This article discusses the form and structure of consideration transferred to a shareholder selling a controlling stake in a business and its treatment under IFRS financial reporting and UK tax rules. The Intrinsic Value of the company being sold (see Business Valuation Series: Parts I-III) will be the starting point for negotiations on price. Once the price is agreed, there will be further discussions about consideration form and timing, driven largely by tax and risk factors. 

Equity value for a specific shareholding will depend on the rights that flow from that interest, in terms of influence over the operating and financing decisions that determine future performance of the business which generates variable returns for the equity holder (dividends and capital growth). This influence comes from the power to appoint directors, to vote at shareholder meetings and other contractual rights. If the acquisition of shares gives the acquirer ‘control’ (usually when a majority, or over 50%, of voting rights is acquired), it will be able to direct the activities that determine the level of returns and hence equity value. 

The purchaser may be able to create value that is incremental to management’s existing plans (Net Present Value from operating, investment and financing policies it would implement if it controlled the business). An investor should be prepared to pay more for a majority holding (‘Control Premium’) compared to a minority interest (valued at a discount to the ‘Control Value’ - a ‘Minority Discount’ or ‘Discount for Lack Of Control’ / ‘DLOC’). Similarly, a share that can be marketed and traded quickly in a ‘liquid’ market will be worth more than one that cannot be, and a ‘Discount for Lack of Marketabilty’ (‘DLOM’) may be required, depending on whether the initial valuation reflects a marketable or non-marketable holding. 

There are, therefore, levels of value that need to be considered before a price negotiation range can be determined. Another level of value will be added, in addition to the Control Value for the acquired business, due to value from incremental revenue and/or cost savings from the integration of the business with the acquirer’s existing businesses (‘Synergies’). An acquirer offering a price for 100% of the target (which this article focuses on) should pay no more than the combined value from the stand-alone initial value, incremental Control Value and Synergies value (otherwise the transaction will destroy value as the Return On Invested Capital will be less than the return required by all providers of capital, the ‘Weighted Average Cost of Capital’). The minimum selling price for the vendors will be their estimate of the as-is stand alone value (for example, the DCF equity value per ordinary share). The final price will be set so that the vendors share some of the value created from control and synergies. Transaction and trading valuation multiples will be assessed when setting this price.

Consideration can take many forms (predominantly cash, shares, loan notes), payable entirely at the date legal ownership is transferred (completion) or on closing with some deferred, where future payments can be fixed and certain (ascertainable) or variable and contingent on future events beyond the control of all parties (unascertainable). Both the form and timing of consideration will affect how it is reflected in financial statements and how it is treated for tax purposes (mainly capital gains). 

In a share-for-share exchange, where the acquirer exchanges newly issued shares for shares owned by the vendor (with or without a cash component), the number of shares issued for each vendor share held in the target (the ‘Exchange Ratio’ / ‘ER’) will determine how much of the benefits (from incremental control and synergies) will be shared with the vendor. If the ER is set too high (the acquirer’s maximum ER), the acquirer’s shareholders may have value in the merged entity that equals their pre-acquisition value; if set too low, the vendor’s wealth may remain the same: the vendor’s share of pre-acquisition target value  equals their share of post-acquisition merged value plus cash received (merged value = target standalone value + acquirer value + incremental control and synergies value  - cash paid out to vendors). The final ER will usually be set at a level equal to the offer price in shares (i.e. offer price x share component percentage) divided by the acquirer price. ER can be structured in a variety of ways to share risk arising from the acquirer share price fluctuations between the sale date and completion (for a quoted acquirer). ER formulae and examples are given in the article.

Capital gains taxed under UK tax legislation will arise on consideration at the date of acquisition, whether or not it is deferred and payable in instalments after ownership of the shares has been transferred. Deferred ascertainable consideration (fixed and certain at the completion date) will be taxed on an undiscounted amount; deferred unascertainable consideration will be taxed on the value of the contigent claims (such as in an ‘Earn-out’, when part of the sale price depends on the business achieving financial metrics over a deferral period, usually 2-3 years), both at the date of acquisition and when Earn-out payments are received (examples are given in the article).

A tax charge on gains may arise at the date of exchange of shares or securities (when the vendor disposes of shares and/or securities in the target in exchange for shares and/or securities in the acquirer) and disposal (vendor sells its new shares / securities in the acquirer). Share-for-share exchanges may qualify under the reorganisation rules, so that no disposal at exchange is deemed to arise and the ‘base cost’ for gains purposes, when the shares in the acquirer are sold, is the cost of the original shares in the target (if the acquirer secures a 25% holding in the target at the exchange, this relief should be possible). Similar rules apply if securities not treated as ‘Qualifying Corporate Bonds' (‘Non-QCBs’) are exchanged for each other, with or without shares. QCBs are exempt from tax on gains, so that gains arising when QCBs in the target are exchanged and when QCBs in the acquirer are disposed of are exempt. If shares/non-QCBs are exchanged for QCBs, then the gain arising on exchange will be ‘frozen’ and taxed when the QCBs are sold (the gain on the QCB from exchange to disposal will be exempt). A detailed example is given in the article.

Other reliefs discussed in the article are: (1) ‘Business Asset Disposal Relief’:  an 18% gains tax rate on qualifying disposals by an individual, including the disposal of a holding of ordinary shares that has given an effective economic ownership (voting rights and other beneficial interests) of at least 5% continuously in the 2 years to disposal, where the individual has been an employee or director of that company over the period; and (2) ‘Substantial Shareholding Exemption’:  a tax exempt gain on the sale by a corporate vendor of shares in a qualifying company in which it has held an economic ownership of at least 10% throughout a continuous period of 12 months, beginning not more than six years before the disposal date.

The shareholding acquired and how it is paid for will affect a corporate acquirer’s treatment in IFRS financial statements, where use of the Acquisition Method for a Business Combination will be required if control (as defined) is achieved (full consolidation). If the control is achieved in stages, the investment may be recognised as an Equity Investment (broadly less than 20%) or Associate (generally 20% - 50%) before control is obtained. At the acquisition date, net assets acquired (including contingent liabilities) will need to be revalued to calculate Goodwill, which is recognised as an Intangible asset and subject to annual impairment testing (this article discusses the Business Combinations in some detail, including fair values and impairment assessments). Separate to the net assets acquired, will be the treatment of consideration paid by the corporate acquirer, and whether it is recognised as a liability (loan notes and present value of future earn-out contingent payments) or equity (shares issued as consideration), subject to the equity-liability definitions in IAS 32.