VALUATION OF PRIVATE BUSINESSES

Valuation of Private companies

The principles of valuation remain the same but the estimation of the inputs are what is unique

While valuing a private firm, the motive behind the valuation can affect the value. In particular the value attached to a private firm that may be going public is different from the one which is being valued to be sold to another private company or a publicly trading company.

What is so special about private firms?

Reduced regulatory and reporting requirements
Unlike publicly traded firms, the accounting practices by private firms are loose and inconsistent Scarcity of information for the no. of years and in the amount of the information available for each year.

Lack of market valuation

There is no constant updated price for equity and historical data. Absence of a ready market also means that liquidating the equity position is more difficult and expensive in private companies

Delineation of expenses and profits

The owner of a private firm is likely to be closely involved with the management and may have a major chunk of his wealth invested in the firm Absence of demarcation may lead to the mixing of personal and company expenses.

Estimation of valuation inputs at private firms

The value of a private firm is the present value of expected cash flows discounted at an appropriate discount rate. The differences between private firms and publicly traded arises in the manner these inputs to the discounted cash flow model are estimated.

Cost of EquityMarket Beta Cost of Debt Cost of Capital Cash flows

Growth and sustainbility of growth Cash flows to Value

Development stages vis--vis valuation techniques

Stage 1
No product revenue, little to no expense history Both income approach and the market approach not reliable in determining the enterprise value due to a lack of revenue or expense history. Asset approach which recognizes that a significant portion of the assets may lie in intangibles Another method which is become popular recently is the backsolve method, a special form of market approach that considers recent stock transactions of the company

Stages 2 & 3
No product revenue, but substantive expense history(Stage 2) No product revenue, but product development near completion (Stage 3) Similar approaches to stage 1 The income approach might be used, but with a relatively high discount rate due to the significant risk associated with further cash flows.

Stages 4, 5 & 6 Some product revenue,

first customer orders, initial shipments (Stage 4) Product revenue and break-even/positive cash flows (Stage 5) Established history of profitability and cash flows (Stage 6) In stage 4, the income and market approaches to be used with a lower discount rate due to the lower level of risk compared with prior stages In stages 5 and 6, under the market approach, lower adjustments would be required in comparing the EV to publicly held start-up companies.

The cost of equity

Starting with discount rates, if we want to value equity, we shall discount cash flows to equity at the cost of equity, if we want to value the firm, we shall discount the cash flows to the firm at the cost of capital

Issues related to computation of cost of equity

1. The investor is not diversified 2. Absence of historical data for computation of the beta

Approaches to estimate market Betas

Accounting Beta Fundamental Beta Bottom Up Beta

PROCEDURE Price information not available but accounting earnings are available for private firms Regress changes in accounting earnings against changes in earnings for an equity index to estimate accounting beta Using operating earnings would yield unlevered beta Using net income would yield a levered beta

LIMITATIONS Measured once a year > Limited information and weak statistical power Earnings are normally smoothed out and subject to accounting judgments

Approaches to estimate market Betas

Accounting Beta Fundamental Beta Bottom Up Beta

Damodaran suggests the following regression that was run on the betas of NYSE and AMEX stocks to 4 variables 1. CVOI: Coefficient of variation in operating income. 2. Book debt/equity

3. Historical growth in earnings(g)

4. Book value of total assets(TA) = 0.6507 + 0.25 CVOI1 + 0.09 D/E + 0.54 g - 0.000009 TA R2=18% Each of these variables for a private firm are measurable and can be used to estimate the beta.
Note: 1. Coefficient of Variation in Operating Income = Standard Deviation in Operating Income/ Average Operating Income

Approaches to estimate market Betas

Accounting Beta Fundamental Beta Bottom Up Beta

Estimate the average beta for publicly traded comparable firms

Estimate the average market value debt-equity ratio of these comparable firms and calculate the unlevered beta for the business

To adjust the unlevered beta for the financial leverage, we may use one of the two alternatives (a) Assume the firms debt to equity ratio is converging with industry average. (b) Use private firms target Debt to Equity or Optimal Debt to Equity (if it can be estimated)

Estimate cost of equity based on the estimated beta.

Adjustment for Non-Diversification

Total Risk vs Market Risk
The Beta of a firm measures only the market risk and is based on the assumption that the investor is well diversified. However, a private firm owner is likely to invest all or the bulk of their wealth invested in the business. Hence their perceived cost of equity is different.

Likely to adjust market beta with total risk measure under following situations: When valuing a private firm for

Sale to an individual

Sale to a private business

Total Risk= Market Beta/ Correlation with the Market The total Beta will be higher than the market beta, the lower the correlation between the market and the private firm the higher the total beta

Cost of debt
Basic Issue
Private firms are generally not rated and do not have bonds outstanding. Consequently to estimate the cost of debt one of the following approaches may be used.

Solutions
Cost of debt for private firm= cost of debt for similar firms(in terms of size) in the industry. Used for firms being valued for an IPO.

Cost of debt=Interest rate on recent borrowings. Used when the private firm has borrowed money recently.

Based on synthetic rating using interest coverage ratios. Then compute the default spreads on these ratings to arrive at cost of debt.

Estimating cost of capital

Basic Issue
The debt ratios are mostly stated in book value terms rather than market values. There is also a chance that the debt ratio may change for a private firm that is planning to go public.

Solutions/Assumptions
Debt Ratio of private firm= Industry Average Debt Ratio
Debt Ratio of private firm=Optimal Debt Ratio Estimate the Debt Ratio of private firm based on circular reasoning. Start with the book debt and cost of capital->estimate the firm and equity value>use these values to arrive at a new debt ratio and cost of capital and reestimate the firm and equity value. Continue till the debt and equity values converge in the cost of capital computation.

It is important that the debt ratio assumption must be consistent while calculating Beta, debt ratings and Cost of Capital

Estimating cash flows

Problems
Intermingling of personal and business expenses. Thin line between salary and dividends. Effect of taxes on value since individual tax rates and corporate tax rates differ

Different accounting practices are followed across different private firms.

Solutions/Assumptions
Restate the earnings using consistent accounting standards Exclude any expenses that may be personal while computing income Estimate a reasonable salary based on the services rendered by the owner to

the firm

Estimating growth rate

Historical growth
The shifting accounting practices may reflect the reported earnings are not representative of actual earnings. Also most private firms are young and there may be lack of historical data

Fundamentals (Reinvestment rate and Return on Capital )

The expected growth rate in operating income is the product of reinvestment rate and the return on capital.

Persistence of growth
The infinite life concept needs to be considered with more caution since the transition from one owner to another need not be smooth. Implications on the value of growth 1. Terminal value of private firm is less than the terminal value of a publicly traded firm. If the owner retires- we may use the liquidation value as terminal value 2. If the owner plans for transition, the value of the business is more than the firm that doesnt have transition plans chalked out. 3. Private firms that are becoming larger even in terms of management, resemble publicly traded firms, and for these we may assume infinite growth

Relative Valuation techniques

Comparable Company Trading Multiple Analysis (Comps) Select the comparable companies Calculate relevant financials and multiples Apply valuation and analyze the results Apply a private company discount

Comparable Transaction Analysis (Transaction Comps) Use of actual transaction multiples instead of trading multiples Industry, timing (recent), geographic location, size etc. Data could be difficult to locate

Drawbacks Not all aspects are captured in multiples Unavailability of metrics other than sales Finding comparable companies and deals may not always be easy Privately owned companies are less desirable

Other commonly used techniques

Asset Appraisal Companies with heavy fixed assets Fair market value of fixed assets and equipment is calculated as a means of evaluating the business.
Break-up Analysis A sum of parts valuation based on different business lines Relevant for private companies with dissimilar business lines Replacement Cost Considers total cost of reproducing operations of the business in todays environment Start-up expenses, real estate, equipment, and inventory and labor costs LBO Analysis To determine range of prices a financial buyer would be willing to pay based on target ROE (IRRs) and leveraged capital structure. Internal Rate of Return Used to calculate the entry price, exit price, or average cash flows in an investment. Given certain inputs such as exit price and cash flows within the investment, can be used to calculate a desired return rate, entry price, or other factors.

Other Adjustments
Class of shares having voting rights more valuable than the ones without voting rights. Difference should be the function of the value of controlling the firm

In case of an IPO
Need to estimate the effects of creating different classes of shares in the IPO and the effects of the options or warrants on the issuance price per share.

Value for control premium to acquire a block of equity

Probability that control of the firm will change.
Value of gaining control of the company = PV(Value of company with change in control-Value of company without change in control) + Side benefits of control

Effects of illiquidity on value

Investments which are more liquid must be traded at a higher price than those that are less liquid investments. No illiquidity discount if sale is being made to a public company

Factors determining illiquidity discount

Size of the firm
Health of the firm Type of assets owned by the firm Cash flow generating capacity Size of the block

Larger the firm , smaller the liquidity discount

Healthier firms->Lower liquidity discount More the liquid the asset, lower the liquidity discount for the firm Generating large amounts of cash>smaller discounts The liquidity discount should increase with the size of the portion being sold.

IPO vs Acquisitions

Preference for Acquisitions: Strong competition in the product market Better valuation of the firm by potential acquirers by virtue of their industry expertise unlike atomistic investors in the IPO market, who can be expected to be at an informational disadvantage with respect to firm insiders

Preference for IPOs: Acquirers can have considerable bargaining power, allowing them to extract the firms net present value (NPV) from insiders Entrepreneur may derive personal benefits from continuing to manage it long term (private benefits of control), which he would lose after an acquisition

Exit conundrum???
Disagreement between entrepreneur and VC on the preferred means of exit in equilibrium

Retention of benefits v/s immediate cash flows Entrepreneur may be biased towards exiting via an IPO due to retention of

private benefits of control whereas the VC may decide based on financial

considerations (cash flow benefits) alone.

Long term v/s short term investor Entrepreneur is typically a long-term investor planning to continue much of his pre-exit equity stake in the firm even after an IPO listing whereas the VC may often be a short-term investor planning to liquidate much of his pre-exit stake

soon after the IPO.

Overvalued v/s undervalued IPOS

Facebook Stock price
45 40 220 35 200 30 180 25 160 20 140 240

Speciality Restaurants Stock price

Price Band : 34-38 $ Issue Size : $104 billion Reasons of Overvaluation: Pricing and not valuation Incorrect underlying assumptions Willing to pay control premium Restricted stock studies

Price Band : 146-165 Rs. Issue Size: Rs. 171.4 - 182.0 Cr.

Reasons of Undervaluation: Excess reliance on Mainland China brand name Difficulty in recouping certain capital improvement costs Volatility in earnings Inability to accurately forecast

Change in Valuation techniques based on motive

Valuation for sale to a private entity
Cost of Equity Based on Total Beta

Valuation for sale to a publicly traded firm or an IPO

Based on market beta since owner is diversified Based upon synthetic ratings, obtained by looking at comparable publicly traded firms Corporate marginal taxes must be used Perpetual value

Cost of debt

May reflect additional spread since it is associated with being a private business Tax rate should be used of private business Finite life terminal value or liquidation value Should be discounted

Operating Cash Flows

Firm life

Illiquidity discount

No illiquidity discount

Present value approaches for valuation

Approach

DDM1

DCF2

EVA3

APV4

Other (LBO) 9.1

Respondents

Dependent Advisors Independent Advisors Private Equity Total

45.5

100.0

45.5

9.1

14.3

85.7

7.1

0.0

21.4

0.0

78.6

14.3

0.0

57.1

17.3

87.2

20.5

2.6

30.8

Notes: 1. DCF = Discounted cashflow model 2. DDM = Dividend discount model 3. EVA = Economic value added 4. APV = Adjusted present value x2 of equal use of present value approaches: p-value = 0.001 Fisher's Exact test of equal use of present value approaches across the three groups of participants (dependent =independent = private equity) = 52.03, p-value = 0.002 Source: Issues in Valuation of Privately Held Firms by CHRISTIAN PETERSEN, THOMAS PLENBORG, AND FINN SCH0LER

Average forecasting horizon

Average (years) 6.1

Respondents

1 year 0.0%

1 5 years 68 years 9-12 years + 12 years 46.2% 33.3% 23.1% 0.0%

Dependent

Independent
Private equity Total

0.0%

27.3%

36.4%

36.4%

0.0%

7.2

0.0% 0.0%

64.3% 42.9%

21.4% 42.9%

7.1% 14.3%

0.0% 0.0%

4.2 5.8

One consequence of using a short forecasting period is a significant under-valuation of a firm, or it requires heroic long-term growth assumptions. The value of a small business often depends on the presence of the owner. As soon as he/she retires, the firm's most valuable asset disappears. The intermingling of business and private expenses is particularly problematic in small businesses This problem of lack of clarity in expense allocation is found to be positively correlated with the level of ownership concentration.

Thank You
Group 2 Akshayita Saxena Prerna Lotlikar Rhea Maini Sai Sunil Bhrugumalla