Session 20: Private Company Valuation

so far in these sessions we've done primarily public companies whether it's discounted cash flow valuation but what if your task is to value a private business a small private business or even a large private business you think what's different about valuing a private business there are two aspects to a private business that I think make valuation a little more difficult the first is there is no market value for the company right now you're saying so what take a look at the discounted cash flow valuation is due to public companies and think of how much you use market values along the way use market values of equity and debt to get your cost of capital use market values of debt and equity to get a level beta and when you were done with the evaluation you actually compared the value that you got to the market value to see if you're within shouting distance of where you should be I'm going to take that market value away from you in a private business the second difference is that accounting statements might be difficult with public companies there might be mild differences across companies but at least they follow a common standard with private businesses especially small private businesses the differences in accounting standards tend to be much larger what does that mean when you're buying a private business its buyer beware you cannot take the financial statements as is and there are two issues at least that you will have to deal with one is the owner might not charge himself or herself a salary the line between salary and dividends is a fine one the second private business is as an intermingling of personal and business expenses that might make the numbers a little deceptive here's the other thing to remember our private businesses if you're ever asked to value private business the first question you need to ask is why motive matters because the value attached to a private business can depend very much on who the potential buyer is in fact I'm going to divide this discussion into four types of transactions you can have a private to private transaction where one individual cells is business to another individual it can be a private to public transaction where you sell your business to a publicly traded company it can be a private to IPO where you taking your private business public not an option for most private businesses but if you have one you might take it and the final scenario I'd like to talk about is a private company that sells a stake in itself to a venture capitalist let's start with what I think is the most difficult of these scenarios a private to private transaction in a private to private transaction there are three big issues you got to deal with along the way the first is your potential buyer in this case because it's another individual is unlikely to be diversified just think so what almost everything we did and coming up with cost of equity and cost of capital for publicly traded companies was based on the assumption that the marginal investor was diversified an assumption you can get away with with most publicly traded companies but with a small private business being bought by another individual that's an assumption that's not going to stand up to scrutiny second in private businesses you have to worry about about what I call the key person the founder or the owner of the private business might account for a big chunk of the value that you see in the business if you're buying the business from that person you could ask us in the question if that person leaves what will happen to this business in most cases that's going to lead to a discount in the value and third it final issue you have to deal with then it's an issue we dealt with input in part when we talk about public companies is the liquidity that comes about when you buy an entire business unlike buying a thousand shares in a public company we can change your mind and sell the shares back if you buy a private business it's much more difficult to get rid of the business if you don't want it anymore that leads to an illiquid 'ti discount so let's start with the first issue how do you deal with the fact that investors and private businesses especially if they're individuals buying the business aren't likely to be diversified let's use a very simple example to bring home this process let's assume you have a business with a hundred units of risk let's assume that 20 of those units are market risk macroeconomic risk risk you cannot diversify away when you use a conventional beta you're measuring the risk in those 20 units if you're buying this business and you're not going to be diversified you're going to be exposed not just to those 20 units of risk you're going to be exposed to all hundred units of risk algebraically you're going to be exposed to five times as much risk as a diversified investor investing in this company I'm going to use that insight to estimate what I call it total and here's my measure of a total beta a market beta measures your exposure to market risk that's what we get when we run that regression we use the slope or all the approaches we use for public companies we were talking about market betas a total beta measured your exposure total risk you might wonder how am I going to go from market beta to total beta let me take a very simple example let's assume you're valuing a privately owned retailer a high-end retailer to get a beta for the company here's what I did I went and looked at publicly traded high-end retailers the beta that I got for those companies on non levered basis was one point one eight that would be the beta I would've used to value of publicly traded high-end retailer but you're a buyer of a private business where you cannot diversify away the risk here so here's the other statistic I looked up when you run a regression to get the beta you also get a sense of how much of the risk in a company comes in the market it's the r-squared of the regression in fact if you take the square root of the R squared you get the correlation of this company with the market on average the correlation of high-end retailers with the market is about 50% I keep track of that number if I divide the unlevered beta 1.18 by 0.5 I come up with a total unlevered beta missing what are you doing I'm essentially assuming that you're exposed not just to the 50% which is market risk but to the remaining 50% that is firm specific in estimating the cost of equity for your company as a private business in a private transaction I'm going to use the total beta and here is a final adjustment I need to make with public companies the debt to equity ratio and debt to capital ratios are used to come up with the cost of equity and cost of capital tend to be market values the private business I don't have those numbers here's a simple way around it I use the industry average debt to equity ratio for publicly traded high-end retailers I'm in a sense assuming that this private business has to operate by that same ratio that ratio is 14 point three three percent plugging that in I get a total beta for the company and a total cost of equity total cost of equity 14 and a half percent is significantly higher than the cost of equity additive estimated for a public company I use it's a measure as my debt ratio to come up with a cost of capital for a private business so the private to private transaction assuming that the buyer is completely under versified one solution to the lack of diversification problem is to adjust the beta use the total beta and use a cost of equity and cost of capital that emerges in the total beta that will give you a value for the private business now let's ask the question about what to do about the fact that the owner might be a key person that in put differently if you bought this business from the owner and the owner left that you might lose some revenue some customers might leave you use a common use your common sense to make the best judgment you can ask yourself this question if I bought this business and the owner / founder were no longer there how much of my revenues drop how much of my operating income drop value the business using that lower operating income then use it as a bargaining chip in what sense go to the owner founder and offer that amount as a value he or she is probably going to be disappointed that the number is so low tell him or her why you're paying a low value maybe you can negotiate away where the owner of founder stays on for a few years and arrange the transition where you don't have as big a drop in operating income that's done in many businesses so that's a key person issue you have to deal with it in the operating income which brings us to the third and final issue is the which is the issue of in liquidity as we mentioned in an earlier session in liquidity is a continuum all investments are in liquid the question is by how much private businesses are particularly illiquid so what you often have to do as a potential buyer of a private business is factor in that in liquidity into your valuations right off from the start and as again with public companies there are two ways you can adjust for liquidity one is you can value the company as you would regularly value the company and then you can use the total beta and you can use the higher cost of capital to make that adjustment but after you come up with a value you can discount that value for a liquidating that's what most appraisers do they now call 15 20 25 percent of value for any liquidity discount while that might or might not be justifiable I'd like you to think about an alternative rather than drop the value of every private business by 20 or 25 percent wouldn't it be more reasonable that discount were a function of the private business being valued small versus large healthy versus unhealthy cash flow producing versus non cash flow producing we can't come up with discounts that vary across businesses and I think we should the other way to adjust for liquidity is to change a discount rate add a premium on foreign liquidity and this is different this is on top of the premium you added for the lack of diversification here again you can use some of the techniques we talked about earlier for adjusting the discount rate but please don't do both if you push up the discount rate for liquidity and you knock off the value for liquidity you're counting it twice so find a place to bring in a liquidity but do it only once so that's for private to private businesses and you can see the issues you have to deal with the next two scenarios are far simpler the first is a scenario where you're a private business and you're trying to sell yourself to a public company because the potential buyer here has investors were diversified it's not the company that has to be diversified its its investors you could argue that in doing this valuation you should use a conventional valuation use the same beta you use elsewhere and nowa liquidity discount the problem though is you're bargaining with a much stronger party the public company is probably going to offer you what do you think you're worth as a private business and not what you should be worth as a public company but you should argue back in fact your argument will be strengthened if you can find a second bidder in this process but your valuation should reflect the fact that the potential buyer here is a diversified investor and should not be using an illiquid e2 discount or a total beta and instead should be using a market beta and valuing your private business as if it were a public company good luck to you don't in that bargaining let's look at a third scenario you're a private company and you're the type of private company that can actually go public you have to do evaluation for an initial public offering right in doing the evaluation follow all the rules we followed with public companies nothing changes so yes to made cash flows come up with the cost of equity in capital based on the market bait and not the total beta you come up with the value for the company it is true in an IPO there are some issues you might that might be specific to the fact that it's an IPO a couple of the issues evaluation issues one is you got to tell me what you plan to do with the proceeds from the initial public offering what am I talking about when you make a public offering and you offer your shares the public cash is going to come into the company right you got to tell me what you plan to do with the cash and here your choices you can use the cash to invest in new assets in which case I'm going to add the cash on to my discounted cash flow valuation because that cash is like any other cash balance you can use the cash to pay down old debt in which case I'm going to change my debt ratio redo my cost to capital and revalue the company but I'm not going to add the cash on to my valuation or you can use the cash to take out of the business so if you're a founder owner of the business when you go public you might use the cash to cash out if that is a case I can ignore the cash in my evaluation so find out what's going to happen the proceeds of valuation also dot your i's and cross your T's in the process of building up to this stage in your in your IPO you might have given options to other people along the way to whom to employees to venture capitalists value those options and take the value of the options out of the value of the equity there are also a couple of institutional details and effect evaluation if you've hired an investment banker to do your IPO and he or she has guaranteed a price to you it's an underwriting guarantee the IPO is not going to be at a fair value it's going to be discounted for an obvious reason let's say I've come up with the value of 10 dollars per share for your company if I offer these shares at $10 I face face a significant risk as an investment banker from backlash if I don't sell it the ten dollars I'm going to buy the shares at ten so I'm going to discount the value and investment bankers routinely do this and I and you as the owner of the company might go along even though it represents a loss of value to you because in most IPOs not all the shares are offered at the initial public offering in fact only five or ten percent of shares might be offered you might say so what here's why you might accept the underpricing by under pricing in the initial offering you might be setting the stage for subsequent offerings and you're two years down the road where you can offer the remaining shares of the higher price and you view this as good public relations so if you have an IPO factor those into your valuation considerations because it will affect the price you see on the IPO which brings me to the final scenario what if a venture capitalist approaches you and wants to take a share of your company in return for providing you with capital a venture capitalist is not quite a diversified investor so you can't use a market beta but he or she is likely to be more diversified than a typical independent buyer so you don't use a total beta so your cost of equity and capital is going to be somewhere between that of a public company and that of a private business in fact here's the interesting follow-up if you have a small private business that you expect to see transition first to being owned by venture capitalists and then to going public and I'm valuing your business I would expect to see different cause of equity over time initially when you're the owner of the business given that you're not diversified I'd be using total beta end up with a high cost of equity and capital two or three years down the road when I see venture capitalists enter the company I'm going to use a lower cost of equity and a lower cost of capital reflecting the fact that those venture capitals are more diversified than you and finally when I get to your five or ten when you go public I'm going to switch to a market beta and a market cost of capital so in summary valuing private businesses you follow the same rule book as you do for public companies you ask to make cash flows correcting for those accounting irregularities we talked about with private businesses you estimated discount rate though that discount rate can be different depending on who the potential buyer is you value the company but you might have some mopping up to do especially if it's a private to private transaction to reflect the key person and liquidity

Channel: Aswath Damodaran

Views: 70,912

Keywords: Valuation

Id: Y_xqFmOrP2Y

Length: 15min 58sec (958 seconds)

Published: Mon Aug 25 2014