In our previous post, we discussed the methods of valuation and types of data that are required in valuation and their sources. Here, we will discuss some of the special considerations when valuing a private company.
While the same valuation approaches can be generally used for both private and publicly listed firms, private companies have special characteristics to be considered in the valuation process:
- Information related to a private company is not as easily available as with public companies.
There is often a lack of transparency in financial disclosures when it comes to private firms. Disclosure and financial reporting requirements are less strict for private firms and, when valuing a private company, one may need to consider if adjustments are required for personal expenses, owner salaries (deciding which portion of the salary is dividend or actual) or other related party transactions.
Start-ups also do not have a long operating history and hence they have fewer years of historical financial information, which increases projection risks.
If business valuation is based on a market-based approach, it may be difficult to find a comparable company in the public market. If this approach is used, the valuer may need to consider company specific factors when applying the multiple. When it comes to historical transactions, information may not be dependable, as private acquisitions are not always disclosed.
- Key management
Some SMEs are family run. Without the owner or the key management leader in the firm post-acquisition, one question would be whether the firm can operate at its current state and derive the same value thereafter.
As private firms do not have access to public markets to fund their capital needs, either by issuing public shares or bonds, their cost of financing are typically higher, hence resulting in a higher WACC (or discount rate).
- Lack of liquidity
It is harder to sell the shares of a private company in comparison to a listed public firm. Hence, a liquidity discount may be applied to the discounted rate.
- Minority interest discount
If a potential investor in the firm is unable to drive future investments or dividend payout policies, or make decisions such as hiring key personnel or the board of directors to protect the buyer’s interests, the investor may want to consider applying the lack of control discount to the discount rate.
The factors above should be thought through in a private company transaction. In our forthcoming post we will discuss some of the factors relating to minority interests.
Definitions of Standards of Value
The field of valuation has its own unique vocabulary, much of which is derived from the accounting profession and the security analysis and banking sector. Value has various definitions, and each one leads to differing estimates. Here are some ways in which value is defined.
- Fair Market Value
The generally accepted definition of fair market value is the cash or cash equivalent price at which an asset would change hands based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market.
Ideally, fair market value is the price that two parties are willing to pay for an asset or a liability, given the following conditions:
- Both parties are well informed about the condition of the asset or liability;
- Neither party is under undue pressure to buy or sell the item; and
- There is no time pressure to complete the deal.
- Market Value
Market value is defined by the International Valuation Standards Committee as “the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion.”
This is typically used in real estate and other tangible asset appraisals.
- Fair Value
Fair value is defined as “the estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties”.
The important differences between fair value and fair market value are that, when it comes to fair value,
- The transaction may not be held at arm’s length, and
- There may be synergies for either party.
When used for financial reporting under the IFRS, fair value has another meaning. Under IFRS, fair value is “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
- Investment Value
Investors make judgement based on the expected specific benefits, such as dividends flows, interest payments and capital gain from appreciated assets to be derived from a given investment over a specific time period. The worth of an investment to a particular investor is called investment value and represents individual investment requirements as opposed to the general, impersonal, and detached fair market value (investment value reflects the worth of a business to a particular investor or class of investors for their own reasons).
Investment value is predicated on the future return of an investor – either one is looking at the potential for investing in a business or the present business owner and is measured by cash flow.
The expectation of the amounts of these cash returns will vary with each investor, depending on, for example:
- The business’s future earning power;
- The degree of the risk in the investment or in an anticipated action that might affect the investment;
- A potential interaction with other businesses owned or controlled by the investor;
- Future government regulations affecting the preservation of the earning power;
- The marketability of the investment at a future date.
Most of the time, the discounted cash flow method is used to estimate the earning power.
- Intrinsic Value
In contrast to the investment value, the concept of intrinsic value focuses on determining the worth based on perceived characteristics of the business, not the requirements of a particular investor. Intrinsic value is most commonly used by security analysts and is usually applied in areas like publicly traded shares.
The calculation of intrinsic value permits the analyst to assess the investment worth of a business before a similar determination under similar conditions is made by the marketplace at large (i.e. the investing public). Analyst techniques used here are:
- Extrapolation and interpretation of the company’s balance and income statement ratios;
- Discounted cash flow calculations based on earning projections;
- Assessment of the liquidation value of business assets.
- Liquidation Value
Liquidation value refers to the net amount that is realised if a business is discontinued and its assets are sold individually. Intangible assets are not included in an entity’s liquidation value.
- Going Concern Value
The concept of the going concern value is not a measure of valuation but an expression of the current status of the business. It is the value of a company with ongoing operations (as compared to a business whose assets are being liquidated). This value differs from the value of a liquidated company's assets, because an ongoing operation is able to continue to earn profit, while a liquidated company does not. Most business valuations will be prepared on the basis of a growing concern.
All in all, it is advisable to seek the expertise of a professional firm which can guide you in all valuation related matters.