Beneficial Ownership Rules – Part 2: Valuation Considerations

In Part 1: Beneficial Ownership Rules – The Basics released on May 28, 2019, we discussed the basic reporting requirements of the new rules. In this blog, we discuss whether a business valuation may be required.

The new beneficial reporting requirements, which come into effect on June 13, 2019, require certain corporations to annually track the identity of their beneficial owners and the details of their respective ownership interests. This process may be simple for some companies and difficult for others, depending on the types of share classes issued by a company.

A company’s Articles of Incorporation describe what classes of shares a corporation is permitted to issue. Many companies only issue one class (common shares) to keep things simple. It is a routine or typical desire, however, to give individual shareholders or groups of shareholders differing rights and benefits. This can be achieved by issuing multiple classes of shares. Some attributes that can differ between classes of shares are:

• The right to vote at shareholder meetings
• The right to participate in the growth of the company
• The right of the company to redeem the shares
• The right of the shareholder to require the company to redeem the shares

The rights and characteristics of a class of shares impact the value of the shares. As one of the requirements of the new beneficial ownership rules is to report the detail of owners who hold more than 25% of the fair market value of the corporation’s shares, it can be difficult to assess the respective ownership interests if the different share classes have different values.

Below we discuss two common situations and the impact on the beneficial ownership rules.

Example #1 – A Simple Share Structure

Linda, John, and Craig are the only shareholders of a fast food restaurant. Currently, Linda holds 400 common shares, John holds 400 common shares, and Craig holds 200 common shares.

For the beneficial ownership rules, the corporation needs to track who holds more than 25% of the fair market value of the corporation’s shares and who has more than 25% of the votes. The shareholders do not know the fair market value of the corporation, and it has never been formally valued. Because there is only one class of shares (common shares), the value of each share does not need to be determined because they all have an equal value. As the corporation has issued 1,000 common shares, it is clear that Linda holds 40% of the value and votes, John holds 40% of the value and votes, and Craig holds 20% of the value and votes.

For the beneficial ownership rules, the corporation would need to track Linda and John’s ownership interest, as they each hold more than 25% of the value and 25% of the votes.

Example #2 – A More Complicated Share Structure

Kathy was the founder and sole shareholder of a manufacturing company. In 2012, she decided to pass on the business to her two adult children, James and Lucy. Because James and Lucy couldn’t afford to buy the company from Kathy, the company’s accountants performed an estate freeze. Kathy exchanged her shares for new preferred shares with a fixed value of $1,000,000. James and Lucy then bought new common shares with a value of $1 each. Although James and Lucy’s shares were only worth $1 each, any future growth of the company will increase the value of their shares, rather than Kathy’s shares.

Now in 2019, the corporation must track its beneficial owners. Assuming Kathy’s shares are non-voting, James and Lucy’s ownership interests would be tracked because they each hold 50% of the votes. But does Kathy’s ownership interest need to be tracked? She doesn’t hold greater than 25% of the votes, but she might hold greater than 25% of the fair market value.

Assuming Kathy hasn’t redeemed or sold any of her shares, Kathy’s shares would still be worth $1,000,000. If the whole company is now worth less than $4,000,000, then Kathy holds greater than 25% of the fair market value and her ownership interest needs to be tracked. If the company is now worth more than $4,000,000, her interest does not need to be tracked as she holds less than 25%.

How are the shareholders in Example #2, or in even more complex share structures, able to know which shareholders need to be tracked for beneficial ownership purposes? In many cases, it will depend on the comparative value of various share classes.

To obtain certainty, a Chartered Business Valuator can prepare a formal valuation of the business. This will not only determine the value of the entire company, but can also segregate the value between the various share classes.

For further information or to discuss how the beneficial ownership rules could affect you more specifically, contact Davis Martindale today. We would be happy to help.

You may also be interested in: Part 1: Beneficial Ownership Rules – The Basics