Does the choice in valuation method matter in the judicial appraisal of private firms?

• Published date: 01 January 2019
• Author: Jani Saastamoinen,Hanna Savolainen
• DOI: http://doi.org/10.1111/jbfa.12364
• Date: 01 January 2019

DOI: 10.1111/jbfa.12364

Does the choice in valuation method matter in the

judicial appraisal of private firms?

Jani Saastamoinen Hanna Savolainen

University of Eastern Finland Business School,

P.O. Box111, FI-81101 Joensuu Finland

Correspondence

JaniSaastamoinen, University of Eastern Finland

BusinessSchool, P.O.Box 111, FI-81101 Joensuu,

Finland.

Email:jani.saastamoinen@uef.fi

JELClassification: G32, K22, M41

Abstract

This paper investigates empirical relations between the redemption

values of minority shares and valuation methods used by dissenting

parties in the judicial valuation of private firms. We examine a com-

prehensive data set of Finnish judicial appraisal cases in which the

judge decides the valuation of the minority stake in a private firm

after learning the valuation estimates put forward by the controlling

shareholder(s) and the minority shareholder(s). Rationality in valua-

tion will be achievedif a valuation estimate incorporates all the avail-

able information regardless of the valuation method adopted. Con-

versely,the measurement perspective argues that biases inherent in

valuation approaches determine the information content in a valua-

tion estimate. Our statistical analyses suggest that the choices made

concerning the valuation method are statistically correlated with the

appraisal outcomes. We interpret this as evidence consistent with

the measurement perspective.

KEYWORDS

business valuation, judicial valuation, law and finance, private com-

pany,sell-out, squeeze-out, valuation methods

1INTRODUCTION

Judicial valuations in shareholder dissent cases seek to provide minority shareholders with an option to exit the com-

pany at fair value (Yee, 2002). An objective judicial appraisalrequires that the judge makes unbiased valuation esti-

mates. However,the characteristics of valuation methods may bias valuation estimates and thus influence the judge's

verdict (Beatty, Riffe, & Thompson, 1999). According to Chen, Yee, and Yoo (2010) (hereafter CYY), there are two

schools of thought on how valuation methods influence the appraisal outcome of litigation. The ‘rationality’ perspec-

tivebelieves that the choice of a valuation method does not affect the outcome. That is, the valuation estimate incorpo-

rates all the available information pertaining to the valuation, and the chosen valuation method is rationally adjusted

if needed. Conversely, the ‘measurement’ perspectiveargues that the chosen method determines which information

and adjustments are incorporated into the valuation estimate. In other words, the limitations and biases inherent in

valuation methods manifest themselves in valuation estimates.

Empirical evidence appears to support the rational perspective on judicial valuation. In an investigation into

public company shareholder litigation cases tried in the Delaware Court of Chancery in the United States, CYY report

J Bus Fin Acc. 2019;46:183–199. wileyonlinelibrary.com/journal/jbfa c

2018 John Wiley & Sons Ltd 183

184 SAASTAMOINENAND SAVOLAINEN

evidenceconsistent with the rational perspective. They find that a valuation method agreement between the judge and

either the plaintiff or the defendant, which means thatthe judge and the litigant use the same valuation approach, is not

associated with the appraisal outcome. In addition, US-based studies of tax court valuations concerning private firms

andassets such as real estate also lend support to the view that the court is capable of discerning the litigants’ divergent

valuation estimates and promulgating unbiased valuations (Beatty et al., 1999; Englebrecht & Jamison, 1979).

However, research into the judicial appraisalof shareholder dissent cases concerning private firms is scarce. Fur-

ther, how valuation methodologies used in judicial valuation are associated with appraisaloutcomes is an unexplored

subject in the context of private firms. Establishing an objective valuation for a private firm is complicated (Boatsman

& Baskin, 1981; Gilson, Hotchkiss, & Ruback, 2000). Private company valuations tend to be highly subjective even if

appraisers use the same appraisal methodologies (Koeplin,Sarin, & Shapiro, 2000; Waldron & Hubbard, 1991). As pri-

vate firms are often small and medium-sized enterprises (SMEs), impediments to valuation include inactivemarkets for

small business equity (Harper & Rose, 1993) and restricted information on their finances and prospects (e.g. LeClair,

1990; Manigart et al., 1997). In addition, most valuation methods produce large estimation errors (Harper & Rose,

1993) and none are superior in predicting the value of a small business (Pricer & Johnson, 1997). Hence, valuation

estimates for private firms are made in an environment where biases may arise consciously or unconsciously from the

inputs and assumptions used in valuation models.

This paper presents an exploratorystudy into the judicial appraisal of private firms. We examine the empirical rela-

tions between the redemption values of minority shares and the valuation methods used by the parties in dispute. We

ask the following research question: “Does the choice in valuation method matter in the judicial appraisal of private

firms?” Since valuation approaches differ in their inputs and assumptions, we also examine how individual valuation

approaches correlate with the outcomes of judicial appraisals.

Our study focuses on shareholder dissent in squeeze-out valuations. In a squeeze-out, the controlling shareholder

buys out the company's minority shareholders. A judicial appraisal resolves a dispute concerning fair compensation

for the minority shareholders’ stake in the firm. Subsequently, the litigants present their valuation estimates to the

judge who, after making his or her own valuation estimate, issues a verdict on the valuation of the firm's equity.Since

a squeeze-out does not involve equal parties, a conflict of interest between the controlling shareholder and minority

shareholder(s) may be detrimental to the latter party's welfare (Bates, Lemmon, & Linck, 2006). Hence, it is important

that the court as an impartial body passes an objective judgment on the firm's valuation.

Our empirical research strategy closely follows CYY and supplements their approach with controls for firm size

and industry affiliation, which are value-relevant characteristics (Chen,Yee, & Yoo, 2007). Our data consists of judicial

valuations of private firm squeeze-outs in Finland. The data is a comprehensive set of hand-collected arbitration pro-

ceedings between 1998 and 2014. Finnish arbitration proceedings follow the principles of the adversarial procedure

previously investigatedby CYY.

Our results suggest that, overall, judicial valuation outcomes depend on the extent of agreement over valuation

approaches. A judge's valuation estimate tends to be closer to the litigant's estimate when the litigant uses the same

valuation approach as the judge. We interpret our results as being consistent with the measurement perspective in

CYY’s terminology.Our findings cannot be attributed to any single valuation approach. To a large extent, these results

are robust to alternative model specifications and statistical tests.

We contribute to the existingresearch on business valuation in several ways. First, we investigate the judicial valua-

tion of private firms, which is a relativelyunexplored area in the business valuation literature. Whilst previous research

has focused on public companies with highly sophisticated corporatelawyers and valuation experts carrying out a judi-

cial appraisal (Chenet al., 2007; 2010), we explore an environment in which information relevant to business valuation

is far less abundant. Second, we link common valuation methods to valuation outcomes and contribute to the literature

on private business valuation. Finally,our empirical setting is from a continental European context, which complements

the judicial valuation literature dominated by US-based studies.

Our findings are significant due to the economic importance of private firms. For instance, estimates suggest that

the total value of private firm equity exceedsthat of public companies (Anderson, 2009). Moreover,SMEs account for

over 95% of businesses in most industrialized economies (OECD, 2013). While the market for private firm equity in