Valuing Private Companies Private companies have undiversified buyers and sellers, making it difficult to assume marginal investors. This leads to higher cost of equity for private companies compared to public ones.
Adjusting Cost of Equity for Liquidity Risk The liquidity discount applied in valuing a private company should vary based on the characteristics of the business and potential buyer. A long-term buyer who doesn't need cash may require a lower discount than a cash-constrained one.
Case Study - Valuation of Restaurant Business A restaurant owner is planning to sell his business which has reported $1.2 million in revenues and $400k pre-tax operating profit with an outstanding lease expense over next twelve years at $120k per year. The financials must be analyzed before determining its value through adjusting cost of equity for liquidity risk factors specific to this case study's situation
Discount Rate Calculation The investment banker calculates the discount rate for a private restaurant company by scaling up the market beta to reflect total risk and estimating debt-to-equity ratio using industry averages or estimated equity value. The cost of capital is higher due to lack of diversification, resulting in lower valuation.
Adjusting Financials and Valuation To adjust financial statements, capitalized leases are treated as an operating expense while factoring in correction costs such as hiring new chefs. A stable growth rate is used with reinvestment rates reflecting necessary upgrades for maintaining physical space. After adjusting for key person discounts, liquidity issues still need addressing through further discounts.
Liquidity Discounts and Restricted Stock Studies Liquidity discounts vary across companies based on factors like size, ownership structure etc., but restricted stock studies provide some evidence on observable liquidity discounts where publicly traded companies issue shares with restrictions that can be observed over time periods ranging from two years pre-IPO to post-IPO transactions between owners VCs founders selling their stakes at discounted prices compared to IPO price due to illiquidity concerns. However these studies have limitations too including flawed logic assumptions etc..
Restricted Stock Studies Restricted stock studies show discounts of 25-35%, but this is due to a sampling bias as the companies that issue restricted stocks tend to be money losing, distressed or risky. After correcting for this bias, the discount becomes much smaller.
IPO Studies IPO studies are even worse than restricted stock studies because they miss out on companies where the IPO falls apart and create a sampling bias. This leads to overestimation of discounts at around 50%.
Liquidity Discount in Private Company Valuation Liquidity discount can be estimated using bid ask spread regression analysis for publicly traded companies which can then be used as an estimate for private company valuation. However, many people double count liquidity risk by adding it into their build-up approach when calculating cost of equity which punishes healthy private businesses twice if they use small cap premium rates pushing up their discount rate and lowering value further with another liquidity adjustment factor.
Public vs Private Company Valuation The value of a business can differ depending on whether it is public or private, with public companies having higher values due to their diversification and liquidity. The negotiating process between buyers and sellers will depend on the number of potential buyers in the market.
Issues in IPO Valuation Valuing a company for an initial public offering (IPO) requires consideration of what will be done with proceeds from the offering, cleaning up special deals made during VC rounds, accounting for multiple classes of shares being consolidated into common stock at IPO time, valuing existing investor claims separately from equity value, and considering investment banking guarantees as discounts.
Investment Banking Services Offered During an IPO Investment banks offer underwriting services that guarantee pricing; book running services where they sell shares through roadshows; valuation services before going public; aftermarket support by buying back shares after the offering.
The Value of Bankers in IPOs Bankers used to be valuable for selling a company's shares and providing pricing valuations, but with the rise of high-profile companies like Facebook, their services have become less useful. Direct listings are becoming more popular as an alternative.
Direct Listings vs Traditional IPOs Direct listings allow demand and supply to set the price instead of bankers setting it beforehand. However, there are institutional constraints that may get in the way. Companies can also choose SPACs (special purpose acquisition companies) or trust high profile investors to negotiate prices.
Non-Cash Working Capital Valuation Issues Valuing a company with negative working capital is difficult because traditional net capex is not being invested while non-cash working capital gets more negative over time. This leads to balance sheets that don't balance and ROIC going from positive to negative over time unless there is significant investment elsewhere or supplier credit use remains small compared to revenues.