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 I: M&A Part II: M&A Process Part III: M&A Part IV: Deal Part V: Alternative
Environment Valuation and Structuring and Business and
Modeling Financing Restructuring
Strategies

Ch. 1: Motivations for Ch. 4: Business and Ch. 7: Discounted Ch. 11: Payment and Ch. 15: Business
M&A Acquisition Plans Cash Flow Valuation Legal Considerations Alliances

Ch. 2: Regulatory Ch. 5: Search through Ch. 8: Relative Ch. 12: Accounting & Ch. 16: Divestitures,
Considerations Closing Activities Valuation Tax Considerations Spin-Offs, Split-Offs,
Methodologies and Equity Carve-Outs

Ch. 3: Takeover Ch. 6: M&A Ch. 9: Financial Ch. 13: Financing the Ch. 17: Bankruptcy
Tactics, Defenses, and Postclosing Integration Modeling Basics Deal and Liquidation
Corporate Governance

Ch. 10: Private Ch. 14: Applying Ch. 18: Cross-Border

Company Valuation Financial Models to Transactions
Deal Structuring
 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”)
1
Businesses 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

9%

72% 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 Valuing
Privately 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
a
Adjust 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?
1
For 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 Net Adjusted Comments

Statements Adjustments Statements
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

1
Revene is booked before product shipped or for products not ordered. Reserves must be high enough to reflect returns and uncollectable accounts..
2
Cost 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
• Capitalization multiples are those that when multiplied a measure of value (e.g.,
earnings, cash flow) provide an estimate of firm value

• Perpetuity (zero growth) or constant growth methods commonly are 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
are 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
1
Assuming 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).
2
Difference between junk bond rate and risk-free rate, return on OTC small stock index and risk-free rate, or
Ibbotson’s suggested firm size adjustments
3
Assuming 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.
4
Dividing 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
β tot = 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
1
In 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) / Ϭm2, 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.
2
Market 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
1
Assumes factors causing the firm’s beta to deviate from one are captured by firm size, industry and firm specific risk adjustments.
2
Data 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.

1
The 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.
1
Control and synergy premiums may be interdependent since the ability to achieve synergies may require a controlling
ownership stake.
2
Control 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 Control Minority
to the power of controlling block shareholder. Premium Discount
(%) (%)
• Investors pay a higher price for control of a
company and a lesser amount for a minority 10 9.1
stake.
• Large control premiums indicate high
15 13.0
perceived value accruing to the controlling
shareholders and significant loss of influence
for minority shareholders
20 16.7
• Increasing control premiums associated with
increasing minority discounts
• Implied Median Minority Discount = 25 20.0
1– 1_______________
(1 + median control premium paid)

Key Point: Minority discounts vary directly with control premiums.

 1
Interaction Between Liquidity Discounts,
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
1
IThe 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..
2
If 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
n
PV = 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 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%)(1+CP%)

Adjust PV for Liquidity Discount and Minority Discount (MD%):1,3

PVadj = PV(1-LD%)(1-MD%)

1
Alternatively, PV could be adjusted by increasing the discount rate to reflect the liquidity discount.
2
Multiplicative 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.
3
Multiplicative 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).
 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 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

 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
= $ 468,936 1

1
Alternatively, 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.