Analyzing Privately

Held Companies
 Course Layout: M&A & Other
Restructuring Activities

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

Motivations for Business & Public Company Payment & Business

M&A Acquisition Valuation Legal Alliances
Plans Considerations

Regulatory Search through Private Accounting & Divestitures,

Considerations Closing Company Tax Spin-Offs &
Activities Valuation Considerations Carve-Outs

Takeover Tactics M&A Integration Financial Financing Bankruptcy &

and Defenses Modeling Strategies Liquidation
Techniques

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 authorities
• Without registration, their shares cannot
be traded in the public securities markets.
• Share ownership usually heavily
concentrated (i.e., firms “closely held”)
 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% Proprietorships

72% 19% Partnerships

Corporations
 Family-Owned Firms
• 89% of U.S. businesses family owned
• 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) rate
4. Adjust firm value for liquidity risk, value
of control, or minority risk if applicable
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
• Depreciation expense
• Reserves
 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
– Intellectual property
– Licenses
– Distributorship agreements
– Leases
– Regulatory approvals
– Employment contracts
– Non-compete agreements
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 Net Adjusted Comments

Statements Adjustments Statements
Revenue 8000 8000
Cost of Sales 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
 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
• Methods: Perpetuity or constant growth
• 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 = $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 = $39.0 million
 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/(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
 Liquidity Discount

• Liquidity is the ease with which investors can sell their

stock without a serious loss in the value of their
investment.
• 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.
• Recent studies suggest a median liquidity discount of
approximately 20% in the U.S.
 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.
• Implied Median Minority Discount =
1 – [1/(1 + median control premium paid)]
 Adjustments to 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
1As a stock becomes less liquid, investors see greater value in more control. Therefore, larger liquidity
discounts are associated with larger control premiums.
 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. LGI
believes that the value of Acuity, including synergy, can be increased by at least 10 percent by
applying professional management methods and by reducing the cost of borrowing by financing
the operations through the holding company. 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 51 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

 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.