In a recent article, I discussed how market prices can sometimes drift away from fundamental value. Public markets are influenced by sentiment, scarcity, future expectations, competitive bidding, and liquidity. As a result, the price paid for a share is not always a direct reflection of the underlying economics of the business.
Interestingly, the opposite challenge often exists in private companies.
In shareholder agreements and employee share schemes, the value at which shares may be bought or sold is frequently determined by a formula contained in the agreement itself. While these formulas provide certainty and reduce disputes, they can produce values that differ significantly from what an independent valuation might conclude.
The reason is simple: private companies face constraints that listed companies generally do not.
Unlike listed shares, private company shares often have limited liquidity. There may be only a handful of shareholders, and there is rarely an active market of willing buyers. When a shareholder exits, the company itself or the remaining shareholders are often expected to purchase the shares. In many cases, affordability becomes a critical consideration.
A valuation formula is therefore often designed not only to determine value, but also to facilitate a practical transaction.
For example, a shareholder agreement may prescribe that shares are acquired at net asset value, or at a fixed multiple of earnings. While these approaches may be straightforward to apply, they may not fully capture future growth prospects, strategic value, intellectual property, customer relationships, or other drivers of intrinsic value.
The result can be a value that is intentionally conservative.
This is particularly common in professional practices, family businesses, and closely held private companies where continuity of ownership is considered more important than maximising the price achieved by an exiting shareholder.
Employee share schemes often take this concept even further.
Many schemes contain “good leaver” and “bad leaver” provisions. A good leaver may be someone who retires, becomes disabled, or leaves under circumstances approved by the board. A bad leaver may be an employee who resigns shortly after joining the scheme, breaches contractual obligations, or is dismissed for cause.
Under these arrangements, the valuation methodology itself may change depending on the circumstances of departure. A good leaver may receive fair value or a prescribed earnings-based valuation, while a bad leaver may receive a significantly discounted value, cost price, or even the lower of cost and formula value.
The objective is not necessarily to determine economic value with precision. Rather, it is to create incentives, discourage undesirable behaviour, and protect the interests of the remaining participants.
This highlights an important principle in valuation: not every valuation mechanism is designed to arrive at intrinsic value.
Some mechanisms are designed to achieve fairness between parties. Others are intended to preserve affordability, maintain ownership stability, facilitate succession, or support employee retention. In these situations, the valuation formula becomes a commercial tool rather than a pure measure of economic worth.
For shareholders and employees alike, it is therefore critical to understand the distinction between a contractual value and an intrinsic value. The value prescribed by an agreement may be entirely appropriate for the purpose for which it was designed, while still being materially different from what an independent valuation expert might conclude.
Understanding that difference can avoid disputes, manage expectations, and ensure that participants enter these arrangements with a clear understanding of both their rights and the economic consequences of their decisions.