Private Company Basics

Private firms encompass sole proprietorships, privately held corporations, and previously public companies that have been taken private. The characteristics that distinguish private and public companies can be delineated into company specific and stock specific factors.

Company Specific Factors

Company specific factors include the following:

• Stage of life cycle. Private companies are typically less mature than public firms. Sometimes, however, private firms are mature firms or bankrupt firms near liquidation.
• The valuation analysis will vary with the life cycle stage of the firm.
• Size. Private firms typically have less capital, fewer assets, and fewer employees than public firms, as such, they can be riskier. Accordingly, private firms are often valued using greater risk premiums and greater required returns compared to public firms.
• A lack of access to public equity markets can constrain a private firm’s growth. However, the regulatory burden associated with issuing public equity may outweigh the benefits of greater access to funds.
• Quality and depth of management. Smaller private firms may not be able to attract as many qualified applicants as public firms. This may reduce the depth of management, slow growth, and increase risk at private firms.
• Management/shareholder overlap. In most private firms, management has a substantial ownership position, reducing principal agent conflict. This gives external shareholders little influence, and it helps the firm to take a longer term perspective.
• Short term investors. Although manager compensation in public firms often includes incentive compensation such as stock options, shareholders often focus on short- term measures of performance, such as the level and consistency of quarterly earnings. In such cases, management may take a shorter term view compared to private firms where managers are long term holders of significant equity interests.
• Quality of financial and other information. Public firms are required to make timely, in depth financial disclosures. A potential creditor or equity investor in a private firm will have less information than is available for a public firm.
• This leads to greater uncertainty, higher risk, and it reduces private firm valuations. Note that in the case of fairness opinions for private firm valuations, the analyst typically has complete access to the firm’s financial statements and business records.
• Taxes. Private firms may be more concerned with taxes than public firms due to the impact of taxes on private equity owners/managers.

Stock Specific Factors

The stock specific differences between private and public firms often include the following:

• Liquidity. Private company equity typically has fewer potential owners and is less liquid than publicly traded equity. Thus, a liquidity discount is often applied in valuing privately held shares.
• Restrictions on marketability. Private companies often have agreements that prevent shareholders from selling, reducing the marketability of shares.
• Concentration of control. The control of private firms is usually concentrated in the hands of a few shareholders, which may lead to greater perks and other benefits to owners/managers at the expense of minority shareholders.

Overall, company specific factors can have positive or negative effects on private company valuations, whereas stock specific factors are usually a negative. Compared to public companies, private companies have greater heterogeneity, so that the appropriate discount rates and methods for valuing them vary widely as well.

There are three reasons for valuing the total capital and/or equity capital of private companies: transactions, compliance, and litigation.

Transaction Related Valuations

Transaction related valuations are necessary when selling or financing a firm:

• Venture capital financing. Firms in the development stage often need external financing for capital investment and receive private financing from venture capital investors. To reduce risk to the venture capital investor, the capital is often provided in rounds after the achievement of specific benchmarks known as milestones.
• Valuations are usually subject to negotiation and are somewhat informal due to the uncertainty of future cash flows.
• Initial public offering (IPO). A public sale of the firm’s equity increases its liquidity. Investment banks often perform IPO valuations using the values of similar public firms as a benchmark.
• Sale in an acquisition. Development stage or mature private firms are often sold to generate liquidity for the owners. Valuations are usually performed by both the firm and the buyer and are subject to negotiation.
• Bankruptcy proceedings. For firms in bankruptcy, accurate valuation can help determine whether the firm should be liquidated or reorganized. If it is determined that the firm can continue as a going concern, accurate valuation is important in its restructuring.
• Performance based managerial compensation. If a firm compensates employees with stock options, grants of restricted stock, or employee stock ownership plans, accurate valuation is necessary for both accounting and tax purposes.
• Debt financing. Lenders may be interested in valuation as part of their underwriting process.

Compliance Related Valuations

Compliance related valuations are performed for legal or regulatory reasons. They primarily focus on financial reporting and tax issues:

• Financial reporting. Valuations in this area are often related to goodwill impairment tests in which units of a public firm are valued using private company valuation methods. The reporting of stock based compensation also requires accurate valuation.
• Tax purposes. At the firm level, transfer pricing, property taxes, and corporate restructuring may necessitate valuations. For individual equity owners, estate and gift tax issues may necessitate valuations.

Litigation Related Valuations

Litigation related valuations may be required for shareholder suits, damage claims, lost profits insurance claims, or divorce settlements.

Because the valuation methods for transactions, compliance, and litigation are often quite different, most appraisers specialize in a single area. Transaction related valuations are usually performed by investment bankers, compliance related valuations by those with accounting or tax knowledge, and litigation related valuations by those comfortable with a legal setting and specific jurisdictions.

In valuing a firm, the appropriate earnings definition is normalized earnings: “firm earnings if the firm were acquired.” The adjustments required to arrive at normalized earnings are discussed as follows.

Estimating Normalized Earnings

Normalized earnings should exclude nonrecurring and unusual items. In the case of private firms with a concentrated control, there may be discretionary or tax motivated expenses that need to be adjusted when calculating normalized earnings. These adjustments can be quite significant when the firm is small.

When a closely controlled firm does business with its owners or other businesses controlled by its owners, firm expenses may be inflated, and reported earnings, therefore, may be artificially low. Artificially low earnings may also be the result of excessively high owner compensation, or of personal expenses charged to the firm. These expenses will also affect the firm’s tax expense.

The adjustments are potentially larger when the owners’ family members have connections to the firm. Use of company- owned assets (e.g., aircraft, personal residences, company provided life insurance, loans for managers/owners) potentially require an adjustment to earnings.

On the other hand, if a firm is performing poorly, the owners may be receiving compensation below market levels. In this case, reported earnings would overstate normalized earnings.

Any real estate owned by the firm may merit treatment separate from that of firm operations. For example, real estate is likely to have different risk characteristics than the firm’s operations. Further, the properties’ depreciation expense is based on historical cost and does not reflect the current rental cost.

Some analysts will remove any income and expenses from real estate on the income statement. If it is used in the firm’s business, a market estimated rental expense is used in calculating or estimating earnings. The value of real estate is, therefore, separated from its operations and treated as a nonoperating asset.

If the real estate is leased from a related party, the lease rate should be adjusted to a market rate.

Other adjustments are common to both private and public companies (e.g., adjustments for differences in depreciation and inventory methods). Additionally, some private firm financial statements are reviewed rather than audited; some may be only compiled (i.e., no auditor opinion is provided). In any case, the analyst should be prepared to make further adjustments.

Estimating Cash Flow

Calculating free cash flow to the firm (FCFF) or to equity holders for private firms can be particularly challenging, given uncertain future cash flows and figures that are often generated using the current owners’ input.

As noted previously, the valuation of equity depends on the definition of value used. Also, controlling and noncontrolling equity interests will have quite different values. These differences should be accounted for in cash flow estimates and assumptions.

When there is significant uncertainty about a private company’s future operations, the analyst should examine several scenarios when estimating future cash flows. For development stage firms, scenarios could include a sale of the firm, an IPO, bankruptcy, or continued private operation. For a mature firm, scenarios might include different ranges of cash flows based on different assumed growth rates.

For each scenario, the analyst must assign a discount rate and probability based on the scenario’s risk and probability of occurring. A firm value for each scenario is estimated, and a weighted average of these values is used to estimate firm value. Alternatively, a weighted average scenario cash flow may be discounted using a single discount rate to arrive at an estimate of firm value.

Cash flow estimates often are based on current management estimates or result from analyst consultation with management. The analyst should be aware of the potential bias in management estimates. For example, management may overstate the value of goodwill or understate future capital needs.

Although analysts use FCFF or free cash flow to equity (FCFE) depending on the purposes of the valuation, FCFF is usually more appropriate when the significant changes in the firm’s capital structure are anticipated. The reasoning is that the discount rate used for FCFF valuation, the weighted average cost of capital (WACC), is less sensitive to leverage changes than the cost of equity, the discount rate used for FCFE valuation. Thus, the FCFF valuation is less sensitive to the degree of financial leverage assumed in the analysis than the FCFE valuation.