Valuation of Private

Companies
Diverse nature of private companies and lack of a recognised regulatory / governing body
providing guidance for valuation has led to use of different practices for valuing private
businesses.

Some points to note

 Relative size of private companies tend to be smaller than public companies. Hence the
business risks may be higher. Small size may reduce growth opportunities.

 Top management has a controlling ownership interest. Hence a long term perspective of
decisions can be assumed. Quality of management may increase the business risks

 Quality of financial information may not be high as reduction of taxable income is a great
incentive for the owners.

 Lack of liquidity of equity investors reduces the value of private companies

 Reasons for private company valuation
Transaction based
1. Private financing
2. IPO
3. Acquisition
4. Bankruptcy
Compliance based
5. Financial Reporting
6. Tax reporting ( property tax, transfer pricing, restructuring )
Litigation
7. Legal proceeding ( damages , lost profits, shareholders disputes )
Valuation Approaches

1. Income/ Cash flow approach ( present value of income/cashflow expectations)

2. Market approach ( Pricing multiples )
3. Asset based approach ( assets held by the business )
Income / cash adjustments

1. Above market compensation paid to owner/ employees

2. Personal expenses ( travel/use of corporate assets for personal use)
3. Properties owned by the private company
4. Using multiple scenarios to ascertain income / cashflows [ e.g for new
companies possiblility of IPO, acquisition, continued operations and for a
mature company different levels of growth and profitability]
5. Managers of private companies may have much more information. Appraiser
can use the same but with awareness of potential bias.
A venture capital firm, valuing a private company A Pvt. Ltd owned by Mr. A . The
following observations are made from the recent years financial results :

A’s salary was Rs. 150 lacs whereas for a CEO of similar company a compensation
Rs. 50 lacs is normal.
A’s business assets include a farmhouse which is not required for core operations.
The expenses related to this asset was Rs. 3000000 in maintenance and
Rs.1000000 as depreciation.
A has a debt of Rs.20 crs ( interest charge 7.5%) which is lower than optimum level
of debt expected for the company. The existing debt to total capital employed is 2%
The most recent income statement is as under:
Amt Rs. crs
Revenues 50
Gross Profit 20
Selling, general and admin exp 5
Depreciation and amortisation 1
EBIT 14
Less: Interest 1.50
EBT 12.50
Less: Taxes ( 30%) 3.75
PAT 8.75

Construct a proforma operating income statement of normalised operating income

Income approach –

Capitalised Cashflow method

Discounted Cashflow method
Excess earning method
Determining the expected rate of return

1. CAPM – Market based data applicable to public companies may not be

appropriate for private companies. Use of expanded CAPM by adding premium for
small size and company specific risk to comparable public companies cost of
capital.
2.Build up approach – When comparable companies are not available, a build up
model is adopted where premium for size, company risk, equity risk is added to risk
free rate.

Adjust for size premium, company specific risk premium

Small size premium- Small stocks have greater risks and provide higher returns
than large companies. Hence a size premium is generally added to expected rate of
return.

Companies traded in stock exchanges are divided into 10 groups based on total
market cap.

The actual return of each group is compared with CAPM return to derive size
premium.

[Duff and Phelps/Morning star Ibbotson]

Control premium is the expected increase in value through synergy which is not reflected in initial valuation.
Generally control premiums are derived using details of acquisition of controlling interests in public companies.
The premium offered by acquirer over the fair market value of the share is used as an estimate of control
premium paid.

Control premium adjustment may be made to the pricing multiple depending on the type of transaction. Control
premium or minority discounts arise from the difference between the optimal value ( existing values +synergies)
and the existing value.

Existing value : 100 crs Optimal value : 125 crs

Value of 51% = 51% of 125 crs = 63.75
Value of 49% = 49% of 100 crs = 49
Control premium = 63.75- 49 = 14.75

Strategic transaction – Synergies are expected on acquisition here a control premium is justified

Financial transaction – No material synergy is expected. No control premium required.

However these premium should be revaluated on case to case basis because the premiums paid have resulted in
poor investments for the buyer. Control premium is adjusted when valuation is done with GPC method.
To value A Pvt Ltd, the venture capitalist VC have identified comparable companies. The following
information is gathered :
Risk free rate : 4.8%
Equity risk premium : consensus : 5%
Similar public companies have a beta of 1.1
A size premium of 3% was considered appropriate ( If CAPM model is used and similar risks are
anticipated for public companies, then size premium need not be added)
A company specific risk premium of 1% was added for owners key role in business.( subjective,
methodologies available for quantification)
Average industry cost of debt 8%
Based on discussion with various sources of financing, Debt to Total Capital employed can be 10%.
( Actual ratio is 2%)

Estimate the required rate of return for equity using :

1. CAPM 2. Expanded CAPM and 3. Build up approach
If the acquirer can optimise the capital structure, what should be WACC.
The following additional inputs are estimated

A 3% growth in sales, GP margin to be maintained, Depreciation to be maintained

at 1.8% of sales, working capital requirement to be 10% of incremental sales.
Capex would be 5% of incremental revenues.

Estimate the value of equity using

Capitalised income method ( assume a capitalization rate of 14%)
Capitalised cash flow method
While acquiring private companies, market based approach can be used.
(Comparable companies, comparable transactions or prior transaction approach)

While P/E is not preferred, EV/ EBITDA can be used for large private companies
whereas EV/ Net Income can be used for smaller companies.

Non financial metrics of the like price per bed for a hospital or price per subscriber
can also be used.

Actual past transactions in the shares of the private company is used to derive
pricing multiples or actual price paid for the shares.
A Ltd is being valued on comparable companies method . Though all comparable
companies were much larger than A Ltd, the following info was collected

EV/EBITDA multiple of similar public companies: 7

A 15% downward revision of multiple was found appropriate to size and growth
prospects of A .
A control premium of 20% was reported in a strategic acquisition case in the past. The
transaction involved exchange of shares.
Normalised EBITDA of target company is 16.90 crs
Debt was reported at 20 crs

Determine value of equity using adjusted pricing multiple.

If VC is not aware of any strategic buyer for A, then what should be the pricing multiple
Business Valuation Approach – An overview
Income Approach Market Approach Asset Approach
Value Driver - Operations Comparable companies Operations are not value
available drivers

Positive income/Cash flows Similar transactions available Company owns substantial

tangible assets

Expected rate of return can Appropriate multiples can be Accurate appraisals of value
be estimated calculated of assets can be obtained

Company’s future - The ownership interest has

performance can be control over the underlying
forecasted assets.