Bid-Ask Spread in Business Valuation: Impact on Beta Factors

Influence of the beta factors

The beta factors indicate how strongly the return on a security moves in comparison to the market as a whole.

• A beta factor of 1 means that the security moves on average as much as the market.
• If the value is greater than 1, this indicates above-average volatility.
• A value of less than 1 indicates below-average volatility.

The beta factors are an essential component of a legally compliant business valuation. Errors in its determination caused by distortions can have a significant impact on the company value.

The bid-ask spread is one of the relevant distortion factors. A high spread can lead to an overestimation or underestimation of volatility and thus to a beta factor that is too high or too low. A distorted beta factor due to a high bid-ask spread has consequences:

• Cost of capital too high: The cost of capital is overestimated, resulting in a lower business valuation.
• Cost of capital too low: The cost of capital is underestimated, which leads to an inflated business valuation.

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What role does the bid-ask spread play in business valuation?

The bid-ask spread is the difference between the highest purchase price (bid) and the lowest selling price (ask) of a security. This factor is often underestimated when determining the beta factors in business valuations. It can be thought of as a kind of uncertainty factor.

High bid-ask spreads add so-called random "noise" to the determination of the beta factors. In the context of business valuation, the bid-ask spread is relevant for three reasons:

• Market liquidity: Because a high spread indicates low market liquidity, this can be an indication of greater uncertainty on the market.
• Volatility: Strong price fluctuations generally lead to a wider spread. Companies with high volatility are riskier. Buyers therefore value them with a higher risk premium.
• Information asymmetry: Wide spreads can be a sign of information imbalances between buyers and sellers. If there is insider knowledge, for example, both parties may have different ideas about the price.

High bid-ask spreads lead to greater valuation uncertainty. This makes it more difficult to determine a precise company value. This is because the actual achievable sales price may be lower or higher than the theoretical value due to the spread.

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Compensation offers in listed squeeze-out proceedings

The beta factors play a decisive role in squeeze-out procedures for publicly traded companies. It is used to determine appropriate compensation for minority shareholders.

In particular, if a company is listed on the stock exchange with only a very small free float after a squeeze-out of 95%, the beta factors become the central valuation criterion. However, determining a reliable beta factor in this situation is challenging:

• After a squeeze-out, the trading volume is usually very low. This leads to a wide bid-ask spread and makes it difficult to calculate a representative beta factors.
• In the period before a squeeze-out, the share is often subject to increased fluctuations. This is because investors are now preparing for the forthcoming offer. This leads to distorted historical volatility measures - and thus to a potentially inflated beta factor.

The question of whether to use the company's own beta or the beta of a peer group is of crucial importance in such cases:

• Own beta: The use of own beta factors is generally desirable. After all, it reflects the specific risks of the company. However, this only makes sense if the beta factors can be calculated on the basis of a sufficient amount of historical data and taking into account the aforementioned distortions.
• Peer group beta: If the company's own beta cannot be reliably determined due to the difficulties mentioned, the alternative is to use a peer group beta. The beta factors of a group of comparable companies are determined and transferred to the valuation object.

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Court decisions on settlement offers

German case law has repeatedly made it clear that the bid-ask spread has a significant influence on the valuation of companies, especially in connection with squeeze-out valuations.

Courts have repeatedly emphasized that a high bid-ask spread can be seen as an indication of low liquidity and thus of an ineffective valuation. Examples from practice are:

• OLG Frankfurt a. M. - Decision of 26.1.2017 - 21 W 75/15: The court stated that liquidity should be assessed using several indicators, including actual trading volume, trading days, free float and the bid-ask spread. It further noted that, although there are no fixed thresholds for the individual indicators, a bid-ask spread clearly above 2% raises significant concerns about share liquidity.‍
• ‍LG Stuttgart – Decision of 5 November 2012 – 31 O 55/08 KfH AktG, published in NZG 2013, 342: The decision addressed the significance of low liquidity for the reliability of a beta factor.
• OLG Frankfurt: In further proceedings, the court has continued to treat liquidity indicators, including the bid-ask spread, as relevant when assessing whether the company’s own beta can reliably be used.
• The case of Augusta-Technologie AG illustrates the practical relevance of this case law. In this case, the Munich I Regional Court objected to the valuation of the company as the bid-ask spread was deemed to be too high.

The bid-ask spread is a decisive factor in the valuation of companies in squeeze-out valuations. A careful analysis of the liquidity of the share and the selection of suitable valuation methods are therefore essential for a legally sound valuation.

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Fundamental importance for business valuation

The significance of the bid-ask spread goes far beyond the specific context of squeeze-out procedures. It is true that compensation offers pose a particular challenge for publicly traded companies. However, the typical valuation occasions in business valuation are more diverse:‍

• ‍Company acquisition: In the case of company acquisitions, the valuation is central to determining the appropriate purchase prices.
• ‍Venture capital: Start-ups and young companies are often valued in order to determine the amount of investment.
• ‍Real estate valuation: Similar principles are also applied to real estate valuations, albeit with different key figures.

Nevertheless, the aforementioned standards also apply here, as the beta factors of peer group companies can also be distorted.

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Conclusion: Bid-ask spread and beta factors

The bid-ask spread is an extremely relevant factor for business valuation. The accuracy of the beta factors is crucial, as a high bid-ask spread can lead to a distortion of the beta factor.

Because this is a central component of many valuation models, a bias has a direct effect on the calculated business valuation.

In squeeze-out procedures, in which a major shareholder forces the remaining shareholders out of the company, the exact determination of the company value is also important. Here, a high spread can lead to considerable differences in the valuation and result in legal disputes.

The bid-ask spread also plays a role in other valuation occasions such as company acquisitions or venture capital financing. It is an indicator of the liquidity of a security and can increase uncertainty about the true value.

To ensure a fair and accurate business valuation, the following aspects should be taken into account:‍

• ‍Selection of the appropriate valuation method: Depending on the situation and data situation, different valuation methods can be used.‍
• Consideration of the bid-ask spread: The spread should be taken into account when selecting the data and calculating the key figures.‍
• Sensitivity analyses: Sensitivity analyses should be carried out to examine the effects of different assumptions on the valuation result.‍
• Alternative valuation methods: Alternative valuation methods can be considered in the event of high uncertainty due to a high spread.

Failure to observe the bid-ask spread can lead to significant errors in the valuation. This would have negative consequences for both companies and investors.

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References

1. OLG Frankfurt am Main (2017). Beschluss vom 26. Januar 2017 – 21 W 75/15. https://dejure.org/dienste/vernetzung/rechtsprechung?Aktenzeichen=21+W+75%2F15&Datum=26.01.2017&Gericht=OLG+Frankfurt
2. LG Stuttgart (2012). Beschluss vom 5. November 2012 – 31 O 55/08 KfH AktG, published in NZG 2013, 342. https://dejure.org/dienste/vernetzung/rechtsprechung?Aktenzeichen=31+O+55%2F08&Datum=05.11.2012&Gericht=LG+Stuttgart