Why a start-up needs a valuation?
In the simple terms, valuation decides the Fair Market Value (FMV) of the equity shares at which the company offers to sell their equity to prospective investors. FMV is the current market value at which the investor is ready to buy the shares. Book value of the shares is derived from the audited financial statements of the company and FMV is from various methods and formula. A comparison between book value and FMV helps the investor to determine how much gain or loss he has attained in the investment transaction. An investment decision is based on his power to negotiate between the book value and FMV as the value depicts the accurate assessed value of the share based on a methodology.
An investor looks at the FMV and compares it with book value to decide the purchase prices. If the company prospects are very good and investor is keen to invest a higher then the fair value can be attained. But mostly the final value is between the book and FMV.
When do you need the valuation of shares
Listed below are some of the reasons where valuation of shares is used?
- During the purchase and sale of share in part or in full;
- Bank ask for valuation if it is used as security for bank loans;
- Two companies decide to merge their business and for this a valuation of shares is done;
- Creation of sweat equity or creating employee stock options or ESOPS’s;
- Conversion of debenture or preference shares to equity;
- On the direction of income tax department for finding FMV of share in case of litigation;
What data we need for the valuation
Calculation of FMV is based on different factors and some of the key ingredients to calculate FMV is:
- History of company financials;
- Current financial statements;
- Investment plans;
- Business growth and projections;
- Cash flow projections for the next 5 years;
- Business growth plan
Various methods for business valuations
Two methods are allowed as per the income tax act with which the merchant banker can value the shares and they are:
Net asset value method
The total asset of the company at the book value minus the liabilities is the net assets which are divided by total outstanding shares in the company decides NAV per share.
Discounted Cash Flow method
Discounted cash flow (DCF) is a valuation method applied on the estimated value of an investment and based on its capacity to generate future cash flows. DCF analysis calculates the present value of expected future cash flows using a discount rate. Calculated present value estimate is then used to evaluate the potential investment. If the value calculated through DCF is higher than the current cost of the investment, the opportunity should be considered.
Important to note that the choice of adopting the valuation method is with the taxpayer, he can either adopt NAV or DCF and it cannot be challenged by the Assessing officer of income tax. However, the taxpayer should be able to explain the methods of collecting the information used in calculating either of the methods. Even though a certified Merchant Banker issues the valuation report, the parameters taken in arriving the valuation should be justified during the scrutiny process by the company. We in CFO Angle helps in ensuring all such notices of assessing officers are challenged.
Tax Impact on sale of shares after valuation
Impact on Seller
Though shares of a private limited company are not freely tradable in any exchange, post valuation a price is quoted to a prospective buyer on FMV. On the sale of shares by the shareholder the difference of purchase price and sales prices are subject to tax under short and long term capital gains. There are ways by which this tax can be avoided. We in CFO angle help to structure the equity in such manner that the tax is not applied.
Impact on Buyer
If buyer purchases shares less than the FMV, then the difference between FMV and purchase prices is subject to income tax under head “Income from other Sources”. When the buyer plans to sell the shares at the later date FMV is considered as cost of purchase to avoid double taxation on the sale then.
CFO Angle helps in structuring the process of shares valuation including valuation, transaction advisory, and Income tax & ROC compliance.