Valuing Private Firms

Introduction:

❑ Principles for valuation remain the same.

❑ Estimation problems that are unique to private businesses.

❑ Since private firms are not often governed by the strict

accounting and reporting standards for publicly traded firms,
the information available for valuation tend to be limited.
Valuing Private Firms

Learning objectives:

❑ Note the important concepts to remember in valuing private

firms.

The motive for the valuation matters and can affect the value:
❑ If it is valued for sale to an individual;
❑ If it is valued for sale to a publicly traded firm;
❑ Or for an initial public offering (IPO)
Valuing Private Firms

What makes private firms different?

❑ There are common characteristics shared by private firms
and publicly traded firms, the following are four (4)
significant differences that can affect how we estimate
inputs for valuation.
1. Governance through a set of accounting standards.
Publicly traded firms allows us what each item in the
financial statement includes, and also to compare earnings
across firms. Private firms operate under far looser
standards.
2. Far less information about private firms in terms of the
number of years of data typically available as compared with
publicly traded firms (through their filings with the SEC)
https://www.wsj.com/market-data/quotes/PH/XPHS/WLCON/financials/annual/income-statement
Valuing Private Firms

What makes private firms different? (cont’n)

3. Constantly updated price for equity and historical data
on this price – a very useful piece of information available
for publicly traded firms but not for private firms.
4. Management structure - In publicly traded firms, the
stockholders tend to hire managers to run the firm and most
stockholders hold equity in several firms in their portfolios.
The owner of a private firm tends to be intimately involved
with management and often has all of his or her wealth
invested in the firm. The absence of separation between
the owner and management can result in an
intermingling of personal expenses with business
expenses and a failure to differentiate between
management salary and dividends (or their equivalent).
Valuing Private Firms
Cash flows
❑ Three (3) issues that affect estimation of cash flows to
private firms:
1. Owners’ salaries and equity cash flows. Many firms do
not adequately consider salaries for owner-managers. This
has to do with forecasting operating income for valuation
purposes. Income and valuation tend to be overstated if it
does not reflect salaries and its adjustments for the owner.
2. Intermixing business and personal expenses. This is a
common problem for small businesses, since the owner
have absolute power over many aspects of the business. If
personal expenses are consolidated with business expenses
or are otherwise a part of business expenses, the operating
income for a private firm has to be estimated prior to these
expenses.
Valuing Private Firms

Cash flows (cont’n)

3. Tax effects. The value of a private firm may vary
across different buyers having different tax rates,
corporate (if the potential buyer is a corporation),
and marginal tax rate for individuals (if the potential
buyer is a wealthy individual). Such tax rates will
affect both the cash flows (through the after-tax
operating income and the cost of capital (through
the cost of debt)
Valuing Private Firms

Persistence of Growth
❑ With private firms, the perpetual life assumption has to be
made with far more caution. Unlike publicly traded firms,
where the transition from one CEO to another is common, the
transition is much more complicated in a private firm since
the owner/manager generally does not want to pass the reins
of power to an outsider. (usually to the next generation of
family successors)
❑ Its implication to valuation is that the terminal value for a
private firm (with no immediate management transition) will
be lower than the terminal value for a publicly traded firm as
its liquidation value is lower than the value of continuing
operations (publicly traded firms with immediate management
transition)
Valuing Private Firms
Illiquidity discounts
❑ With Publicly traded firms, liquidation of equity position is
simple and generally has a low cost – the transaction costs of
liquid stocks are a small percent of the value.

❑ With equity in a private business, liquidation costs as a

percent of firm value can be substantial. Consequently, the
value of equity in a private business may need to be
discounted for this potential illiquidity.
Valuing Private Firms

Control Issues
❑ Always consider the competence and strengths of the
management of the firm.

❑ Private firms with managers/owners having absolute control

vs publicly traded firms where incompetent managers can be
easily replaced.
Valuing Private Firms

Conclusion
❑ There are differences in the way we estimate the value of a
private firm vs a publicly traded firm through the present
value of the cash flows they are expected to generate,
discounted back at a rate that reflects both the risk in the
private firm and the mix of debt and equity used.
❑ When valuing a private firm for sale to an individual or
private entity, three (3) specific things to consider:
❑ Cost of equity (for risks that cannot be diversified)
❑ Equity holdings in private businesses are illiquid leading to a discount
on estimated value
❑ Controlling interest in equity of a private firm can trade at a significant
premium over a minority interest
Valuing Private Firms

Conclusion (cont’n)
❑ The valuation of a private firm for sale to a publicly traded
firm or initial public offering follows a much more conventional
route.
❑ The cost of equity should be based only upon non-
diverisifiable risk and there is no need for an illiquidity
discount.
❑ There can still be a control value, if less than a controlling
interest is sold to the publicly trade firm or if non-voting
shares are issued in the initial public offering.
Valuing Private Firms

End of Presentation
Thank You
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