24 - Private Company Basics

Question 1

There are three reasons for valuing the total capital and/or equity capital of private companies

Answer 1

transactions, compliance, and litigation.

Question 2

Transaction-Related Valuations

Answer 2

Venture capital financing

Initial public offering (IPO)

Sale in an acquisition

Bankruptcy proceedings

Performance-based managerial compensation

Question 3

Compliance-Related Valuations

Answer 3

Financial reporting

Tax purposes

Question 4

Litigation-Related Valuations

Answer 4

shareholder suits, damage claims, lost profits claims, or divorce settlements.

Question 5

approaches to private company valuation

Answer 5

income approach, the market approach, and the asset-based approach.

Question 6

normalized earnings

Answer 6

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.

Question 7

Example: Normalized earnings

Tim Groh is the principal shareholder, CEO, and founder of Arbutus Generators. Arbutus reports the following:
1 - Groh’s compensation of $2,500,000 is included in the firm’s selling, general, and administrative (SG&A) expenses.
2 - Arbutus leases a warehouse for $100,000 a year from one of its largest suppliers.
3 - Arbutus owns a vacant office building with reported SG&A expenses of $150,000 and $25,000 of depreciation expense.
4 - Arbutus’s capital structure has too little leverage.

An analyst determines that a market-based compensation figure for Groh’s position is $1,000,000 and that the office building is not needed for core operations. The market lease rate of the warehouse is $130,000.

Based on 1–4 above, what adjustments should the analyst make to Arbutus’s reported income to estimate normalized earnings (earnings), assuming the firm will be acquired?

Answer 7

Answer:

1- Because the market rate is $1,500,000 less, SG&A expenses should be reduced by $1,500,000 to reflect a normalized compensation expense.
2 - Because the market lease rate is $30,000 higher than reported, SG&A expenses should be increased by $30,000 to reflect a normalized lease rate.
3 - Because the office building is non-core, SG&A expenses should be reduced by $150,000, and depreciation expense should be reduced by $25,000.
4 - Because the capital structure is non-optimal, the analyst will drop interest expense from the calculation of operating income under the assumption that the capital structure will be changed if the firm is acquired. As we will see, interest expense is added back when calculating free cash flow to the firm.

Question 8

In a strategic transaction

Answer 8

valuation of the firm is based in part on the perceived synergies with the acquirer’s other assets

Question 9

A financial transaction

Answer 9

assumes no synergies, as when one firm buys another in a dissimilar industry.

Question 10

Forms of the Income Approach to Valuation

Answer 10

free cash flow, capitalized cash flow, and/or excess earnings methods.

Question 11

The Free Cash Flow Method

Answer 11

Once free cash flows have been estimated as we have done previously, they are discounted by a rate that reflects their risk.

Question 12

Valuing the firm as a whole using the Capitalized Cash Flow Method

Answer 12

Question 13

Valuing the equity as a whole using the Capitalized Cash Flow Method

Answer 13

Question 14

The Excess Earnings Method

Answer 14

Excess earnings are firm earnings minus the earnings required to provide the required rate of return on working capital and fixed assets

Question 15

Example: Calculating firm value using the excess earnings method

Given the following figures, calculate the value of the firm using the EEM.

Answer 15

Step 1:
Calculate the required return for working capital and fixed assets.

Based on the required rates of return for working capital and fixed assets, the required earnings are:

working capital: $300,000 × 6% = $18,000

fixed assets: $1,000,000 × 10% = $100,000

Step 2:
Calculate the excess earnings.

excess earnings = $130,000 − $18,000 − $100,000 = $12,000

Step 3:
Value the intangible assets.

Using the formula for a growing perpetuity, the discount rate for intangible assets, and the growth rate for excess earnings:

value of intangible assets = ($12,000 × 1.05) / (0.14 − 0.05) = $140,000

Step 4:
Sum the asset values to arrive at the total firm value.

firm value = $300,000 + $1,000,000 + $140,000 = $1,440,000

Question 16

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

Answer 16

Size premiums

Availability and cost of debt

Acquirer versus target

Projection risk

Management may not be experienced with forecasting and may underestimate or overestimate future earnings

Lifecycle stage

Question 17

models used to estimate the required rate of return to private company equity

Answer 17

CAPM
Expanded CAPM
Build-up method

Question 18

The three Market approaches to valuing private firms

Answer 18

guideline public company method (GPCM),
the guideline transactions method (GTM), and
the prior transaction method (PTM).

Question 19

guideline public company method (GPCM)

Answer 19

uses price multiples from trade data for public companies, with adjustments to the multiples to account for differences between the subject firm and the comparables.

Question 20

Guideline Transactions Method

Answer 20

prior acquisition values for entire (public and private) companies that already reflect any control premiums are used, so no additional adjustment for a controlling interest is necessary.

Question 21

prior transaction method (PTM)

Answer 21

uses transactions data from the stock of the actual subject company and is most appropriate when valuing minority (noncontrolling) interests.

Question 22

Describe the asset-based approach to private company valuation.

Answer 22

The asset-based approach estimates the value of firm equity as the fair value of its assets minus the fair value of its liabilities. It is generally not used for going concerns.

Question 23

The Discount for Lack of Control

Answer 23

Question 24

total discount =

Answer 24

1 − [(1 − DLOC)(1 − DLOM)]