Private Company Valuation

A firm's assets typically consist of both operating and nonoperating assets:

Nonoperating assets, those not crucial to the firm's primary operations and focus, are typified by excess cash and investment accounts. However, nonoperating assets constitute a portion of firm value and must be included when valuing a firm.

Estimating Normalized Earnings:

Normalized earnings should exclude nonrecurring and unusual items. In the case of private firms with a concentrated control, there may be discretionary or tax-motivated expenses that need to be adjusted when calculating normalized earnings. These adjustments can be quite significant when the firm is small.

The income approach refers to valuation methods based on the idea that the value of an asset is the present value of its future income. Three methods consistent with the income approach are:

The free cash flow method (a.k.a. discounted cash flow method), the capitalized cash flow method, and the residual income or excess earnings method.

Fair market value: *Most often used for tax purposes* in the United States, fair market value is a cash price characterized by:

• A hypothetical willing and able seller sells the asset to a willing and able buyer. • An arm's length transaction (neither party is compelled to act) in a free market. • A well-informed buyer and seller.

Market value: This is frequently *used for appraisals of real estate and other real assets* where the *purchase will be levered*. The International Valuation Standards Committee defines market value as the value estimated on a particular date characterized by:

• A willing seller and buyer. • An arm's length transaction. • An asset that has been marketed. • A well-informed and prudent buyer and seller.

Fair value for financial reporting: This is *similar to fair market value* and is used for financial reporting. Using International Financial Reporting Standards (IFRS) and U.S. GAAP, *fair value is the current price paid to purchase an asset or to transfer a liability*. It is characterized by:

• An arm's length transaction. • A well-informed buyer and seller.

In valuing a firm, the appropriate earnings definition is normalized earnings:

"firm earnings if the firm were acquired."

Estimating the discount rate in a private firm valuation can be quite challenging for the following reasons (cont'd):

*Projection risk:* Because of the lower availability of information from private firms and managers who are inexperienced at forecasting, that analyst should increase the discount rate used. *Lifecycle stage:* It is particularly difficult to estimate the discount rate for firms in an early stage of development. If such firms have unusually high levels of unsystematic risk, the use of the CAPM may be inappropriate. Although ranges of discount rates can be specified for the various lifecycle stages, it may difficult to classify the stage a firm is in.

When a closely controlled firm does business with its owners or other businesses controlled by its owners, firm expenses may be:

Inflated and reported earnings, therefore, may be artificially low. Artificially low earnings may also be the result of excessively high owner compensation or of personal expenses charged to the firm. These expenses will also affect the firm's tax expense. The adjustments are potentially larger when the owners' family members have connections to the firm. Use of company-owned assets (e.g., aircraft, personal residences, company-provided life insurance, loans for managers/ owners) potentially require an adjustment to earnings.

Cash flow estimates often are based on current management estimates or result from analyst consultation with management. The analyst should be aware of the potential bias in management estimates. For example:

Management may overstate the value of goodwill or understate future capital needs.

A valuation or appraisal should only be used for its intended purpose. A valuation performed on one date according to a specific definition and for a specific purpose:

May not be relevant for other purposes and dates. For example, the fair market value of equity for a controlling interest will likely be much different than the investment value of a minority interest that has little influence over the firm's decisions. Furthermore, valuations prepared for tax purposes will likely require adjustment before they can be used for financial reporting.

For small private companies with limited assets:

Net income multiples might be used instead of EBITDA multiples. A revenue multiple might be used for extremely small firms, given the greater likelihood and impact of discretionary expenses such as owner compensation.

Estimating the discount rate in a private firm valuation can be quite challenging for the following reasons:

*Size premiums:* Size premiums are often added to the discount rates for small private companies. Estimating this premium using small public firm data may be biased upward by the fact many of the small firms in the sample are experiencing financial distress. *Availability and cost of debt:* A private firm may have less access to debt financing than a public firm. Because equity capital is usually more expensive than debt and because the higher operating risk of smaller private companies results in a higher cost of debt as well, WACC will typically be higher for private firms. *Acquirer versus target:* When acquiring a private firm, some acquirers will incorrectly use their own (lower) cost of capital, rather than the higher rate appropriate for the target, and arrive at a value for the target company that is too high.

The three major *approaches* to private company valuation are the income approach, the market approach, and the asset-based approach:

1. Income approach: Values a firm as the *present value of its expected future income*. Such valuation may be based on a variety of different assumptions and variations. 2. Market approach: Values a firm using the *price multiples* based on recent sales of comparable assets. 3. Asset-based approach. Values a firm's *assets minus its liabilities*.

If an interest in a firm cannot be easily sold, discounts for lack of marketability (DLOM) would be applied (sometimes termed a discount for lack of liquidity). It is often the case that if a DLOC is applied:

A DLOM will also be applied. For example, if a controlling shareholder believes that a private firm should not be sold, minority shareholders both lack control and lack the ability to sell their position.

For each scenario, the analyst must assign a discount rate and probability based on the scenario's risk and probability of occurring:

A firm value for each scenario is estimated, and a weighted average of these values is used to estimate firm value. Alternatively, a weighted average scenario cash flow may be discounted using a single discount rate to arrive at an estimate of firm value.

Some analysts will remove any income and expenses from real estate on the income statement. If it is used in the firm's business:

A market-estimated rental expense is used in calculating or estimating earnings. The value of real estate is therefore separated from its operations and treated as a nonoperating asset. If the real estate is leased from a related party, the lease rate should be adjusted to a market rate.

There has been an increased focus on the valuation of private companies, in part due to the use of fair value estimates for financial reporting. As a result:

A number of valuation standards have been developed, which specify the formation and dissemination of the valuation. There is no single valuation standard.

Quality of financial and other information:

A potential creditor or equity investor in a private firm will have less information than is available for a public firm. This leads to greater uncertainty, higher risk, and reduces private firm valuations.

Initial public offering (IPO):

A public sale of the firm's equity increases its liquidity. Investment banks often perform IPO valuations using the values of similar public firms as a benchmark.

This method is also known as the capitalized income method or the capitalization of earnings method. Under this method:

A single measure of economic benefit is divided by a capitalization rate to arrive at firm value, where the capitalization rate is the required rate of return minus a growth rate. This is a growing perpetuity model that assumes stable growth and is, in effect, a single-stage free cash flow model. It is most often used for small private companies. It may be suitable when no comparables are available, projections are quite uncertain, and stable growth is a reasonable assumption.

To estimate the DLOM, an analyst can use one of three methods. Third method:

A third method would estimate the DLOM as the price of a put option divided by the stock price, where the put used is at-the-money. The time to maturity of the valued option could be the time to the IPO. The volatility used could be based on the historical volatility of publicly traded stock or the implied volatility of publicly traded options. The advantage of this approach over the other two DLOM estimation methods is that the estimated risk of the firm can be factored into the option price. The drawback of this approach is that a put provides a certain selling price, not actual liquidity.

The valuation of equity depends on the definition of value used. Controlling and noncontrolling equity interests will have quite different values. These differences should be:

Accounted for in cash flow estimates and assumptions.

Short-term investors:

Although manager compensation in public firms often includes incentive compensation such as stock options, shareholders often focus on short-term measures of performance such as the level and consistency of quarterly earnings. In such cases, management may take a shorter-term view *compared to private firms where managers are long-term holders of significant equity interests*.

If a firm is performing poorly, the owners may be receiving compensation below market levels. In this case:

Reported earnings would overstate normalized earnings.

Litigation-related valuations may be required for shareholder suits, damage claims, lost profits claims, or divorce settlements:

Because the valuation methods for transactions, compliance, and litigation are often quite different, most appraisers specialize in a single area. Transaction-related valuations are usually performed by investment bankers, compliance-related valuations by those with accounting or tax knowledge, and litigation-related valuations by those comfortable with a legal setting and specific jurisdictions.

The characteristics that distinguish private and public companies can be delineated into:

Company-specific and stock-specific factors. Overall, company-specific factors can have positive or negative effects on private company valuations, whereas stock-specific factors are usually a negative. Compared to public companies, private companies have greater heterogeneity so that the appropriate discount rates and methods for valuing them vary widely as well.

For the free cash flow method, the terminal value can be calculated using a:

Constant growth model (e.g., dividend discount model). Some analysts use a price multiple approach to estimate a firm's terminal value. Note, however, that if the price multiple is for a firm in a high growth industry, the price multiple applied will often reflect both high growth and normal growth. In this case, the high growth is double counted, once in the price multiple and once in the periodic cash flow forecasts.

Sale in an acquisition:

Development-stage or mature private firms are often sold to generate liquidity for the owners. Valuations are usually performed by both the firm and the buyer and are subject to negotiation.

Once free cash flows have been estimated as we have done previously, they are:

Discounted by a rate that reflects their risk. Typically, there is a series of discrete cash flows and a terminal value that reflects the value of the business as a going concern at some future date. The terminal value is calculated for a point of time in the future, at which the growth rate is expected to level off and remain constant. *In practice, most analysts estimate the terminal value five years out.*

Large private firm valuation is usually based on:

EBIT or EBITDA multiples. The numerator would be the market value of invested capital (MVIC), from which the market value of debt could be subtracted when examining equity value. Because the market value of debt is often hard to ascertain, the book value can be used if the firm has low financial leverage and is stable. If the firm has high debt levels or volatility, an analyst could use matrix pricing, where the prices of similar debt are used to infer a value for the subject's debt.

Bankruptcy proceedings:

For firms in bankruptcy, accurate valuation can help determine whether the firm should be liquidated or reorganized. If it is determined that the firm can continue as a going concern, accurate valuation is important in its restructuring.

When there is significant uncertainty about a private company's future operations, the analyst should examine several scenarios when estimating future cash flows:

For development stage firms, scenarios could include a sale of the firm, an IPO, bankruptcy, or continued private operation. For a mature firm, scenarios might include different ranges of cash flows based on different assumed growth rates.

Nonfinancial measures may be appropriate in some industries:

For example, a hospital's price per bed could be used. These measures should be accepted in its industry and accompanied by financial measures.

Venture capital financing:

Firms in the development stage often need external financing for capital investment and receive private financing from venture capital investors. To reduce risk to the venture capital investor, the *capital is often provided in rounds after the achievement of specific benchmarks known as milestones*. Valuations are usually subject to negotiation and are somewhat informal due to the uncertainty of future cash flows.

Performance-based managerial compensation:

If a firm compensates employees with stock options, grants of restricted stock, or employee stock ownership plans, accurate valuation is necessary for both accounting and tax purposes.

Valuing the firm as a whole using the CCM:

If growth is non-constant, the capitalized cash flow method (CCM) should be avoided in favor of the free cash flow method. The CCM could be used to back out the discount rate or growth rate implicit in market data.

A transaction may be either strategic or financial (nonstrategic):

In a strategic transaction, valuation of the firm is based in part on the perceived synergies with the acquirer's other assets. A financial transaction assumes no synergies, as when one firm buys another in a dissimilar industry.When estimating normalized earnings for a strategic transaction, the analyst should incorporate any synergies as an increase in revenues or as a reduction in costs.

Management!shareholder overlap:

In most private firms, management has a substantial ownership position. In this case, external shareholders have less influence and the firm may be able to take a longer-term perspective.

Valuation methods for private companies are similar to those used to value public companies, but they have different names:

In the public equity world, *the income approach is known as discounted cash flow or present value* analysis. The income approach and the asset-based approach are termed *absolute valuation models*.

Firm size is also a consideration in choosing a valuation methodology:

Price multiples from large public firms should not be used to value a small private firm without some assurance that the risk and growth prospects of the firms are similar.

Stage of lifecycle:

Private companies are typically less mature than public firms. Sometimes, however, private firms are mature firms or bankrupt firms near liquidation. The valuation analysis will vary with the lifecycle stage of the firm.

Restrictions on marketability:

Private companies often have agreements that prevent shareholders from selling, reducing the marketability of shares.

Liquidity:

Private company equity typically has fewer potential owners and is less liquid than publicly traded equity. Thus, a liquidity discount is often applied in valuing privately held shares.

Taxes:

Private firms may be more concerned with taxes than public firms due to the impact of taxes on private equity owners/managers.

Size:

Private firms typically have less capital, fewer assets, and fewer employees than public firms and, as such, can be riskier. Accordingly, private firms are often valued using greater risk premiums and greater required returns compared to public firms.

The excess earnings method (EEM) is used infrequently but can be used for:

Small firms when their intangible assets are significant. However, the required return for working capital and fixed assets is subject to estimation error.

Quality and depth of management:

Smaller private firms may not be able to attract as many qualified applicants as public firms. This may reduce the depth of management, slow growth, and increase risk at private firms.

Because they are applied in a sequential process, the DLOC and DLOM are multiplicative, not additive:

So if the DLOC is 20%, and the DLOM is 13%, the total discount is:

Other adjustments are common to both private and public companies (e.g., adjustments for differences in depreciation and inventory methods). Additionally:

Some private firm financial statements are reviewed rather than audited; some may be only compiled (i.e., no auditor opinion is provided).

*Market approaches* to valuing private firms *use price multiples and data from previous public and private transactions*. The three methods discussed in the following are:

The *guideline public company method (GPCM)*, the *guideline transactions method (GTM)*, and the *prior transaction method (PTM)*. Many *practitioners prefer market approaches* to valuation over income and asset approaches *because actual sales data are used*. Although *U.S. tax courts* accept both market and income approaches, they *usually prefer market approaches*.

The selection of an *appropriate valuation approach* depends on:

The firm's operations and its lifecycle stage. *Early in its life*, a firm's future cash flows may be subject to so much uncertainty that an *asset-based approach* would be most appropriate. As the firm moves to *a high growth phase*, it might be appropriately valued using an *income approach*. A *mature firm* might be more appropriately valued using the *market approach*.

In general, adjustments are required when the liquidity or control position of an acquisition differs from that of the comparable companies. If, for example:

The comparable firm values are for the purchase of an entire public company and we wish to value a minority stake in a private firm, we would need to apply discounts for both a lack of control and a lack of marketability (liquidity).

Concentration of control:

The control of private firms is usually concentrated in the hands of a few shareholders, which may lead to greater perquisites and other benefits to owners/managers at the expense of minority shareholders.

When evaluating a controlling equity interest in a private firm (GPCM):

The control premium (i.e., the value of control) should be estimated. The control premium equals the difference between the pro rata value of a controlling interest and the pro rata value of a noncontrolling interest. Most public share trades are for small, noncontrolling interests; therefore, the price multiple does not reflect a control premium.

Although these methods provide a basis for calculating the DLOM, it is often challenging to implement them:

The data may be limited, the interpretation of the data will vary, and the magnitude of the DLOM applied to a company will vary by analyst. In addition to the DLOC and DLOM, other discounts could be applied, such as key person discount.

Under the excess earnings method, the analyst starts with:

The earnings that should be generated by working capital and fixed assets based on an estimate of the required return. Excess earnings are firm earnings minus the earnings required to provide the required rate of return on working capital and fixed assets. The value of intangible assets can be estimated as the present value of the (growing) stream of excess earnings (using the excess earnings and the growing perpetuity formula from the CCM). This value for the intangible assets is added to the values of working capital and fixed assets to arrive at firm value.

Under U.S. GAAP SFAS 157, fair value is:

The exit price (i.e., the price received by the seller), which will likely be lower than the entry price paid by the buyer in a transaction. IFRS does not specify an exit or entry price in fair value determination.

The asset-based approach estimates the value of firm equity as

The fair value of its assets minus the fair value of its liabilities.Because it is easier to find comparable data at the firm level compared to the asset level, the income and market approaches would be preferred when valuing going concerns. It is generally not used for going concerns. Of the three approaches, the asset-based approach generally results in the lowest valuation because the use of a firm's assets in combination usually results in greater value creation than each of its parts individually.

To estimate the DLOM, an analyst can use one of three methods. Second method:

The price of pre-IPO shares is compared to that of post-IPO shares. One complicating factor is that post-IPO firms are generally thought to have more certain cash flows and lower risk, so the estimated DLOM may not purely reflect changes in marketability.

To estimate the DLOM, an analyst can use one of three methods. First method:

The price of restricted shares is used. As an example, SEC Rule 144 may restrict the sale of shares acquired in a firm prior to its IPO. In this case, the price of the restricted shares is compared to the price of the publicly traded shares.

Minority shareholders are at a disadvantage relative to controlling shareholders because they have less power to select the directors and management. Without a voice, they cannot determine the investment and payout policies that affect the value of the firm and the distribution of earnings. However, firms that will experience an IPO or sale are less likely to pursue actions that damage minority shareholders. The *factors for determining a discount for lack of control (DLOC) are*:

The same as those for the control premium discussed earlier. Because it is difficult to measure the disadvantage from a lack of control, the discount is usually backed out of the control premium.

In response to the U.S. savings and loan crisis in the late 1980s and early 1990s, the Uniform Standards of Professional Appraisal Practice (USPAP) were created by the Appraisal Foundation:

These standards cover real estate, fixed income, and private business valuations. Although the Appraisal Foundation is a congressionally authorized provider of standards, business appraisers are not required to adhere to the standards. The International Valuation Standards Committee (IVSC) has created the International Valuation Standards, covering businesses, business interests, real estate, and tangible as well as intangible assets. These standards also include a separate application standard covering valuations for financial reporting.

Intrinsic value:

This is derived from investment analysis and is described as the market value once other investors arrive at this "true" value. Intrinsic value is independent of any short-term mispricing.

Fair value for litigation:

This is similar to fair value but its definition depends on U.S. state statutes and legal precedent in the jurisdiction of the litigation.

Expanded CAPM:

This version of the CAPM includes additional premiums for size and firm-specific (unsystematic) risk.

The guideline public company method (GPCM) uses price multiples from:

Trade data for public companies, with adjustments to the multiples to account for differences between the subject firm and the comparables. The data should be checked to see that they are comparable.

There are three reasons for valuing the total capital and/or equity capital of private companies:

Transactions, compliance, and litigation.

CAPM:

Typically, beta is estimated from public firm data, and this may not be appropriate for private firms that have little chance of going public or being acquired by a public firm. Due to the differences between large public firms and small private firms, some U.S. tax courts have rejected the use of the CAPM for private firms.

Calculating free cash flow to the firm or to equity holders for private firms can be particularly challenging given:

Uncertain future cash flows and figures that are often generated using the current owners' input.

Although analysts use FCFF or FCFE depending on the purposes of the valuation, FCFF is:

Usually more appropriate when the significant changes in the firm's capital structure are anticipated. The reasoning is that the discount rate used for FCFF valuation, the weighted average cost of capital (WACC), is less sensitive to leverage changes than the cost of equity, the discount rate used for FCFE valuation. Thus, the FCFF valuation is less sensitive to the degree of financial leverage assumed in the analysis than the FCFE valuation.

The prior transaction method (PTM) uses transactions data from the stock of the actual subject company and is most appropriate when:

Valuing minority (noncontrolling) interests. The valuation under this method can be based on the actual transaction price or multiples derived from such transactions. Ideally, the previous transactions would be arm's-length, of the same motivation (strategic or financial) as the subject transaction, and fairly recent.

The appropriate valuation method depends on:

What the valuation will be used for and whether the firm is a going concern.

Build-up method:

When it is not possible to find comparable public firms for beta estimation, the build-up method can be used. Beginning with the expected return on the market *(beta is implicitly assumed to be one)*, premiums are added for small size, industry factors, and company specific factors.

The DLOM varies with the following:

• An impending IPO or firm sale would decrease the DLOM. • The payment of dividends would decrease the DLOM. • Earlier, higher payments (i.e., shorter duration) would decrease the DLOM. • Contractual restrictions on selling stock would increase the DLOM. • A greater pool of buyers would decrease the DLOM. • Greater risk and value uncertainty would increase the DLOM.

Investment value: Focuses on the *value to a particular buyer and is important in private company valuation*. Investment value may be different for different investors, depending on:

• Estimates of future cash flows. • Perceived firm risk. • Appropriate discount rates. • Individual financing costs. • Perceived synergies with existing buyer assets.

Compliance-related valuations are performed for legal or regulatory reasons and primarily focus on financial reporting and tax issues:

• Financial reporting: Valuations in this area are often related to goodwill impairment tests in which units of a public firm are valued using private company valuation methods. The reporting of stock-based compensation also requires accurate valuation. • Tax purposes: At the firm level, transfer pricing, property taxes, and corporate restructuring may necessitate valuations. For individual equity owners, estate and gift tax issues may necessitate valuations.

The asset-based approach might be appropriate in the following circumstances:

• Firms with minimal profits and little hope for better prospects. In this situation, the firm might be valued more highly for its liquidation value rather than as a going concern by a firm that can put the assets to better use. • Finance firms such as banks, where their asset and liability values (loan and security values) can be based on market prices and factors. • Investment companies such as real estate investment trusts (REITs) and closed-end investment companies (CEICs) where the underlying assets values are determined using the market or income approaches. Management fees and the value of management expertise may result in values different from net asset value. • Small companies or early stage companies with few intangible assets. • Natural resource firms where assets can be valued using comparables sales.

The stock-specific differences between private and public firms often include the following:

• Liquidity • Restrictions on marketability • Concentration of control

Considerations when using market approaches to valuing private firms:

• Private firms may have risks not common to public firms, such as greater company risk and illiquidity. Therefore, it is important that the public comparables be chosen carefully. • Price multiples reflect both risk and growth. Each of these should be extracted from the price multiple and compared to the subject private firm to decide what adjustments might be made. • When choosing the comparables, commonalities in industry, operations, size, and lifecycle are desired.

Company-specific factors include the following:

• Stage of lifecycle • Size • Quality and depth of management • Management!shareholder overlap • Short-term investors • Quality of financial and other information • Taxes

There are many challenges involved with the implementation of appraisal standards:

• The compliance with these standards is usually at the discretion of the appraiser because most buyers are still unaware of them. • Because most valuation reports are private, it is very difficult for the organizations to ensure compliance to the standards. • Although the organizations provide technical guidance on the use of their standards, it is necessarily limited due to the heterogeneity of valuations.

The variability of estimated discounts for adjustments varies with the following:

• The data used to estimate them and the analyst's interpretation of them. • The perceived importance of the invested position. • The allocation of shares and the resulting effect on control. • The relationships between various parties. • The protection provided to minority shareholders by state laws. • The likelihood of an IPO or sale. • The payment of dividends.

Any real estate owned by the firm may merit treatment separate from that of firm operations for the following reasons:

• The real estate may have different risk characteristics than firm operations. • The real estate may have different growth prospects than firm operations. • The cost of the real estate owned by the firm will be reported as depreciation expense. However, depreciation is most often based on historical cost and may understate the current cost in the market of the use of the assets.

To estimate a control premium, a public transaction should be used where a firm was acquired. When estimating a control premium, the following issues should be considered (GPCM):

• Transaction type: Recall that a transaction may be either strategic or financial (nonstrategic). A financial transaction typically has a smaller price premium. • Industry conditions: Periodically, there is a flurry in industry acquisition activity, driving up acquisition prices. In such markets, share prices of public companies may already reflect some premium for control. • Type of consideration: Some historical acquisitions involve the acquirer's stock rather than cash. Estimates of the control premium when acquisitions are made with shares that are at higher temporary or "bubble" values will be overstated. • Reasonableness: The use of control premiums and price multiples can quickly result in significant differences in valuations from historical pricing.

When using the guideline transactions method (GTM), prior acquisition values for entire (public and private) companies that already reflect any control premiums are used, so no additional adjustment for a controlling interest is necessary. Data on the sale of private firms are more limited and not always accurate compared to public companies. When using multiples from historical transactions, several issues should be considered:

• Transaction type: a prior transaction may be a strategic transaction where firm value was based, in part, on perceived synergies. If the subject transaction is nonstrategic, the analyst may need to adjust the historical multiple. • Contingent consideration: the part of the acquisition price that is contingent on the achievement of specific company performance targets, such as receiving FDA approval for a drug. As contingent consideration increases the risk to the seller, transactions with contingent consideration should be scrutinized before they are compared to transactions without such contingencies. • Type of consideration: some transactions are for stock rather than cash. Comparing transactions of different consideration type may not be relevant. • Availability of data: The historical data for comparables that are relevant and accurate may be limited. • Date of data: If the sales of the comparable companies were very long ago, the prices and estimated premiums may not be relevant to the extent that macroeconomic and industry conditions have changed.

Transaction-related valuations are necessary when selling or financing a firm.

• Venture capital financing • Initial public offering (IPO) • Sale in an acquisition • Bankruptcy proceedings • Performance-based managerial compensation