Private Company Valuation

An introduction to market accepted

valuation adjustment factors
For Founders & Directors of private companies a valuation exercise can be
confusing and challenging. But at its essence it is an exercise in understanding the
quality of the financial prospects of the company – including both future growth
and risk.

Proactive strategic planning can result in significant benefits in minimising the

impact that various risk factors may represent to a private company’s value and
maximising factors that will be looked upon favourably.

Author: Nicholas Assef

LCC Asia Pacific©

Table of Contents
Valuation – Planning For Future Opportunities & Exit ................................................................................ 3
Day To Day vs Transaction Value Impact ..................................................................................................... 3
Private Company Cashflows ........................................................................................................................ 3
Simple Factors That Can Impact Value ........................................................................................................ 5
Illiquidity Discount ................................................................................................................................... 5
Size Of Company Discounts ..................................................................................................................... 5
Corporate Growth ................................................................................................................................... 5
Underfunded Capital Expenditure ........................................................................................................... 5
Share Transfer Mechanisms .................................................................................................................... 6
Founder Risk ............................................................................................................................................ 6
Revenue Diversification ........................................................................................................................... 6
Litigation .................................................................................................................................................. 6
Contingent Liabilities ............................................................................................................................... 6
Supplier Dependent ................................................................................................................................. 6
Shareholder Disputes .............................................................................................................................. 6
Key Employee Disputes ........................................................................................................................... 6
More Complex Issues That Can Impact Value ............................................................................................. 7
Minority Shares ....................................................................................................................................... 7
Profit Margin Stability ............................................................................................................................. 7
Client Mix / Quality .................................................................................................................................. 7
Recurring Revenue .................................................................................................................................. 7
Debt to Equity Leverage .......................................................................................................................... 7
Technology Risk ....................................................................................................................................... 8
Country / Sovereign Risk ......................................................................................................................... 8
Macro Market Factors ............................................................................................................................. 8
Additional Factors For Consideration .......................................................................................................... 9
Market Timing ......................................................................................................................................... 9
“Black Swan Events” ................................................................................................................................ 9
Bidder Factors (where a transaction) ...................................................................................................... 9
Premiums For Control ............................................................................................................................. 9
Plan For A Valuation Event ........................................................................................................................ 12

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Valuation – Planning For Future Opportunities & Exit

Whilst the high-level process of valuing private companies is the same as that for valuing a public company
there are significant differences in the application of technical market accepted valuation approaches.

Unlike a public company whose ordinary shares trade on a day-to-day basis on a stock exchange there is no
observable day to day market value for a private company share – which of course raises challenges.

The public company’s ordinary share is an “objective” observation of value at any point in time – with daily
transactions on a stock exchange providing convenient valuation data points. The private company ordinary
share does not enjoy this “liquidity benefit” and as such any valuation is inherently biased by subjective
motives influenced by any agenda upon which analysis is being performed. In the event there are multiple
bidders in a potential deal (as an example) each may have their own interpretation of value – as the private
company might represent a different opportunity in each bidders’ hands.

This paper outlines several factors that private company shareholders and directors should consider in
preparing for any exit transaction/valuation exercise. The reality is, however, each valuation exercise is
bespoke and requires significant attention in order to arrive at a logical valuation range.

Day To Day vs Transaction Value Impact

Founders are busy on a day-to-day basis running their companies. As such it can be difficult to step outside
of that framework to “look in on” the company from a third party’s valuation perspective.

This looking from distance approach is essential to understand how the business might be valued through a
different lens to the Founder’s:

o As a day-to-day operation – often for financing purposes or alternatively initiatives such as internal
incentive mechanisms such as Employee Share Option Plans (ESOPs).
o As a potential change of control transaction opportunity – including for merger or sale purposes.
o From a prospective investor’s perspective – seeking to understand the platform that exists today
and how additional capital will allow that platform operation to grow.

Many of the issues raised in this paper can be subtle in individual application – but cumulatively with other
factors have a material impact. As such reviewing these factors needs to be through a “dynamic eye”.

Private Company Cashflows

A company’s value is the present-day confidence of future cashflows. Whilst historic data is helpful
it is not generally the principal data upon which any decision is made.

The cash flows of a private company can be influenced by many high-level factors including:

 Aggressive accounting standards application compared to public company approaches – including

changes in revenue recognition policy and across the Balance Sheet conservative approaches to
line items such as Inventory.

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 The mixing of personal and business-related expenses.

 Non-core assets that are on balance sheet, but not actually required for the day to day operation
of the company.
 Lower levels of corporate governance than in public companies.
 Founders and directors that take low salaries with a preference for higher dividend flows.
Typically to minimise taxes such as in Australia – payroll tax.
 Inconsistent funding approaches including the use of director loans.
 “Off the books” revenue or costs.
 Reduced amounts of financial information given the typical director focuses more on operating
the business than producing detailed reports for external investors.

In practice this leads to an initial task in any valuation exercise of “normalising” the operational & financial
business models so that any aberrations that arise as a result of the private company function are
harmonised.

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Simple Factors That Can Impact Value
From accepted commercial and academic
approaches to business valuation there are various
factors that may be relevant for consideration in
arriving at a valuation range.
Whilst the “headings” for valuation adjustment are
well accepted, their application on each company is
still very much a case-by-case basis. As such some
may be relevant in part, substantially or at times not
relevant at all.
The “heads of adjustment” highlighted are not
raised in any order or importance or priority, nor is
this an exhaustive coverage of the subject.
Illiquidity Discount
This refers to the fact that in most private
companies there is no organised market to buy and
sell shares in that company. As such there are
limited options in the sale of a private company’s
shares which in turn impacts the pool of potential
acquirers (which also can be low).
Larger private companies that have employee
ownership programmes can have private markets
for the transacting of share sales, but this is
generally the exception and not the norm.
Size Of Company Discounts
This line of approach basically highlights the smaller
the company generally the greater the reliance on
its founder or founders.
Smaller companies also do not tend to have robust
standalone operating systems that will make
analysis and planning more straightforward.
These typical higher levels of risk translate into
higher discount rate than larger private companies.
Corporate Growth
Growth is one of the most important factors that
impacts the overall valuation exercise. Confidence
Private Company Valuation
in growth both delivers a positive impression and
assurance that cash flows will improve in the years
to come (therefore positively impact any DCF
model). Any valuation exercise will examine
business aspects such as how future budgets are
put together & the assumptions that underly any
such budget.
Low/no growth business operations are generally
less attractive than high-growth alternatives. Such
companies may still be highly profitable – but the
lack of growth means that they are positioned as
“harvest models” where the shareholder enjoys
dividends but generally not capital growth in their.
Underfunded Capital Expenditure
Many private companies operate on a shoestring
budget that does not factor in structured re-
investment strategies. To pursue growth, however,
ongoing investment is required.
From a valuation perspective any large near-term
capital expenditure that is required as a result of
historic underinvestment may have an impact on
the overall corporate value.
This could be machinery that requires replacing,
fleet that needs expanding, systems that require
upgrading or other one off styled expenditure that
has a direct line to operational efficiency.
In certain industries (including those relying on
heavy equipment) CAPEX observation can extend to
often what is referred to as “sustaining CAPEX”
which is the annual maintenance associated with
keeping equipment in top operating order. A failure
to spend can increase the risk of an unpredictable
breakdown. In some ways this can be looked at an
unquantified contingent liability on the Balance
Sheet – and something that a detailed valuation
exercise will both identify and take account of.
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Share Transfer Mechanisms
Illiquidity can be further complicated by complex
transfer mechanisms that exist in any shareholder
agreement.
The existence of a right of last refusal on the sale of
shares, for example, reduces the marketability of
those securities. Such mechanisms may need to be
removed prior to any transaction being pursued as
parties fear being “stalking horses”.
Founder Risk
The smaller the private company the higher the
likelihood that there is a substantial risk to future
cashflows should the founder leave.
In particular this is the case with revenue where the
founder is the key rainmaker. Through valuation an
understanding of how the private company will
transition to third party ownership – without
impacting revenue or operations – is a fundamental
test. High probabilities of founder risk translate
into high discount rates.
Revenue Diversification
Private companies are often dependent on revenue
from a key business relationship or relationships.
Often this will be 50% or more from a key client.
In due diligence analysis of the top 10 clients
revenue contribution is a standard approach. The
more concentrated the revenue the greater the risk
should revenue from that key relationship be either
lost or reduced.
Litigation
Uncertainty on any lawsuit or dispute raises the
potential of an unplanned financial cost.
In addition to the cost of any unfavourable litigation
result and the associated attorney costs is the
distraction to the private company leadership team
in having to deal with such issues.
Private Company Valuation
Contingent Liabilities
Contingent liabilities can take a number of forms
but basically the concept is financial and business
liabilities that will be accepted by the bidder (in any
deal).
These can include such things as environmental
liabilities where there is evidence of pollution
(asbestos as an example), land remediation
liabilities and other liabilities that may present from
biased commercial relationships – including with
landlords.
Supplier Dependent
Similar to the risk of revenue concentration the
total dependence on a supplier can represent a
number of risks.
Not only is there the risk of loss of the relationship
but more subtle changes such as an increase in the
price of products or services supplied after a
transaction has been concluded.
In a corporate valuation exercise this may present
as a potential for future free cashflows to be
negatively impacted.
Shareholder Disputes
In private companies shareholders are usually a
part of the operational day to day framework.
Any disputes between shareholders will be
interpreted as risk to potential operational
performance.
Key Employee Disputes
If any dispute is between the Company and a key
employee, the short-term valuation impact can be
significant. It takes time to replace effective
employees.
Furthermore, the wider impact within the private
company from any dispute with an employee can
have a knock-on negative impact.
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More Complex Issues That Can Impact Value
Other factors that are relevant on a case-by-
case basis include:
Minority Shares
The sale (or standalone valuation) of a small piece
of the equity (say 10%) typically is at a discounted
value to the sale of 50% or more.
This is because the rights that that a small
shareholder enjoys are restricted usually to the
right to:
o receive dividends;
o vote at a shareholder meeting; and
o receive proceeds in the event of a sale of
the company.
Minority shareholders have very little power to
impact the operations of a private company.
Profit Margin Stability
Industrial sector private company valuations can be
materially impacted by confidence in operating
margin. Financial performance can be impacted by
many scenarios including increasing cost of goods
(inflation), supply chain dislocation, a more
competitive business landscape and other factors.
Sophisticated private companies are very focused
on annual operational margin improvement of even
1% to 2% as a core discipline. Smaller companies
that are “price takers” vs “price makers” with
regard to cost inputs can be at greater risk of margin
instability. High margin instability can result in a
higher discount rate.
Client Mix / Quality
In the client mix of any company can be a mix of
clients.
Too heavy a bias towards client companies that
might pose a credit risk will potentially impact
future cashflows – and require higher levels of
Provisions to be taken on the Balance Sheet.
Private Company Valuation
Recurring Revenue
Understanding the recurring nature of revenue
from core business relationships is also an
important observation that goes to the quality of
earnings of the private company.
In contrast to generally applied approaches such as
looking for long-term contracts, an option is to
observe the underlying revenue contribution year-
on-year from a business relationship.
The difference between these two approaches is
that long-term contracts typically come at highly
controlled margins and include (often) draconian
payment terms.
Sustainable business relationships can often deliver
more flexible outcomes for the private company in
terms of margin on work undertaken and flexibility
in payment terms.
High levels of recurring revenue are generally
regarded as positive, in particular from an
accounting “quality of earnings” perspective.
Debt to Equity Leverage
Private companies have less flexibility in raising
capital than public companies.
A public company can via a stock exchange make an
offering of shares to investors and raise capital even
when in distress. Its public status allows it flexibility
in approaches to capital raising.
Private companies have a more complex path to
walk to raise capital – and the timetable is generally
longer than for their public cousins.
As such the overall value of a private company
handcuffed with considerable debt can be
negatively impacted due to the (potential) risk
associated with potential bankruptcy.
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Technology Risk
Commercialising any technology is a complex
matter which can consume large amounts of capital.
Furthermore, failure of any private company
technology can have a material impact on the
overall business continuity of that company.
A valuation analysis may include a study of both the
risk of commercialisation in technology and both
the capital and time required to finalise any project.
Country / Sovereign Risk
Operating a private company in multiple
countries/jurisdictions can have an impact on
overall value. Often “exotic” destinations will both
deliver opportunity but not at inconsiderable risk.
Such jurisdictions cause problems in valuation as
they represent unknown risks. In corporate
transactions often there is a pre-deal housecleaning
exercise to simplify operations so that these foreign
entities do not present challenges in due diligence
and overall valuation.
Private Company Valuation
Macro Market Factors
Private companies can be impacted materially
where a Macro Market factor affects the
attractiveness of all companies within that sector.
For example, Environmental Social Governance
(ESG) has impacted several industrial sectors. The
appetite to affect acquisitions in any such impacted
sectors has reduced as has the pool of potential
bidders.
Not surprisingly in order to attract any bidder into a
private company within an impacted sector, any
valuation may need to be discounted to a level that
makes a decision a financial one versus a standard
corporate one (strategic).
At times sectors can also be prone to technology
risk making their current business models
redundant. As a valuation exercise can look 10
years + into the future the current market for
products and/or services may only have passing
relevance.
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Additional Factors For
Consideration
In addition to many factors that are predictable for
a valuation exercise there are also other areas that
the private company leadership team should also
pay attention to.
The list of factors that can be considered in this
analysis can be numerous, but include:
Market Timing
Private companies can both benefit and
suffer from their decision to pursue a transaction
against a market backdrop. Valuation outcomes can
change materially because of this timing.
Industrial and technology sectors are at times in
favour with investors and other times out of favour.
The overall value of the private company can
benefit from analysis whilst a sector is in vogue. And
correspondingly might appear unsatisfactory when
the sector is not in appeal.
Investment banking data platforms provide
detailed charts of “value over time” and can be
used for understanding macro cycles for any sector.
Figure 1 is an example of EV / EBITDA valuation
volatility over five years with BHP Limited.
Understanding just how volatile public company
valuations can be over time is often a challenge for
the private company leadership to understand –
simply because they have never had reason to
consider it.
“Black Swan Events”
Unforeseen events can have a substantial impact on
the value of a company – short term or longer term.
In particular private companies need to be sensitive
to the “domino effect” that can result from events
such as:
o Warranty claims on products.
o Industrial accidents.
Private Company Valuation
o Contractual complexities including as
company needing to deliver a project or
product on a fixed price basis where costs
are flexible and increasing.
The timing of any such event might be short lived,
but often the private company needs to raise
additional capital to deal with the issue – and that
capital raising could not come at a more
inconvenient time.
An event can also have longer term impacts on free
cashflows – including higher insurance premiums
and the potential for some form of financial
bonding / guarantee (which again impacts future
cashflows and capital requirements).
Bidder Factors (where a transaction)
Any private company should also be educated in
the financial and operational position of any
potential public company bidder.
In any sector at any given time there are companies
that lead in terms of overall valuation and those
that investors do not view as favourably, hence they
trade at a discount (to their peers).
Any valuation presented to a private company
should be reviewed and analysed against the actual
performance of the presenting party.
Figure 2 provides a standard performance
benchmarking of a group of mining & resources
sector companies over a three-year time horizon.
Where these companies are not performing well
themselves there is little motivation to pay a proper
strategic value.
Premiums For Control
For successful private companies the decision to
exit can be a complex one. Particularly where that
private company is continuing a path of annual
growth and there is a track record of paying annual
dividends. Often these companies are also debt free
or carry very low levels of long-term debt.
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The theory of the value of a premium for control is
a straightforward one. Shareholders in a successful
private company are not under pressure to
complete a transaction nor even to engage in
discussion.
As such any bidder needs to provide a valuation
incentive for transacting today, and as such giving
away the potential upside of growth and dividend
flows that tomorrow may deliver.
Control premia in a private company setting is more
complex than a public company given there are
typically less shareholders to deal with and as such
the process of a corporate deal can be snuffed out
by a non-co-operative major shareholder (for
example) simply saying no.
In public company transactions premiums for
control are accepted as normal in the range of 25%
to 30%.
Private Company Valuation
In private company deals, however, there are
instances where unique assets in high growth
sectors attract “strategic valuations” that can have
little relevance to the standard control premium
approach. The bidder is convinced that the future
for the private company is bright and so wants to
acquire at any reasonable cost.
In these instances, the “uniqueness” or “scarcity” of
alternate assets can drive very high valuations.
Where any investment or acquisition is made on
aggressive financial assumptions on future
performance there is an increased risk of “winner’s
curse”. That is the risk of over valuation for
purposes of any transaction.
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Figure 1: BHP Limited valuation over Five Year Period (EV/EBITDA LTM)

Figure 2: Comparative valuation observation over Three Year Period (EV/EBITDA LTM)

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Plan For A Valuation Event

For private company founders and directors, it may appear that there are an overwhelming
number of potential complexities that need be considered in arriving at a reasonable and “defendable”
corporate value.

Whilst there can be many factors to be considered their relevance is driven by one fundamental data concept.

And that is how any of those factors may in isolation or combination impact the potential for future free
cashflows.

This paper is designed to provide a general overview of issues that will likely arise when a private company
performs a corporate value assessment on itself, or alternatively where it enters discussions relating to a
corporate transaction or financing.

For the sophisticated private company understanding these “headings” to value adjustment allows advanced
financial and operational planning that can both minimise valuation impact and maximise shareholder value.

The best private companies periodically review their risk profile in relation to future
financial performance in order to be well positioned to maximise shareholder value.

Nicholas Assef is the Founder & Principal of LCC Asia Pacific. With over 25 years in M & A practice Nicholas has
assisted public companies, financial sponsors and private organisations with their growth & exit strategic
requirements. Nicholas is currently completing his PhD in the area of Merger & Acquisition effectiveness which
considers various issues on corporate value in depth. Nicholas can be contacted on naa@lccapac.com

Copyright in this paper to Nicholas Assef

Graph used in this paper developed by Nicholas Assef

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Private Company Valuation