Analyzing Privately Held Companies

Maier’s Law: If the facts do not conform to the theory,

they must be disposed of.

Exhibit 1: Course Layout: Mergers, Acquisitions, and Other Restructuring Activities

Part IV: Deal Structuring and

Financing

Part II: M&A ProcessPart I: M&A Environment

Ch. 11: Payment and Legal Considerations

Ch. 7: Discounted Cash Flow Valuation

Ch. 9: Financial Modeling Techniques

Ch. 6: M&A Postclosing Integration

Ch. 4: Business and Acquisition Plans

Ch. 5: Search through Closing Activities

Part V: Alternative Business and Restructuring

Strategies

Ch. 12: Accounting & Tax Considerations

Ch. 15: Business Alliances

Ch. 16: Divestitures, Spin-Offs, Split-Offs,

and Equity Carve-Outs

Ch. 17: Bankruptcy and Liquidation

Ch. 2: Regulatory Considerations

Ch. 1: Motivations for M&A

Part III: M&A Valuation and

Modeling

Ch. 3: Takeover Tactics, Defenses, and Corporate Governance

Ch. 13: Financing the Deal

Ch. 8: Relative Valuation

Methodologies

Ch. 18: Cross-Border Transactions

Ch. 14: Valuing Highly Leveraged

Transactions

Ch. 10: Private Company Valuation

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

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.

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

• M&A market in U.S concentrated among smaller, family-owned firms

-- Firms with 99 or fewer employees account for

98% of all firms with employees

Percent Distribution of U.S. Firms Filing Income Taxes in 2008

Proprietorships

Partnerships

Corporations

72%

9%

19%

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.

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)

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

Steps Involved in Valuing Privately Held Businesses

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 ratea

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

aAdjust for specific business risk.

Step 1: Adjusting the Income Statement

• Owner/officer’s 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)

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

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

– 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 target’s cash flows.

Adjusting the Target’s Financial Statements

Target’s 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 owner’s 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.

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 firm’s cost and revenues are understated or overstated? Give specific examples.

Step 2: Determine Appropriate Valuation Methodology

• Income or DCF approach

• Relative or market-based approach

• Replacement cost approach

• Asset-oriented approach

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(1+g)/(WACC – g) = [(1+g)/(WACC – g)] x FCFF, where g is the constant growth rate and [(1+g)/(WACC-g)] is the constant growth capitalization (valuation) multiple

• Assume discount rate is 8% and firm’s 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.

Step 3: Select Appropriate Discount (Capitalization) Rates

• Capital asset pricing model (CAPM)– Estimate systematic risk by calculating firm’s 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 management’s target debt to equity ratio or industry average ratio4

1Assuming private firm leveraged, estimate private firm’s leveraged beta based on unlevered beta for comparable publicly firms adjusted for private firm’s target debt to equity ratio and marginal tax rate. Alternatively, use industry average ratio assuming firm’s 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 Ibbotson’s suggested firm size adjustments3Assuming firms with similar interest coverage ratios will have similar credit ratings, estimate what private firm’s credit rating would be and base its pre-tax cost of borrowing on a comparably rated public firm’s cost of borrowing.4Dividing D/E by (1+D/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 firm’s goal is to achieve and sustain the industry average ratio.

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 owner’s 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 (βtot), unlike market betas (β) estimated from comparable public firms,

measure total risk to the business owner and can be estimated as follows:1

βtot = Market β / √R2

where R2 is the coefficient of determination estimated for comparable

public companies and √R2 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, β = Cov(i,m)/ Ϭm2

and may be rewritten as (Ϭi/Ϭm)R, since (Ϭi/Ϭm) x Cov(i,m) / (Ϭi x ϬM) = Cov(i,m) / Ϭm

2, where Ϭi standard deviation (volatility) of a ith security, Ϭm 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 β = (Ϭi/Ϭm)R, where 0 ≤ R ≤ 1. Dividing by R to calculate βtot eliminates R resulting in βtot > β.

Alternative Ways to Estimate Discount Rates: The Build-Up Method

• Represents the sum of risks associated with a particular firm by adding to the CAPM’s estimate of the firm’s cost of equity (for which the firm’s 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 firm’s 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 Morningstar’s Ibbotson Stocks, Bonds, Bills & Inflation and Duff & Phelps Risk Premium Report. Firm specific risk often obtained through management interviews and firm site visits.

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)

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 firm’s 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.

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 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.

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.

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 interest’s 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.

Adjusting Target Firm Value nPV = Σ FCFFi / (1+ke)n + TV / (1+ke)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 controlTV = 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%)(1+CP%)

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.

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

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(1+CP%)(1-LD%), where k is the cost of equity including liquidity discount and value of control, then

k = ke/(1+CP%)(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).

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 Acuity’s 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 firm’s 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

Incorporating Liquidity Risk, Control Premiums, and Minority Discounts in Valuing a Private Business

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 target’s financial statements reveals that it’s 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?

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.

Things to Remember…

• The U.S. M&A 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 firm’s 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.