Valuation of a company: Over and over again: annual valuation of equity investments
When preparing the annual statements each financial year in accordance with commercial law, the legal representatives of a company have to decide whether the assets reported on the balance sheet have retained their value. In this regard, special attention should be given to the assessment of the value of substantial investments. A key topic for investors of start-ups which is worth to know the general framework of the annual valuation of equity investments.
Investments are recorded in the balance sheet with their acquisition costs as of the date of acquisition. In the case of an acquisition from third parties, this will include the agreed purchase price and any incidental acquisition costs, e.g. notary costs or capital contributions in the case of a start-up company. It is irrelevant for the classification of a shareholding in a company as an investment under German commercial law whether the shares are held in a corporation or a partnership. The investment is reported in the fixed assets when it is lasting in nature and serves the company’s own business. This will normally be the case, where there are no plans to sell the investment.
Shareholdings are not normally subject to scheduled depreciation as they are not moveable assets subject to wear and tear. On each accounting reference date, therefore, an assessment has to be made as to whether depreciation is necessary. German commercial law provides some leeway with the evaluation of shareholdings, as there is only an obligation to report depreciation for a lasting loss in value. Where the loss is not lasting, the company can choose whether to report depreciation. In general, the use or waiver of this option should always be applied consistently over time and in comparable cases, in order to maintain an uniform method of valuation.
It should be noted that “lasting” does not mean permanent depreciation. In accordance with the principle of prudence, in the case of moveable assets, one speaks of a lasting depreciation when, at the point of time in which the annual reports are prepared, there is no specific indication of the recovery of value. Indications of lasting depreciation include, in particular, the lasting erosion of assets or diminished future prospects. On the other hand, weakness in earnings, a deteriorating income situation, economic fluctuations in the sector or mere start-up losses could indicate that the loss in value is only temporary.
Devaluation can, or rather must be undertaken when fair value falls below book value. Fair value is not defined in German law. If available, fair value can be derived from the market or stock market price. As this will not normally be possible, fair value is will normally be derived from the earning value or using the discounted cash flow method in accordance with the Principles for the Performance of Business Valuations of the Institute of Public Auditors in Germany (IDW S 1) (see IDW Opinion of the Accounting and Auditing Board on financial reporting, IDW RS HFA 10). Both procedures derive the company value as the present value of future profits and have the same conceptual basis (calculation of the capital value). While the income approach discounts future profits by the relevant capitalisation interest rate, the discounted cash flow method divides the predicted future earnings by the weighted average cost of capital. When the same valuation assumptions are applied, both of these valuation methods recognised in IDW S 1 lead to the same company value. The above-named indications of value are generally already considered in the planning of future profits.
The Institute of Public Auditors (Institut der Wirtschaftsprüfer – IDW) in Germany specified in IDW RS HFA 10 which of the relevant aspects must be taken into account for valuation for the purposes of annual financial statements. Underpinning the valuation from a German commercial law perspective is the concept of protection of creditors. Valuations therefore are designed, in particular, to determine whether the company can cover its debts. Possible creditors only have access to company assets. Consequently, the valuation of an investment must be approached from the point of view of the company writing the financial report. As a result, the only aspects which can be taken into account are synergy effects and measures that are not yet implemented, which the company itself – i.e. including subsidiaries, but not parent or affiliated companies - can implement. In addition, both the corporate taxes at the level of the investment company (which the company own shares in) and the corporate taxes resulting from the inflow to the company preparing the accounts must be taken into account. In contrast, income tax of the shareholders of the company preparing the account should not be taken into account.
Whether and to what extent a precise valuation is necessary, also in light of economic considerations, should in practice be decided on the basis of a prior assessment of the indications, which include the amount of the investment book value. If a positive asset, finance and earnings position prevails, the (proportionate) equity value of the investment company exceeds the balance sheet book value for the investment and there are no reasons for a decrease in future earnings power, a firm valuation may be unnecessary, depending on the book value of the investment. However, if there are any indications of possible depreciation in value, a reliable assessment of the valuation of an investment, with the help of recognised valuation methods, is required. When, for example, an in-depth valuation of the investment was carried out the previous year, the business position of the company has remained constant and assumptions about future earnings potential remain unchanged, it can be sufficient to rely on the valuation from the previous year, where there are sufficient hidden reserves.