide assistance with valuation and
locating a buyer, as it is in their best interest to make sure that the business continues
uninterrupted.

The Best Choice May Be a Combination

Although the Earning Value Approach is the most popular business valuation method, for most
businesses, some combination of business valuation methods will be the fairest way to set a
selling price. The first step is to hire a professional Business Valuator; he or she will be able to
advise you on the best method or methods to use to set your price so you can successfully sell
your business.