Analyzing Privately
Held Companies
Maier’s Law: If the facts do not
conform to the theory,
they must be disposed of.
Course Layout: M&A & Other
Restructuring Activities
Part I: M&A
Environment
Part II: M&A
Process
Part III: M&A
Valuation &
Modeling
Part IV: Deal
Structuring &
Financing
Part V:
Alternative
Strategies
Motivations for
M&A
Business &
Acquisition
Plans
Public Company
Valuation
Payment &
Legal
Considerations
Business
Alliances
Regulatory
Considerations
Search through
Closing
Activities
Private
Company
Valuation
Accounting &
Tax
Considerations
Divestitures,
Spin-Offs &
Carve-Outs
Takeover Tactics
and Defenses
M&A Integration
Financial
Modeling
Techniques
Financing
Strategies
Bankruptcy &
Liquidation
Cross-Border
Transactions
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 2004
9%
72%
19%
Proprietorships
Partnerships
Corporations
Family-Owned Firms
• 89% of U.S. businesses family owned
• Not all family-owned firms are small (e.g., WalMart, Ford, Motorola, Loews, and Bechtel)
• Major challenges include:
– succession,
– 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 (capitalization)
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 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
Revenue
8000
Cost of Sales
5000
Depreciation
Adjusted
Statements
Comments
8000
Check for premature
booking of revenue &
adequacy of reserves1
(400)
4600
Convert LIFO to FIFO
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
1Revenue
2Cost
Net
Adjustments
1135
is booked before product shipped or for products not ordered. Reserves must be high enough to reflect returns and uncollectable accounts.
of sales = purchased materials & services - ∆inventories.
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
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 capitalization
(valuation) multiple
– FCFF(1+g)/(WACC – g) = [(1+g)/(WACC – g)] x FCFF, where g is the
growth rate [(1+g)/(WACC-g)] is the 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 firm’s beta based on comparable publicly
listed firms1
– Adjust for specific business risk2
• 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. Alternatively, use industry average ratio assuming
firm’s target D/E will move to industry average..
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 adjustments
3Assuming 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
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 prices different from market
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.
• The size of the liquidity discount will vary with
profitability, growth rate and degree of risk (e.g.,
beta or leverage) of the 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 different
--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)
• 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.
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 Minority
Premium 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.
• 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 and
control premiums 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
n
PV = Σ FCFFi / (1+WACC)n + TV / (1+WACC)n
I=1
Where
PV = Present value of projected target firm free cash flows
FCFF = Free cash flow to the firm
WACC = Weighted average cost of capital
TV = Terminal value
Adjust PV for Liquidity Discount (LD%):
PVadj = PV(1 – LD%)
Adjust PV for Liquidity Discount and Control Premium (CP%):1
PVadj = PV(1 – LD%)(1+CP%)
Adjust PV for Liquidity Discount and Minority Discount (MD%):2
PVadj = PV(1-LD%)(1-MD%)
1Multiplicative
2Multiplicative
to reflect interaction between LD& and CP%.
to reflect interaction between LD% and CP%.
Generalizing Adjustments
to Target Firm Value
PVMAX = (PVMIN + PVNS)(1 + CP%)(1 – LD%) and
PVMAX = (PVMIN + PVNS)(1 – LD% + CP% – CP% x 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 factors1
1Control
premiums tend to be positively correlated with minority and liquidity discounts. When a stock is relatively
illiquid, minority shareholders have few options, either sell to the controlling shareholder or to outside investors at a
substantial discount. The inability of minority shareholders to sell their shares gives controlling shareholders
significant power. In such situations, minority shareholders will apply large larger liquidity discounts and controlling
shareholders large premiums to what they are willing to pay for shares of the firm. Therefore, large control
premiums are associated with large liquidity discounts.
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. LGI believes that the value of Acuity, including synergy, can be 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 10-3 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?
Discussion Questions
1. What is a liquidity risk premium? Why is it
important to adjust projected cash flows for this
risk?
2. How might the size of a firm affect its level of
risk? Be specific.
3. Does beta in the capital asset pricing model
have meaning for a firm that is not publicly
traded? Explain your answer.
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.