Investors who hold publicly-traded securities have the luxury of knowing the value of their investment at virtually any time. An internet connection and a few clicks of a mouse are all it takes to get an up-to-date stock quote. Of all U.S. companies, however, fewer than 1% are publicly-traded, meaning that the vast majority of companies are privately-held. Investors in privately-held companies do not have such a readily available value for their ownership interests. How are the values of privately-held businesses determined when a couple’s assets are being divided in a divorce, then? This article is meant to answer that question at a high level and serve as a quick-reference guide for you when dealing with the cases that involve the valuation of privately-held companies.
Levels of Value
All values are not created equal — for example a company’s “equity value” can be vastly different than its “enterprise value.” Therefore, before beginning any valuation analysis, it is important to establish what type of value is being determined.
Common valuation terms that relate to a company’s capital structure are equity value and enterprise value:
Equity Value – Equity value is the value of a company allocable to its equity investors. Equity value is the most commonly-determined value as it represents the value of an investor’s ownership interest in a company.
Enterprise Value – Enterprise value is the value of a company on a debt-free, cash-free basis. In other words, enterprise value removes the impact of how much cash and debt a company is carrying (which are simply financing decisions). Enterprise value can be used to calculate an equity value (and vice versa) based on the formulas below:
Enterprise Value = Equity Value + Debt - Cash
Equity Value = Enterprise Value - Debt + Cash
It is critical to understand that these values measure different components of a company’s capital structure, but that they are interrelated. For example, when the market approach is applied using revenue of EBITDA multiples, it typically produces in an enterprise value. Therefore, it is necessary to adjust the resultant value for the interest-bearing debt and cash of the company being valued to arrive at its equity value.
The most commonly utilized asset-based approach to valuation is the Adjusted Net Asset Method. This balance sheet-focused method is used to value a company based on the difference between the fair market value of its assets and liabilities. Under this method, the assets and liabilities of the company are adjusted from book value to their fair market value.
Adjustments are made to the company’s historical balance sheet in order to present each asset and liability item at its fair market value. Examples of potential normalizing adjustments include:
Adjusting fixed assets to their respective fair market values
Reducing accounts receivable for potential uncollectible balances
Reflecting any unrecorded liabilities
Consideration of the Adjusted Net Asset Method is typically most appropriate when:
Valuing a holding company or a capital-intensive company
Losses are continually generated by the business
Valuation methodologies based on a company’s net income or cash flow levels indicate a value lower than its adjusted net asset value
One needs to keep in mind that when income or market-based valuation approaches indicate values higher than the Adjusted Net Asset Method, it is typically dismissed in reaching the concluded value of the company. This is because income and market-based valuation approaches provide a much more accurate reflection of any goodwill or intangible value that the company may have.
There are two income-based approaches that are primarily used when valuing a business, the Capitalization of Cash Flow Method and the Discounted Cash Flow Method. These methods are used to value a company based on the amount of income the company is expected to generate in the future.
Capitalization of Cash Flow Method – The Capitalization of Cash Flow Method is most often used when a company is expected to have a relatively stable level of margins and growth in the future — it effectively takes a single benefit stream and assumes that it grows at a steady rate into perpetuity. The Capitalization of Cash Flow Method is typically applied when valuing mature companies with modest future growth expectations.
Discounted Cash Flow Method – The Discounted Cash Flow method, on the other hand, is more flexible than the Capitalization of Cash Flow Method and allows for variation in margins, growth rates, debt repayments and other items in future years that may not remain static. The Discounted Cash Flow Method is used when future growth rates or margins are expected to vary from a company’s historical levels.
There are two market approaches that are primarily used when valuing a business, the Guideline Transaction Method and the Guideline Public Company Method. These methods are used to value a company based on the pricing multiples observed for similar companies that were sold or are publicly-traded.
Guideline Transaction Method – The Guideline Transaction Method values a business based on pricing multiples derived from the sale of companies that are similar to the subject company. The steps taken in using the Guideline Transaction Method include finding transactions involving the purchase of comparable companies, selecting the transactions that closely mirror the company’s operations and which occurred in similar industry and economic conditions, and finally, applying the indicated pricing multiples from the representative transactions.
Valuation experts typically subscribe to databases that allow them to perform searches for comparable transactions. Once a population of guideline transactions is identified, some valuation experts also analyze transaction subsets that focus on specific groups of transactions such as companies of similar size, companies with similar margins, and transactions that have occurred most recently.
It should be noted that the calculated transaction multiples are typically based on the enterprise value of the purchased companies, meaning that we arrive at an enterprise value of the subject company when using the Guideline Transaction Method. Therefore, one must subtract the subject company’s debt and add its cash to the calculated enterprise value to arrive at its equity value.
Guideline Public Company Method – The Guideline Public Company Method values a business based on trading multiples derived from publicly traded companies that are similar to the subject company. The steps taken in applying the Guideline Public Company Method include identifying comparable public companies, adjusting the guideline public company multiples for differences in the size and risk of these companies compared to the subject company, and then applying the adjusted pricing multiples from the representative companies.
Also similar to the Guideline Transaction Method, the calculated multiples are often based on the enterprise values of the guideline public companies, meaning that we arrive at an enterprise value of the subject company when using the Guideline Public Company Method. As a result, adjustments for a company’s debt and cash balances are often necessary to arrive at an equity value.
Discounts for Lack of Control and Lack of Marketability
Before a conclusion of value can be rendered, the nature of the ownership interest being valued must be considered. The value of an ownership interest is influenced by many of its characteristics, including marketability and control, which can have a meaningful impact on value.
Control – Whether or not the ownership interest being valued has control over the subject company can impact on its value. Controlling owners have the ability to:
- Elect directors or appoint management
- Set levels of management compensation and other perks
- Determine cash dividends/distributions
- Set company policies or business course
- Purchase or sell assets
- Determine when and how to sell the company
The ownership of a non-controlling interest in a company does not have the ability to unilaterally direct the items above, which generally makes it less valuable than a controlling ownership interest.
The impact of lack of control on the value of an ownership interest is typically reflected in one of the following two ways:
- Directly in benefit stream being used to value the subject company
- Through the application of a discount for lack of control
Marketability – There are certain marketability differences between an ownership interest in a privately-held company and an ownership interest in a publicly-traded company. An owner of publicly-traded securities can sell those holdings at a moment’s notice and receive the cash within several days. This would not be the case with an ownership interest in a privately-held company, though. Consequently, liquidating a position in a privately-held company is a more costly, uncertain and time-consuming process than selling the stock of a publicly-traded entity. An investment in which the owner can achieve liquidity in a timely fashion is worth more than an investment in which the owner cannot sell the investment quickly. Privately-held companies sell at a discount that reflects the additional costs, increased uncertainty and longer time commitments associated with selling these types of investments.
The applicable lack of marketability discounts are typically based on consideration of the following:
- Empirical studies (such as restricted stock studies and pre-IPO studies)
- Option models
- Qualitative factors (such as those identified in Bernard Mandelbaum, et al. v. Commissioner).
Valuing a privately-held company is much more involved than simply typing a ticker symbol into Yahoo! Finance. This article is meant to provide a high-level overview of the valuation methods that are most frequently used in the valuation of privately-held companies. It should be kept in mind that there are additional nuances specific to each valuation that are not addressed here. At the end of the day, however, the valuation of privately-held companies comes down to the application of asset, income and market-based valuation approaches.
Sean Saari is a partner at Skoda Minotti and manages the firm’s Valuation & Litigation Advisory Services group. He assists a diverse client base in valuations for litigated matters, domestic disputes, shareholder disputes, estate and gift tax planning, financial reporting and strategic planning. In addition to being a CPA, Sean is Accredited in Business Valuation (ABV) and is a Certified Valuation Analyst (CVA). He became a CMBA member in 2015. He can be reached at (440) 449-6800 or email@example.com.