Session 20: Private Company Valuation

Valuing Private Businesses

In this section, the speaker discusses the challenges of valuing private businesses and highlights two aspects that make it difficult.

Differences in Valuation for Private Businesses

• There is no market value for a private business, making valuation more challenging.

• Accounting statements may be difficult to interpret due to differences in accounting standards across small private businesses.

• The value attached to a private business can depend on who the potential buyer is.

Four Types of Transactions for Private Businesses

• Private-to-private transaction: One individual sells their business to another individual.

• Private-to-public transaction: A private business is sold to a publicly traded company.

• Private-to-IPO: A private business goes public.

• Sale of stake to venture capitalist: A private company sells a stake in itself.

Challenges with Private-to-Private Transactions

• Potential buyers are unlikely to be diversified, leading to exposure to all risks associated with the business.

• Key person risk must be considered when buying from the founder or owner of a private business.

• Illiquidity discount must be factored in since it's much more difficult to get rid of an entire business than selling shares back.

Total Beta Measure

• Total beta measures your exposure to all units of risk if you're not diversified.

Valuing Private Businesses

In this section, the speaker discusses how to value private businesses and the challenges that come with it.

Using Beta to Value Private Businesses

• The beta for publicly traded high-end retailers on a non-levered basis is 1.18.

• The correlation of high-end retailers with the market is about 50%.

• To estimate the cost of equity for a private business, use the total beta which includes both market risk and firm-specific risk.

• Use industry average debt-to-equity ratio for publicly traded high-end retailers if you don't have those numbers for a private business.

Dealing with Key Person Risk

• Estimate how much revenue and operating income would drop if the owner/founder were no longer there.

• Use that lower operating income as a bargaining chip in negotiations.

• Consider negotiating where the owner/founder stays on for a few years to arrange a smoother transition.

Adjusting for Illiquidity

• Factor in illiquidity into your valuations from the start.

• Discount value by 15%-25% or adjust discount rate by adding premium for illiquidity.

• Don't do both as it counts liquidity twice.

Selling Private Business to Public Company

• Potential buyer has diversified investors so key person risk and illiquidity are less of an issue.

Valuing Private Businesses

This section discusses how to value private businesses in different scenarios, including selling to a private buyer, going public through an IPO, and receiving investment from venture capitalists.

Selling to a Private Buyer

• When valuing a private business for sale to a private buyer, the valuation should reflect the fact that the potential buyer is a diversified investor.

• The valuation should not use an illiquid e2 discount or total beta but instead use a market beta and value the business as if it were a public company.

• Finding a second bidder can strengthen your argument during bargaining.

Going Public Through an IPO

• When doing an evaluation for an initial public offering (IPO), follow all the rules used for public companies.

• Use market beta instead of total beta when calculating cost of equity and capital.

• If cash comes into the company during IPO, you need to tell what you plan to do with it. You can invest in new assets or pay down old debt.

• Institutional details such as options given along the way and underwriting guarantee by investment bankers affect valuation.

Receiving Investment from Venture Capitalists

• Venture capitalists are not quite diversified investors so you cannot use market beta but they are more diversified than independent buyers so you don't use total beta either.

• Cost of equity and capital will be somewhere between that of a public company and that of a private business.

• Over time, cost of equity will decrease as venture capitalists enter the company because they are more diversified than owners/founders.

In summary, when valuing private businesses, follow similar rules as those used for public companies. Correct cash flows for accounting irregularities specific to private businesses. Estimate discount rate using market beta instead of total beta.