Analyzing and Valuing

Privately Held Companies

 Privately Held U.S. Firms

• There are more than 28 million firms in the U.S.

• Of these, 7.4 million have employees, with the rest
being largely self-employed, unincorporated businesses.
• Firms with 99 or fewer employees account for 98% of
all firms with employees.
• Implications:
• M&A market is concentrated among smaller, owner-managed firms.
• Most of these are private firms.
 What is a Private Firm?

• A firm whose securities are not registered with

state or federal authorities.
• Without registration, their shares cannot be traded
in the public securities markets.
• Reference Securities Act
• Share ownership usually heavily concentrated (i.e.,
private firms are usually “closely held”).
 Valuing Private Firms:
Challenges
• Lack of externally generated information.
• Lack of adequate internal documentation.
• Lack of internal controls and rigorous reporting
systems.
• Common forms of manipulating reported income
• Revenue may be understated and expenses overstated
to minimize tax liabilities
• The opposite may be true if the firm is for sale
Valuing Private Businesses: Steps

1 2 3
Adjust target firm data to Determine and implement Adjust firm value for lack
reflect true current appropriate valuation of liquidity and, if
profitability and cash methodology (e.g., DCF, appropriate, lack of
flow. relative valuation, control, or control
replacement value). premium.
 Adjusting Financial Statements
• Areas to scrutinize include:
• Owner/officer’s salaries and benefits
• Travel and entertainment expenses
• Auto expenses and personal life insurance
• Expenses and compensation for family members
• Rent or lease payments in excess of fair market value
• Professional service fees (e.g., legal or consulting)
• Depreciation expenses (e.g., accelerated makes economic sense when
equipment obsolescence is rapid)
• Reserves (e.g., for doubtful accounts, pending litigation, future retirement or
healthcare obligations)
 Areas Commonly Understated

• When a business is being sold, the following

expenses are often understated by the seller:
• Marketing and advertising expenditures required to
support an aggressive growth forecast
• Training sales forces to market new products
• Tail liabilities, e.g., environmental clean-up and pending
litigation
• Employee safety
 Areas Commonly Overlooked
• When a business is being sold, the following assets are
often overlooked by the buyer as potential sources of
value:
• Customer lists (e.g., cross-selling opportunities)
• Intellectual property (e.g., unused patents and licenses)
• Distributorship agreements (e.g., alternative marketing channels
for acquirer products)
• Regulatory approvals (e.g., permits sale of acquirer products)
• Employment contracts (e.g., employee retention)
• Non-compete agreements (e.g., limits competition)
 Discussion Questions

• Why is it often more difficult to value privately

owned companies than publicly traded firms? Give
specific examples.
• Why is it important to restate financial statements
provided to the acquirer by the target firm?
• How could an analyst determine if the target firm’s
cost and revenues are understated or overstated?
 Valuation Methodology

• The same methodologies for valuing public firms

are used to value private companies, subject to
some special considerations.
• DCF approach
• Relative or market-based approach
• Replacement cost approach
DCF Valuation of Private Firms

• Very similar to DCF valuation of public firms,

• Use CAPM to estimate cost of equity.
• Calculate beta using bottom-up approach, that is, based on
beta’s of comparable publicly listed firms.
• Estimate cost of debt based on the yield to maturity on
bonds of public firms with similar debt profiles.
• Use management’s target debt to equity ratio or industry
average D/E ratio to estimate capital structure weights.
 Post-valuation Adjustments

• Discounts applied to firm value

• Liquidity discount
• Reflects potential loss in value when selling an illiquid
asset.
• This is unique to private firms
• Minority discount
• Reflects lack of control associated with minority
ownership. Varies with size of ownership position.
• This is not unique to private firms
 Post-valuation Adjustments

• Premium applied to firm value

• Control premium
• Recognizes the ability to direct activities of the firm
(e.g., make key decisions, declare a dividend, hire or
fire key employees, direct sales to or purchases from
preferred customers or suppliers at other than
market-determined price levels).
• This is not unique to private firms.
 Liquidity Discount
• A liquidity discount is a reduction in the offer price to recognize
potential loss of value due to the lack of liquidity when sold.
• Discount varies by country.
• Recent studies suggest a median liquidity discount of approximately
20% in the U.S.
• Discount also varies with factors that may affect ease of sale:
• Profitability
• Growth rate
• Customer/brand perceptions
• Financial leverage.
 Control Premium

Purchase price
premium is the amount
a buyer pays in excess
of the target’s current
share price.
It includes both a
synergy component
and control premium.

Control premium
Synergy reflects
reflects the value of
increases in cash flow
the right to direct
from combining the
activities of the target
two companies.
firm.
 Control Premium
• Control premiums vary widely across countries.
• About 2-5% in countries with relatively effective investor
protections (e.g., U.S. and U.K.).
• As much as 60-80% in countries with poor governance regimes
(e.g., Brazil, Italy, and Czech Republic).
• Median estimates across countries are 10 to 12 percent.
 Minority Discount

• Minority discounts reflect loss of influence due to the

power of a controlling block shareholder.
• A buyer will pay a higher price per share for control of a
company and a lesser amount for a minority stake.
• Minority discounts vary directly with control premiums.

• Example: A control premium of 10% implies a minority

discount of 9.1% (that is, 1 – 1/1.1 = 0.091).
 Private Firm FCF Valuation:
Example
Athena, LLP is a private equity fund located in Brookline, MA. The firm is evaluating Poseidon,
Inc., a small private company headquartered in Orlando, Florida for a potential acquisition or
minority investment. Your boss at Athena has asked you to perform a valuation of Poseidon, Inc.,
and you have collected the following financial statement data to help you with your analysis. All
dollar amounts are in millions.
Operating expenses include $3.85 million and $2.25 million in stock-based compensation for 2020
and 2019, respectively. Poseidon’s free cash flows are expected to grow at the rate of 30% per year
from 2020 and 2023, but the growth rate is expected to decline steadily each year after 2023 to a
stable growth rate of 4% per year by 2033. The company’s cost of capital is 18% and its combined
marginal tax rate is 25%.
Since Poseidon is a private company, you understand that an illiquidity discount is necessary and
have estimated that a discount of 30% is appropriate. Athena expects to pay a control premium of
20% if it acquires a majority stake in Poseidon. What is the maximum amount Athena can offer for
a 25% stake? How about a 60% stake? All valuation is as of the end of 2020. Assume that the long-
term investments and long-term debt have market values of $6.55 million and $24.64 million as of
the same period.
Income Statement Excerpts

  2020 2019
Net sales 960 750
Cost of sales 665 524
Gross profit 295 226
Operating expenses 133 117
Income from operations 162 109
Balance Sheet Excerpts
2020 2019
Cash and cash equivalents 135 108
Marketable securities 65 55
Inventories 85 55
Accounts receivable 39 32
Deferred taxes 11 8
Total current assets 335 258
Fixed assets, net 60 42
Investments 5 6
Intangible assets 58 32
Total assets 458 338
Accounts payable 168 136
Notes payable 5 4
Accrued expenses 68 45
Deferred revenue 6 5
Total current liabilities 247 190
Long-term debt 20 16
Post-employment obligations 33 19
Deferred revenue 10 8
Stockholders’ equity 148 105
Total liabilities and stockholders’ equity 458 338
 Solution: Calculate 2020 FCF
Note: WACC = 18% (given, so no need to calculate).
FCF2020 = EBIT2020*(1-T) + SBC2020 – ΔNOC2020
EBIT2020 = 162; T = 0.25; SBC2020 = 3.85

ΔNOC2020 = NOC2020 – NOC2019

NOC2020 = (135 + 85 + 39 + 60 + 58) – (168 + 68 + 6 + 10)
= 377 – 252 = 125
NOC2019 = (108 + 55 + 32 + 42 + 32) – (136 + 45 + 5 + 8)
= 269 – 194 = 75
ΔNOC2020 = NOC2020 – NOC2019 = 125 – 75 = 50

FCF2020 = 162*(1 – 0.25) + 3.85 – 50 = 75.35

 Solution: Calculate Other FCFs
and Horizon Value
FCF grows by 30% in 2021, 2022, and 2023.
FCF2021 = FCF2020*1.30 = 75.35*1.30 = 97.96
FCF2022 = FCF2021*1.30 = 97.96*1.30 = 127.35
FCF2023 = FCF2022*1.30 = 127.35*1.30 = 165.56
Growth rate declines from 30% in 2023 to 3% in 2033 and stays
constant. Use H-formula to find horizon value (VOPS 2023)
VOPS2023 = 165.56*(1.04)/(0.18-0.04) +
165.56*(0.30-0.04)*(10/2)/(0.18-0.04)
= 1,229.87 + 1,537.34 = 2,767.21
 Solution: Calculate VOPS, Enterprise
Value, Adjusted Enterprise Value
Note: 2020 is Year 0, so exclude FCF2020 when calculating VOPS2020
VOPS2020 = PV of FCF2021, FCF2022, and (FCF2023 + VOPS2023) at 18%
= PV of 97.96, 127.35, and (165.56 + 2,767.21) at 18%
= 1,959.45

V2020 = VOPS2020 + Non-operating Assets2020 – Non-operating Liabilities2020

= 1,959.45 + (65.00 + 11.00 + 6.55) – (33) = 2,009

Apply discount for lack of liquidity:

Adjusted V2020 = V2020*(1 – Illiquidity discount) = 2,009*(1 – 0.30) = 1,406.30

 Solution: Maximum Offers
First, calculate standalone market value of common equity:
VE2020 = Adjusted V2020 – market value of non-equity financial claims.
= 1,406.30 – 5.00 – 24.64 = 1,376.66
For a minority stake, apply a minority discount.
Control premium = 20%; therefore minority discount = [1 – 1/(1.2)] = 16.7%

Maximum for 25% stake = 1,376.66*(1 – 0.167)*25% = $286.69 million

For a controlling stake, apply a control premium:
Maximum for a 60% stake = 1,376.66*(1 + 0.20)*60% = $991.20 million