Analyzing Privately Held Companies

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Analyzing Privately Held Companies
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Maiers Law If the facts do not conform to the
theory, they must be disposed of.
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(No Transcript)
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Learning Objectives

• Primary learning objective Provide students with
  a knowledge of how to analyze and value privately
  held firms
• Secondary learning objectives Provide students
  with a knowledge of
• Characteristics of privately held businesses
• Challenges of valuing and analyzing privately
  held firms
• Why and how private company financial statements
  may have to be recast and
• How to adjust maximum offer prices for liquidity
  risk, the value of control, and minority risk

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What is a Private Firm?

• A firm whose securities are not registered with
  state or federal authorities1
• Without registration, their shares cannot be
  traded in the public securities markets.
• Share ownership usually heavily concentrated
  (i.e., firms closely held)
• 1Businesses must generally register their legal
  form with the Secretary of State and with the
  State Revenue agencies for tax purposes.

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Key Characteristics of 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 largely self-employed, unincorporated
  businesses
• MA market in U.S concentrated among smaller,
  family-owned firms
• -- Firms with 99 or fewer employees account for
• 98 of all firms with employees

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Percent Distribution of U.S. Firms Filing Income
Taxes in 2008
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72
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Family-Owned Firms

• 89 of U.S. businesses family owned
• Not all family-owned firms are small (e.g.,
  Wal-Mart, Ford, Motorola, Loews, and Bechtel)
• Major challenges include
• succession,
• access to capital
• lack of corporate governance,
• informal management structure,
• less skilled lower level management, and
• a preference for ownership over growth.

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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

• Lack of externally generated information
• 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
• 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

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Steps Involved in Valuing Privately Held
Businesses

• Adjust target firm data to reflect true current
  profitability and cash flow
• Determine appropriate valuation methodology
  (e.g., DCF, relative valuation, etc.)
• Estimate appropriate discount ratea
• Adjust firm value for liquidity risk, value of
  control, or minority risk if applicable
• aAdjust for specific business risk.

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Step 1 Adjusting the Income Statement

• Owner/officers salaries
• Benefits
• Travel and entertainment
• Auto expenses and personal life insurance
• Family members
• Rent or lease payments in excess of fair market
  value
• Professional service fees (e.g., legal or
  consulting)
• Depreciation expense (e.g., accelerated makes
  economic sense when equipment obsolescence rapid)
• Reserves (e.g., for doubtful accounts, pending
  litigation, future retirement or healthcare
  obligations)

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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 value1
• Customer lists (e.g., cross-selling
  opportunities)
• Intellectual property (e.g., unused patents)
• Licenses (e.g., unused licenses)
• Distributorship agreements (e.g., alternative
  marketing channels for acquirer products)
• Leases (e.g., at less than current fair market
  value)
• Regulatory approvals (e.g., permits sale of
  acquirer products)
• Employment contracts (e.g., employee retention)
• Non-compete agreements (e.g., limits competition)
• How 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 targets cash flows.

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Adjusting the Targets Financial Statements
Targets Statements Net Adjustments Adjusted Statements Comments
Net Revenue 8000 8000 Check for premature booking of revenue adequacy of reserves1
Cost of Sales2 5000 (400) 4600 Convert LIFO to FIFO
Depreciation 100 (40) 60 Convert accelerated to straight line
Selling Salaries/Benefits 1000 (100) 900 Eliminate family member
Selling Rent 200 (100) 100 Eliminate sales offices
Selling Insurance 20 (5) 15 Reduce premiums
Selling Advertising 20 10 30 Increase advertising
Selling Travel Enter 250 50 300 Increase travel
Admin. Salaries/Benefits 600 (100) 500 Reduce owners pay
Admin Rent 150 (30) 120 Reduce office space
Admin Directors/Prof. Fees 280 (40) 240 Reduce fees
Total Expenses 7620 (755) 6865
EBIT 380 1135
1Revene is booked before product shipped or for
products not ordered. Reserves must be high
enough to reflect returns and uncollectable
accounts.. 2Cost of sales purchased materials
services - ?inventories. The objective is to
align revenue in a given period with the actual
cost of producing that revenue. Such costs could
reflect both current production and past
production when units sold come from inventory.
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Discussion Questions

1. Why is it often more difficult to value privately
   owned companies than publicly traded firms? Give
   specific examples.
2. Why is it important to restate financial
   statements provided to the acquirer by the target
   firm? Be specific.
3. How could an analyst determine if the target
   firms cost and revenues are understated or
   overstated? Give specific examples.

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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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Common Capitalization Multiples

• Perpetuity (zero growth) or constant growth
  methods commonly used in valuing small, privately
  owned firms for simplicity and due to data
  limitations
• FCFF/WACC (1/WACC) x FCFF, where (1/WACC) is
  the zero growth capitalization (valuation)
  multiple
• FCFF(1g)/(WACC g) (1g)/(WACC g) x FCFF,
  where g is the constant growth rate and
  (1g)/(WACC-g) is the constant growth
  capitalization (valuation) multiple
• Assume discount rate is 8 and firms current
  cash flow is 1.5 million. Multiples in brackets.
• If cash flow expected to remain level in
  perpetuity, the implied valuation is 1/.08 x
  1.5 12.5 x 1.5 18.75 million
• If cash flow expected to grow 4 percent annually
  in perpetuity, the implied valuation is (1.04) /
  (.08 - .04) x 1.5 26 x 1.5 39.0 million
• Note 12.5 and 26 represent the capitalization
  multiples for the zero and constant growth
  models, respectively.

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Step 3 Select Appropriate Discount
(Capitalization) Rates

• Capital asset pricing model (CAPM)
• Estimate systematic risk by calculating firms
  beta based on comparable publicly listed firms or
  historical data1
• Adjust for nonsystematic risk2
• Weighted Average Cost of capital
• Cost of debt based on what public firms of
  comparable risk are paying3
• Weights reflect managements target debt to
  equity ratio or industry average ratio4
• 1Assuming private firm leveraged, estimate
  private firms leveraged beta based on unlevered
  beta for comparable publicly firms adjusted for
  private firms target debt to equity ratio and
  marginal tax rate. Alternatively, use industry
  average ratio assuming firms target D/E will
  move to industry average (See Chapter 7).
• 2Difference between junk bond rate and risk-free
  rate, return on OTC small stock index and
  risk-free rate, or Ibbotsons suggested firm size
  adjustments
• 3Assuming firms with similar interest coverage
  ratios will have similar credit ratings, estimate
  what private firms credit rating would be and
  base its pre-tax cost of borrowing on a
  comparably rated public firms cost of borrowing.
• 4Dividing D/E by (1D/E) converts D/E into a
  debt to total capital ratio, which subtracted
  from one gives the equity to total capital ratio.
  Using the industry average debt-to-equity
  or-total capital ratio implies the firms goal is
  to achieve and sustain the industry average
  ratio.

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Alternative Ways to Estimate Discount Rates
Total Beta

• CAPM betas measure systematic risk of the
  marginal investor (buyer) in a firm, with such
  investors diversifying away nonsystematic risk.
• Empirical evidence suggests that CAPM understates
  financial returns on small companies
• Small firm owners net worth often primarily
  their ownership stake in the firm. Because of the
  difficulty in attracting new investors, the
  current owner can be viewed as the marginal
  investor in the firm. Therefore,
• They are not well diversified and are concerned
  about both systematic and nonsystematic risk
  (i.e., total risk)
• Total betas (ßtot), unlike market betas (ß)
  estimated from comparable public firms,
• measure total risk to the business owner
  and can be estimated as follows1
• ßtot
  Market ß / vR2
• where R2 is the coefficient of
  determination estimated for comparable
• public companies and vR2 is the correlation
  coefficient
• Total betas are larger than CAPM betas2

1In a linear regression of the return on the ith
stock against the return on diversified market
index of stocks, ß Cov(i,m)/ ?m2 and may be
rewritten as (?i/?m)R, since (?i/?m) x Cov(i,m) /
(?i x ?M) Cov(i,m) / ?m2, where ?i standard
deviation (volatility) of a ith security, ?m is
the standard deviation of the overall stock
market, and R is the correlation coefficient
between the ith security and the overall stock
market. The correlation coefficient indicates
direction of the relationship between the ith
stock and the overall market and the covariance
measures the volatility of the ith stock versus
the overall market. 2Market beta ß (?i/?m)R,
where 0 R 1. Dividing by R to calculate ßtot
eliminates R resulting in ßtot gt ß.
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Alternative Ways to Estimate Discount Rates The
Build-Up Method

• Represents the sum of risks associated with a
  particular firm by adding to the CAPMs estimate
  of the firms cost of equity (for which the
  firms market beta is assumed to be one)1 an
  estimate of firm size, industry risk, and firm
  specific risk.
• The build-up method could be displayed as
  follows
• ke Rf ERP FSP IND
  CSR
  
• where ke cost of equity
• Rf risk free return
• ERP Equity risk premium
• FSP firm size premium (measures
  risk of default)
• IND Industry risk premium
  (measures operating risk)
• CSR Firm specific risk premium
  (e.g., excessive dependence
• of a single customer,
  narrow product focus, limited access to
• capital)2

1Assumes factors causing the firms beta to
deviate from one are captured by firm size,
industry and firm specific risk
adjustments. 2Data for firm size and industry
risk premiums available from Morningstars
Ibbotson Stocks, Bonds, Bills Inflation and
Duff Phelps Risk Premium Report. Firm specific
risk often obtained through management
interviews and firm site visits.
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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 (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)

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Liquidity Discount

• 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 the market.1
• Recent studies suggest a median liquidity
  discount of approximately 20 in the U.S. Varies
  by country.
• The size of the liquidity discount will vary with
  profitability, growth rate, and degree of risk
  (e.g., beta or leverage) of the target firm.
• 1The offer price can be reduced by either
  directly reducing the target firms valuation as
  a standalone business by an estimate of the
  appropriate liquidity discount or by increasing
  the discount rate used in valuing the firm by an
  amount which reflects the perceived liquidity
  risk.

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Control Premium

• Purchase price premium represents amount a buyer
  pays seller in excess of the sellers current
  share price and includes both a synergy and
  control premium
• Control and synergy premiums are distinctly
  different1
• --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)2
• 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.

1Control and synergy premiums may be
interdependent since the ability to achieve
synergies may require a controlling ownership
stake. 2Control can be achieved at less than 50
percent ownership if other shareholders own
relatively smaller stakes and do not band
together to offset votes cast by the largest
shareholder.
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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.
• Large control premiums indicate high perceived
  value accruing to the controlling shareholders
  and significant loss of influence for minority
  shareholders
• Increasing control premiums associated with
  increasing minority discounts
• Implied Median Minority Discount
• 1 1_______________
• (1 median control premium paid)

Control Premium () Minority Discount ()
10 9.1
15 13.0
20 16.7
25 20.0
Key Point Minority discounts vary directly with
control premiums.
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Interaction Between Liquidity Discounts,1 Control
Premiums, and Minority Discounts

• When markets are liquid, investors place a lower
  value on control since investors dissatisfied
  with controlling shareholder decisions can easily
  sell their shares driving down the value of the
  controlling interests stake.
• When markets are illiquid, investors place a
  higher value on control since shareholders can
  only sell their shares at a substantial discount.
  Minority shareholder stakes are illiquid in part
  because
• Minority shareholders cannot force the sale of
  the business and
• Controlling shareholders have little to gain by
  buying their shares
• This implies that the size of liquidity
  discounts, control premiums, and minority
  discounts are positively correlated.2

1IThe size of liquidity discounts is affected
primarily by the availability of liquid markets,
as well as the profitability, growth rate, and
riskiness of the target firm.. 2If control
premiums and minority discounts and control
premiums and liquidity discounts are positively
correlated, minority discounts and liquidity
discounts must be positively correlated.
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Adjusting Target Firm Value

• n
• PV S FCFFi / (1ke)n TV / (1ke)n
• I 1
• Where
• PV Present value of projected target firm free
  cash flows
• FCFF Free cash flow to the firm
• ke Cost of equity excluding liquidity and
  minority discounts and value of control
• TV Terminal value
• Adjust PV for Liquidity Discount (LD)1
• PVadj PV(1 LD)
• Adjust PV for Liquidity Discount and Control
  Premium (CP)1,2
• PVadj PV(1 LD)(1CP)
• Adjust PV for Liquidity Discount and Minority
  Discount (MD)1,3
• PVadj PV(1-LD)(1-MD)

1Alternatively, PV could be adjusted by
increasing the discount rate to reflect the
liquidity discount. 2Multiplicative to reflect
interaction between LD and CP, i.e., for a
given CP, a higher LD increases the PV of the
firm to the controlling investor. 3Multiplicative
to reflect interaction between LD and MD, i.e.,
for a given MD, a higher LD reduces the value
of a minority investment in the firm.
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Generalizing Adjustments to Target Firm Value

• Question What is the maximum amount an acquirer
  should pay for an ownership interest in a firm?
• PVMAX (PVMIN PVNS)(1 CP)(1 LD) and
• PVMAX (PVMIN PVNS)(1 LD CP CP x LD)
• (PVMIN PVNS)(1 LD CP(1
  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 factors

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Adjusting Cost of Equity for Illiquidity, Value
of Control, and Minority Discount

• Liquidity discount Assume ke k(1-LD), where k
  is the cost of equity including liquidity
  discount, then
• k ke/(1-LD)
• Liquidity discount and value of control Assume
  ke k(1CP)(1-LD), where k is the cost of
  equity including liquidity discount and value of
  control, then
• k ke/(1CP)(1-LD)
• Liquidity discount and minority discount Assume
  ke k(1-MD)(1-D), where k is the cost of
  equity including liquidity and minority
  discounts, then
• k ke/(1-MD)(1-LD)
• Recalculate PVMAX using the appropriate value of
  k
• That is, other things equal
• k increases with illiquidity (PVMAX decreases).
• k decreases with an increasing value of control
  (PVMAX increases).
• k increases with size of the minority discount
  (PVMAX decreases).

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Incorporating Liquidity Risk, Control Premiums,
and Minority Discounts in Valuing a Private
Business
LGI wants to acquire a controlling interest in
Acuity Lighting, whose estimated standalone
equity value equals 18,699,493. LGI believes
that the present value of synergies is 2,250,000
due to cost savings generated by combining Acuity
with LGI. LGI believes that the value of Acuity,
including synergy, can be further increased by at
least 10 percent by applying professional
management methods. To achieve these
efficiencies, LGI must gain control of Acuity.
LGI is willing to pay a control premium of as
much as 10 percent. LGI reduces the median 20
liquidity discount by 4 to reflect Acuitys high
financial returns and cash flow growth rate. What
is the maximum purchase price LGI should pay for
a 50.1 percent controlling interest in the
business? For a minority 20 percent interest in
the business? To adjust for presumed liquidity
risk of the target firm due to lack of a liquid
market, LGI discounts the amount it is willing to
offer to purchase 50.1 percent of the firms
equity by 16 percent. PVMAX (18,699,493
2,250,000)(1 - .16)(1 .10)) x .501

20,949,493 x .924 x .501
9,698,023 If LGI
were to acquire only a 20 percent stake in
Acuity, it is unlikely that there would be any
synergy, because LGL would lack the authority to
implement potential cost saving measures without
the approval of the controlling shareholders.
Because it is a minority investment, there is no
control premium, but a minority discount for lack
of control should be estimated. The minority
discount is estimated using Equation 10-5 in the
textbook (i.e., 1 (1/(1 .10)) 9.1).
PVMAX (18,699,493
x (1- .16)(1 -.091)) x .2 2,855,637
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Practice Problem

• An investor believes that she can improve the
  operating income of a target firm by 30 percent
  by introducing modern management and marketing
  techniques. A review of the targets financial
  statements reveals that its operating profit in
  the current year is 150,000. Recent
  transactions, resulting in a controlling interest
  in similar businesses, were valued at six times
  operating income. The investor also believes that
  the liquidity discount for businesses similar to
  the target firm is 20 percent. What is the most
  she should be willing to pay for a 50.1 percent
  stake in the target firm?

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Practice Problem Solution

• PVMAX (PVMIN PVNS)(1 LD)(DOP)
• Where PVMAX Maximum purchase price
• PVMIN Minimum firm value (i.e.,
  standalone value)
• PVNS Net synergy or value
  added
• LD Liquidity discount ()
• DOP Desired ownership percentage
• Maximum Purchase Price ((6 x 150,000) .3 x
  (6 x 150,000))
• x
  (1 - .2) x .501
• 
  (900,000 270,000) x .8 x .501
• 
  468,9361
• 1Alternatively, the maximum purchase price could
  be estimated as follows (6 x 150,000 x 1.3) x
  (1 - .2) x .501 468,936. Note also that the
  problem states that recent comparable
  transactions were believed to contain a control
  premium, therefore eliminating the need to
  include a control premium in the calculation of
  the maximum purchase price.

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Things to Remember

• The U.S. MA market is concentrated among small,
  family-owned firms.
• Valuing private firms is more challenging than
  public firms because of the dearth of reliable,
  timely data.
• The purpose of recasting private company
  statements is to calculate an accurate current
  profit or cash flow number.
• Maximum offer prices should be adjusted for a
  liquidity discount and control premium If the
  market for the firms equity is illiquid and a
  controlling interest is desired
• Maximum offer prices for a minority interest in a
  firm should be adjusted for a minority discount.