VALUING PRIVATE FIRMS So far in this book, we have concentrated on the valuation of publicly traded firms. In this chapter, we turn our attention to the thousands of firms that are private businesses. These businesses range in size from small family businesses to some that rival large publicly traded firms. The principles of valuation remain the same, but there are estimation problems thatare unique to private businesses. The information available for valuation tends to be much more limited, both in terms of history and depth, since private firms are often not governed by the strict accounting and reporting standards of publicly traded firms. In addition, the standard techniques for estimating risk parameters (such as beta and standard deviation) require market prices for equity, aninput that is lacking for private firms.
When valuing private firms, the motive for the valuation matters and can affect the value. In particular, the value that is attached to a publicly traded firm may be different when it is being valued for sale to an individual, for sale to a publicly traded firm or for an initial public offering. In particular, whether there should be a discount on valuefor illiquidity and non-diversifiable risk or a premium for control will depend upon the motive for the valuation. We will consider each of these components over the course of this chapter.
What makes private firms different? There are a number of common characteristics shared by private firms with publicly traded firms, but there are four significant differences that can affect both how weestimate inputs for valuation. • Publicly traded firms are governed by a set of accounting standards that allow us to identify what each item in a financial statement includes but to also compare earnings across firms. Private firms, especially if they are not incorporated, operate
2 under far looser standards and there can be wide differences between firms on how items are accounted. • There isfar less information about private firms, both in terms of the number of years of data that is typically available and, more importantly, the amount of information available each year. For instance, publicly traded firms have to break down operations by business segments in their filings with the SEC, and provide information on revenues and earnings by segment. Private firms do not have to, andusually do not, provide this information. • A constantly updated price for equity and historical data on this price is a very useful piece of information that we can obtain easily for publicly traded firms but not for private firms. In addition, the absence of a ready market for private firm equity also means that liquidating an equity position in a private business can be far more difficult (andexpensive) than liquidating a position in a publicly traded firm. • In publicly traded firms, the stockholders tend to hire managers to run the firm, and most stockholders hold equity in several firms in their portfolios. The owner of a private firm tends to be intimately involved with management, and often has all of his or her wealth invested in the firm. The absence of separation between theowner and management can result in an intermingling of personal expenses with business expenses, and a failure to differentiate between management salary and dividends (or their equivalent). Each of the differences cited above can have change value by affecting discount rates, cash flows and expected growth rates. To examine the issues that arise in the context of valuing private firms, we willconsider two firms. The first firm is the New York Yankees, a fabled baseball franchise and the second is a private software firm called InfoSoft. We will value the Yankees for sale in a private transaction, whereas we will value InfoSoft for sale in an initial public offering.
3 Estimating Valuation Inputs at Private Firms The value of a private firm is the present value of expected cash flows...