Discount Rate

Estimating the discount rate in a private firm valuation can be quite challenging for the following reasons:

• Size premiums. Size premiums are often added to the discount rates used for small private companies. Estimates of this premium based on small public firm data may be biased upward if some of the small firms in the sample were formerly larger companies that are now experiencing financial distress.
• Availability and cost of debt. A private firm may have less access to debt financing than would a public firm. Because equity capital is usually more expensive than debt, and because the higher operating risk of smaller private companies also results in a higher cost of debt, WACC will typically be higher for private firms.
• Acquirer versus target. When acquiring a private firm, some acquirers will incorrectly use their own (lower) cost of capital, rather than the higher rate appropriate for the target. Thus, they will arrive at a value for the target company that is too high.
• The target should be valued using its own cost of capital to reflect risk differences between the target and the acquirer.
• Projection risk. The lower availability of information about private firms may make it appropriate for an analyst to apply a higher discount rate. Additionally, the private firm’s management may be inexperienced at forecasting, making the upward or downward adjustment of earnings forecasts appropriate.
• (However, such adjustments are highly subjective.)
• Life cycle stage. It is particularly difficult to estimate the discount rate for a firm in an early stage of development. If such firms have unusually high levels of unsystematic risk, the use of the capital asset pricing model (CAPM) may be inappropriate.
• Although ranges of discount rates can be specified for the various life cycle stages, it may be difficult to accurately classify the stage a firm is in.

Using the CAPM, the expanded CAPM, and build up methods to estimate discount rates for private firms may not be as straightforward as it is for public firms.

With CAPM, beta is traditionally estimated from public firm data. However, such a beta estimate may not be appropriate for private firms that have little chance of going public or being acquired by a public firm. Due to the differences between large public firms and small private firms, some U.S. tax courts have rejected the use of the CAPM for private firms.

While using comparable beta as a proxy for the subject company, an adjustment should be made for leverage differences.

First, we unlever the comparable public company beta using its tax rate and debt to- equity ratio:

Then, to arrive at the estimate of private company beta, we adjust this unlevered beta using the subject private company’s tax rate (t*) and leverage (D/E)*:

Beta is a measure of systematic risk, which makes it appropriate in a well diversified portfolio context. However, investments in private companies may be large, unique, and undiversified. Thus, additional risk premiums may be applicable.

The expanded CAPM version includes additional premiums for size and firm specific (unsystematic) risk.

The build up method can be used when it is not possible to find comparable public firms for beta estimation. Beginning with the expected return on the market (i.e., beta is implicitly assumed to be one), premiums are added for small size, industry factors, and company specific factors.

Strategic and Nonstrategic Buyers

A transaction may be either strategic or financial. In a strategic transaction, valuation of the firm is based in part on the perceived synergies with the acquirer’s other assets. Conversely, a financial transaction assumes no synergies, such as when one firm buys another in a dissimilar industry.

When estimating normalized earnings for a strategic transaction, the analyst should incorporate synergies as an increase in revenues, or as a reduction in costs.

Discount for Lack of Control

Regarding a discount for lack of control (DLOC), minority shareholders are at a disadvantage because they have less power to select the directors and management than do the controlling shareholders. Without a voice, minority shareholders cannot determine the investment policies and payout policies that affect the value of the firm and the distribution of earnings.

Controlling shareholders may enjoy excessive compensation and other perks to the detriment of minority shareholders. However, firms that will experience an IPO or sale are less likely to pursue actions that damage minority shareholders.

Because estimates of lack of control discount are not easily available, we back this information out of control premiums observed in public company takeover transactions:

For example, if the control premium is 25%:

Valuations based on discounted cash flow methods such as free cash flow (FCF) and the capitalized cash flow method (CCM) could also require adjustments, depending on whether the estimated and subject cash flows were on a controlling or noncontrolling interest basis.

Discount for Lack of Marketability

If an interest in a firm cannot be easily sold, a discount for lack of marketability (DLOM) should be applied. (A DLOM is sometimes also called a discount for lack of liquidity.) It is often the case that if a DLOC is applied, a DLOM will also be appropriate.

For example, if a controlling shareholder believes that a private firm should not be sold, minority shareholders lack both the control and the ability to sell their position.

The DLOM may be impacted by numerous factors:

• An impending IPO or firm sale will decrease the DLOM.
• Contractual restrictions on selling stock will increase the DLOM.
• A larger pool of buyers will decrease the DLOM.
• Greater ownership concentration will increase the DLOM.

To estimate the DLOM, an analyst can use one of three methods:

1. In the first method, the price of the restricted shares is compared to the price of the publicly traded shares. (SEC Rule 144, for example, may restrict the sale of shares acquired in a firm before its IPO.)
2. In the second method, the price of pre IPO shares is compared to that of post IPO shares. However, one complicating factor is that post IPO firms are generally thought to have more certain cash flows and lower risk, so the estimated DLOM may not purely reflect changes in marketability.
3. A third method estimates the DLOM as the value of an at the money put option of a comparable public company, divided by its stock price. The time to maturity of the option should correspond to the time to the IPO, and the volatility is based on the historical volatility of publicly traded stock, or the implied volatility of publicly traded options. An advantage of this option valuation approach over the other two DLOM estimation methods is that the estimated risk of the private company can be factored into the option price.

The drawback of this approach is that a put option indicates a certain selling price, not actual liquidity.

Although these methods provide a basis for calculating the DLOM, it can be challenging to implement them. The data may be limited, and the interpretation of the data will vary; thus, the magnitude of the DLOM applied to a company will vary by analyst.

Because they are applied sequentially, the DLOC and DLOM are multiplicative, not additive. So, if the DLOC is 20%, and the DLOM is 13%, the total discount is NOT calculated as 20% + 13% = 33%, but as follows: