Chapter 10Analyzing Privately Held Companies

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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.

• Share ownership usually heavily concentrated (i.e., firms “closely held”)– Timberland – June 2011. 43% premium.– Boston Beer

• How do they perform versus non private firms? ?

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What is a Private Firm?

• Of the + 150,000 companies with revenues > $10 M, 90% privately owned¹.

• General rule - less than 300 shareholders, no SEC registration or reporting required.

• Includes both private or closely held as well as family owned or controlled businesses.

• Scope of market greater than perception.¹ See PrivCo, The Private Company Financial Data Authority, http://www.privco.com/knowledge-bank/private-company-valuation

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Percent Distribution of U.S. Firms Filing Income Taxes in 2004

Proprietorships

Partnerships

Corporations

72%

9%

19%

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Increase in Flow Thru Returns

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Impact of Flow Through Entities

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Change in Entity Filing Statistics

• Trends¹ :– LLCs and LLPs – “entity of choice”– “C” Corporations and ~ “S” Corporations

down– Currently

• “S” Corp. & Partnership returns - 24-25% ↑19%• “C” Corporations – 6% ↓ 9%.• Schedule C (Proprietorship) – up a bit 70+%

– Potential impact on valuation process?¹ http://www.taxfoundation.org/

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Private & Family-Owned Firms

• 89% of U.S. businesses family owned• Major challenges include:

– Succession – record is not good, – lack of corporate governance - Board F&F, – informal management structure, – less skilled lower level management, and – a preference for wealth & ownership over growth.

• Trade growth for control = reduced firm value?¹

¹ Villalonga & Amit, How Do Family Ownership, Control and Management Affect Firm Value, Journal of Financial Economics 80, 385-417

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Governance Issues

• What works for public firms may not for private companies.

• “Market model” relies on dispersed ownership with ownership & control separate

• “Control model” more applicable where ownership tends to be concentrated and the right to control the business is not fully separate from ownership (e.g., small businesses)

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Challenges of Analyzing and ValuingPrivately Held Firms

• Estimates influenced by reason for sale.– Sale– Raise capital– Divorce settlement– Management buyout– Estate & gift tax planning– ESOP– Income taxation purposes

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Challenges of Analyzing and ValuingPrivately Held Firms

• Lack of externally generated information – Audited financial• Lack of adequate documentation of key intangible assets such

as software, chemical formulae, recipes, etc.• Lack of internal controls and rigorous reporting systems• Firm specific problems

– Narrow product offering– Lack of management depth – Timberland/Boston Beer/Apple– Lack of leverage with customers and vendors– Limited ability to finance future growth

• 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

• Risk is likely higher in private company13

Four Steps Involved in Valuing Privately Held Businesses – W. Buffett

1. Adjust target firm data to reflect true current profitability and cash flow

2. Determine appropriate valuation methodology (e.g., DCF, relative valuation, etc.)

3. Estimate appropriate discount (capitalization) rate

4. Adjust firm value for liquidity risk, value of control, or minority risk if applicable.

5. Before beginning process, consider “rules of thumb” valuation applied to value drivers.

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Rules of Thumb¹• Often used by appraisers.

– Professional service firms (CPA, lawyer) – 90-150% billings plus fixed assets with one year billing guarantee.

– Day care - $1,000 -$2,000 per child at 100%– May use Seller’s Discretionary Cash (SDC)

• SDC=NI+ Depn + Owner’s salary + interest + excess comp etc.

• Consumer based (bowling & restaurant) – 5 or 6 X SDC if real estate included. If not, 3 or 4 times.

¹ For an understandable description of private business valuation alternatives, see Note on Valuing Private Businesses, Dwight B. Crane, Harvard

Business School, 2011.

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Step 1: Adjusting the Income Statement – Closely Held

• Owner/officer’s salaries – high or low• Benefits – client shenanigans (A true story)• Travel and entertainment• Auto expenses and personal life insurance• Family members• Rent or lease payments in excess of fair market

value• Professional service fees• Depreciation expense• Reserves

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Areas Commonly Understated

• When a business is being sold, the following expense categories are often understated by the seller:– The marketing and advertising expenditures required

to support an aggressive revenue growth forecast– Training sales forces to market new products– Environmental clean-up (“long-tailed” liabilities)– Employee safety– Pending litigation

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Areas Commonly Overlooked• When a business is being sold, the following asset

categories are often overlooked by the buyer as potential sources of value:1 Not on financials– Customer lists– Intellectual property – Licenses– Distributorship agreements– Leases– Regulatory approvals– Employment contracts– Non-compete agreementsHow might you value each of the above items?1For these items to represent sources of incremental value they must represent sources of revenue or

cost reduction not already reflected in the target’s cash flows.

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Step 2: Determine Appropriate Valuation Methodology

• Income or DCF approach

• Relative or market-based approach

• Replacement cost approach

• Asset-oriented approach

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Step 4: Adjust Firm Value for Liquidity Risk, Value of Control, or Minority Risk

Discount Applied to Firm Value• Liquidity risk: Reflects potential loss in value when an

asset is sold in an illiquid market • Minority risk: Reflects lack of control associated with

minority ownership. Risk varies with size of ownership position

Premium Applied to Firm Value• Value of control: Ability to direct activities of the firm

Estate and Gift Valuations – Discounts of 35% from IRS.

Review HBS Professor Villanoga’s Slides on website.

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Liquidity/Marketability Discount

• Liquidity is the ease with which investors can sell their stock without a serious loss in the value of their investment.

• A liquidity discount is a reduction in the offer price for the target firm by an amount equal to the potential loss of value when sold due to the lack of liquidity in market.

• Recent studies suggest a median liquidity discount of approximately 20% in the U.S.

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Control Premium• Purchase price premium represents amount a buyer pays seller in

excess of the seller’s current share price and includes both a synergy and control premium

• Control and synergy premiums are distinctly different --Value of synergy represents revenue increases and cost savings

resulting from combining two firms, usually in the same line of business

--Value of control provides right to direct the activities of the target firm (e.g., change business strategy, declare dividends, and extract private benefits)• Country comparisons indicate huge variation in median control

premiums from 2-5% in countries with relatively effective investor protections (e.g., U.S. and U.K.) to as much as 60-65% in countries with poor governance practices (e.g., Brazil and Czech Republic).

• Median estimates across countries are 10 to 12 percent.

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Minority Discount

• Minority discounts reflect loss of influence due to the power of controlling block shareholder.

• Investors pay a higher price for control of a company and a lesser amount for a minority stake.

• Implied Median Minority Discount =

1 – [1/(1 + median control premium paid)]

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Adjustments to Firm Value

PVMAX = (PVMIN + PVNS)(1 + CP%)(1 – LD%) and

PVMAX = (PVMIN + PVNS)(1 – LD% – CP% – CP% x LD%)

Where PVMAX = Maximum purchase price

PVMIN = Minimum firm value

PVNS = Net synergy LD% = Liquidity discount (%) CP% = Control premium or minority discount (%) CP% x LD% = Interaction of these factors1

1As a stock becomes less liquid, investors see greater value in more control. Therefore, larger liquidity discounts are associated with larger control premiums.

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