How valuation formulas in shareholders’ agreements can go wrong

Adam Johnson

Valuation clauses are often included in shareholders’ agreement with the noble intent of securing agreement among all parties with respect to the price at which the shares of an exiting shareholder will be purchased. In some cases, these valuation clauses include “valuation formulas” – a mathematical basis dictating how to value a particular shareholding. In theory, valuation formulas sound like a good idea: they are easy to implement, simplistic to explain, and aim to minimize conflict with respect to how much an exiting shareholder should receive for its shares. However, valuation formulas can be problematic to the point that they can result in the exact opposite of what they are designed to help avoid: increased acrimony, higher legal fees, and potentially unfair outcomes for shareholders.

Problem #1: Agreements may be poorly worded

A few months ago, I was approached by a shareholder who was exiting his company on unfriendly terms; the amount to which he was entitled pursuant to the shareholders’ agreement was in dispute. He showed me his shareholders’ agreement. The legal drafting was downright sloppy.

The agreement included a “valuation formula” that was based on a multiple of “average earnings” over the prior three years. Nowhere in the agreement was the term “earnings” defined, and this led to a disagreement over whether “earnings” simply meant the company’s net income reported on its financial statements, pre-tax income, or some other metric. The company’s accountants prepared a one-page set of calculations with little explanation or transparency. While the accountants may have very well reached the correct answer based on their interpretation of the shareholders’ agreement, the opacity around the term “earnings” left the exiting shareholder feeling as if the valuation formula was being used to his disadvantage.

Problem #2: Formulas may not be appropriate for the business or industry

Valuing a restaurant is different than valuing a tech company which is different than valuing a manufacturing company which is different than valuing a real estate holding company. This much should be obvious, but hastily drafted shareholders’ agreements can be prone to the inclusion of valuation “formulas” which are inappropriate for the nature of the business at hand.

Problem #3: Reported “earnings” metrics may be distorted

A valuation formula that is based simply on reported “earnings” or “net income” (or some other variant thereof) may fail to address a common valuation issue: the ‘normalization’ of a company’s earnings.

Suppose Victor is a 30% shareholder exiting a company that earned $500,000 in pre-tax earnings in each of the last three years. The company’s shareholders’ agreement includes a “valuation formula” stating that the company should be valued at 5 times the average pre-tax income for the last three years.

Based on the wording of the agreement, Victor’s math is easy: $500,000 × 5 = an implied company value of $2,500,000. Based on Victor’s 30% shareholding, his shares should be purchased at $750,000 [$2,500,000 × 30%].

However, what this valuation formula fails to address is that Victor and his partners took large bonuses in each of the last three years totalling $250,000 in each year. The company didn’t need to pay these bonuses to the shareholders; this was done simply for tax planning purposes in order to reduce the company’s taxable income to the small business deduction limit. Otherwise, the company may have opted to take these amounts as dividends (which would not have reduced the company’s pre-tax income).

If Victor’s company was valued on the basis of “pre-tax income before management bonuses”, the math would look drastically different, with the total company being valued at $3,750,000 [($500,000 + $250,000) × 5] or 50% more than the valuation implied by the stated formula.

A notional valuation would generally normalize the earnings of the company to adjust shareholders’ compensation to an ‘economic’ or ‘market’ rate of remuneration commensurate with their roles in the company. The simplicity of Victor’s shareholders’ agreement fails to capture this nuance.

Rigid valuation formulas based on an “earnings” metric can also potentially be problematic if “earnings” in a given year are heavily impacted by a one-time or non-recurring revenue expense item. Suppose that, for example, Victor’s company suffered a $100,000 non-recurring inventory loss last year, reducing last year’s earnings to $400,000. This would effectively reduce the amount assigned to Victor’s shares by almost 7% (or $50,000), even though this non-recurring item may have limited predictive value with respect to his company’s future earnings.

Problem #4: Inflexibility

The effects of COVID have pulled back the curtain to further reveal how valuation formulas may be too inflexible to capture economic reality. In theory, a company’s value should be based on prospective future cash flows and not simply based on historical results.

In April, Statistics Canada reported that more than half of Canadian companies saw their revenues and earnings drop during COVID. Specifically, more than one-third of companies surveyed saw revenues drop by more than 40%.

The mechanics of valuing a business during a pandemic is a different topic for a different day. But in some cases, a decline in revenues and earnings may be temporary, or perhaps mitigated in the long run. How this impacts the value of an individual business is ultimately dependent on factors that differ from firm to firm. If a valuation “formula” is based on a simple multiple of last year’s revenues, does a 40% decline in revenues translate into a 40% erosion in a company’s fair market value? Not necessarily.

If the value of a shareholder’s equity interest in a company is determined by a prescriptive formula based on ‘X%’ of historical revenue or ‘Y times’ historical earnings – at a specific point in time such as the COVID era where revenue or earnings may be abnormally deflated – this prescriptive formula has the potential to create an unfair result.


Valuation formulas in shareholders’ agreements should be approached with caution. Vague, ill-informed, or inflexible valuation formulas can end up increasing the temperature of shareholder disputes and can completely undermine the purpose for which they were originally designed.

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