EcoMachines Ventures: Funding and Valuing Early Stage Businesses
Group02 Valuing Private Businesses
Transcript of Group02 Valuing Private Businesses
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VALUATION OF PRIVATE BUSINESSES
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Valuation of Private companies
While valuing a private firm, the motive behind thevaluation can affect the value. In particular the value
attached to a private firm that may be going public is
different from the one which is being valued to be sold toanother private company or a publicly trading company.
The principles of valuation remain the same but the
estimation of the inputs are what is unique
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Unlike publicly traded firms, the accounting
practices by private firms are loose andinconsistent Scarcity of information for the no. of years and
in the amount of the information available foreach year.
Reduced
regulatory andreporting
requirements
There is no constant updated price for equityand historical data.
Absence of a ready market also means thatliquidating the equity position is more difficultand expensive in private companies
Lack of marketvaluation
The owner of a private firm is likely to beclosely involved with the management andmay have a major chunk of his wealthinvested in the firm
Absence of demarcation may lead to themixing of personal and company expenses.
Delineation ofexpenses and
profits
What is so special about private firms?
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The value of a private firm is the present value ofexpected cash flows discounted at an appropriatediscount rate.The differences between private firms and publiclytraded arises in the manner these inputs to thediscounted cash flow model are estimated.
Cash flows to Value
Growth and sustainbility of growth
Cash flows
Cost of Capital
Cost of Debt
Cost of EquityMarket Beta
Estimation of valuation inputs at private firms
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No product revenue,little to no expensehistory Both income approachand the market
approach not reliable indetermining theenterprise value due to alack of revenue orexpense history. Asset approach whichrecognizes that asignificant portion of the
assets may lie inintangibles Another method whichis become popularrecently is the back-solve method, a specialform of market approach
that considers recentstock transactions of thecompany
Stage 1
No product revenue,but substantive expensehistory(Stage 2) No product revenue,but product development
near completion (Stage3) Similar approaches tostage 1 The income approachmight be used, but witha relatively high discountrate due to the
significant riskassociated with furthercash flows.
Stages 2 & 3 Some product revenue,first customer orders,initial shipments (Stage4) Product revenue andbreak-even/positive cashflows (Stage 5)
Established history ofprofitability and cashflows (Stage 6)In stage 4, the incomeand market approachesto be used with a lowerdiscount rate due to the
lower level of riskcompared with priorstages In stages 5 and 6,under the marketapproach, loweradjustments would berequired in comparing
the EV to publicly heldstart-up companies.
Stages 4, 5 &
6
eve opmen s ages v s- -v s va ua ontechniques
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Starting with discount rates, if we want to value equity,we shall discount cash flows to equity at the cost ofequity, if we want to value the firm, we shall discountthe cash flows to the firm at the cost of capital
1. The investor is not diversified
2. Absence of historical data for computation of thebeta
Issues related to computation of cost of equity
The cost of equity
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AccountingBeta
FundamentalBeta
Bottom UpBeta
PROCEDUREPrice information not available but accounting earnings are
available for private firms Regress changes in accounting earnings against changes inearnings for an equity index to estimate accounting beta Using operating earnings would yield unlevered beta Using net income would yield a levered beta
LIMITATIONS Measured once a year> Limited information and weak statisticalpower Earnings are normally smoothed out and subject to accountingjudgments
Approaches to estimate market Betas
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Damodaran suggests the following regression that was run on the betas of
NYSE and AMEX stocks to 4 variables
1. CVOI: Coefficient of variation in operating income.2. Book debt/equity
3. Historical growth in earnings(g)
4. Book value of total assets(TA)
= 0.6507 + 0.25 CVOI1
+ 0.09 D/E + 0.54 g - 0.000009 TA R2=18%
Each of these variables for a private firm are measurable and can be used
to estimate the beta.
Note: 1. Coefficient of Variation in Operating Income = Standard Deviation in Operating Income/ Average Operating Income
AccountingBeta
FundamentalBeta
Bottom UpBeta
Approaches to estimate market Betas
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Estimate the average beta for publicly traded comparable firms
Estimate the average market value debt-equity ratio of these comparable firms andcalculate the unlevered beta for the business
To adjust the unlevered beta for the financial leverage, we may use one of the twoalternatives
(a) Assume the firms debt to equity ratio is converging with industry average.
(b) Use private firms target Debt to Equity or Optimal Debt to Equity (if it can beestimated)
Estimate cost of equity based on the estimated beta.
AccountingBeta
FundamentalBeta
Bottom UpBeta
Approaches to estimate market Betas
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The Beta of a firm measures only the market risk and is based on the assumptionthat the investor is well diversified. However, a private firm owner is likely to invest allor the bulk of their wealth invested in the business. Hence their perceived cost ofequity is different.
Likely to adjust market beta with total risk measure under following situations: Whenvaluing a private firm for
Sale to a private business
Total Risk= Market Beta/ Correlation with the Market
Total Risk vs Market Risk
The total Beta will be higher than the market beta, the lower the correlation betweenthe market and the private firm the higher the total beta
Adjustment for Non-Diversification
Sale to an individual
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Private firms are generally not rated and do not have bonds outstanding.Consequently to estimate the cost of debt one of the following approaches maybe used.
Basic Issue
Solutions
Cost of debt for private firm= cost of debt for similar firms(in terms of size) in theindustry. Used for firms being valued for an IPO.
Cost of debt=Interest rate on recent borrowings. Used when the private firm hasborrowed money recently.
Based on synthetic rating using interest coverage ratios. Then compute thedefault spreads on these ratings to arrive at cost of debt.
Cost of debt
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Estimating cost of capital
The debt ratios are mostly stated in book value terms rather than marketvalues. There is also a chance that the debt ratio may change for a privatefirm that is planning to go public.
Basic Issue
Solutions/Assumptions
Debt Ratio of private firm= Industry Average Debt Ratio
Debt Ratio of private firm=Optimal Debt Ratio
It is important that the debt ratio assumption must be consistentwhile calculating Beta, debt ratings and Cost of Capital
Estimate the Debt Ratio of private firm based on circular reasoning. Startwith the book debt and cost of capital->estimate the firm and equity value-
>use these values to arrive at a new debt ratio and cost of capital and re-estimate the firm and equity value. Continue till the debt and equity valuesconverge in the cost of capital computation.
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Estimating cash flows
Problems
Solutions/Assumptions
Restate the earnings using consistent accounting standards
Exclude any expenses that may be personal while computing income
Estimate a reasonable salary based on the services rendered by the owner to
the firm
Intermingling of personal and business expenses.
Thin line between salary and dividends.
Effect of taxes on value since individual tax rates and corporate tax rates differ
Different accounting practices are followed across different private firms.
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The expected growth rate in operating income is the product of reinvestment rateand the return on capital.
Historical growth
Fundamentals (Reinvestment rate and Return onCapital )
The shifting accounting practices may reflect the reported earnings are notrepresentative of actual earnings. Also most private firms are young and there maybe lack of historical data
Persistence of growth
The infinite life concept needs to be considered with more caution since the
transition from one owner to another need not be smooth. Implications on the valueof growth1. Terminal value of private firm is less than the terminal value of a publicly tradedfirm. If the owner retires- we may use the liquidation value as terminal value2. If the owner plans for transition, the value of the business is more than the firmthat doesnt have transition plans chalked out.
3. Private firms that are becoming larger even in terms of management, resemblepublicly traded firms, and for these we may assume infinite growth
Estimating growth rate
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Comparable Company Trading Multiple Analysis (Comps)
Select the comparable companiesCalculate relevant financials and multiplesApply valuation and analyze the resultsApply a private company discount
Comparable Transaction Analysis (Transaction Comps)
Use of actual transaction multiples instead of trading multiplesIndustry, timing (recent), geographic location, size etc.Data could be difficult to locate
Drawbacks
Not all aspects are captured in multiplesUnavailability of metrics other than salesFinding comparable companies and deals may not always be easyPrivately owned companies are less desirable
Relative Valuation techniques
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Asset AppraisalCompanies with heavy fixed assetsFair market value of fixed assets and equipment is calculated as a means ofevaluating the business.
Break-up AnalysisA sum of parts valuation based on different business linesRelevant for private companies with dissimilar business lines
Replacement CostConsiders total cost of reproducing operations of the business in todaysenvironmentStart-up expenses, real estate, equipment, and inventory and labor costs
LBO AnalysisTo determine range of prices a financial buyer would be willing to pay based ontarget ROE (IRRs) and leveraged capital structure.
Internal Rate of ReturnUsed to calculate the entry price, exit price, or average cash flows in aninvestment.Given certain inputs such as exit price and cash flows within the investment,
can be used to calculate a desired return rate, entry price, or other factors.
Other commonly used techniques
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Value for control premium to acquire a block of equity
Probability that control of the firm will change.
Value of gaining control of the company = PV(Value of company with change incontrol-Value of company without change in control) + Side benefits of control
Need to estimate the effects of creating different classes of shares in the IPO andthe effects of the options or warrants on the issuance price per share.
In case of an IPO
Class of shares having voting rights more valuable than the ones without votingrights.
Difference should be the function of the value of controlling the firm
Other Adjustments
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Factors determining illiquidity discount
Size of the firm Larger the firm , smaller the liquiditydiscount
Health of the firm Healthier firms->Lower liquidity discount
Type of assets owned by the firm More the liquid the asset, lower theliquidity discount for the firm
Cash flow generating capacity Generating large amounts of cash->smaller discounts
Size of the block The liquidity discount should increase
with the size of the portion being sold.
Investments which are more liquid must be traded at a higher price than those thatare less liquid investments.
No illiquidity discount if sale is being made to a public company
Effects of illiquidity on value
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Preference for Acquisitions:
Strong competition in the product market
Better valuation of the firm by potential acquirers by virtue of their industry
expertise unlike atomistic investors in the IPO market, who can be expected to
be at an informational disadvantage with respect to firm insiders
Preference for IPOs:
Acquirers can have considerable bargaining power, allowing them to extract
the firms net present value (NPV) from insiders
Entrepreneur may derive personal benefits from continuing to manage it long
term (private benefits of control), which he would lose after an acquisition
IPO vs Acquisitions
E i d ???
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Retention of benefits v/s immediate cash flows
Entrepreneur may be biased towards exiting via an IPO due to retention of
private benefits of control whereas the VC may decide based on financial
considerations (cash flow benefits) alone.
Long term v/s short term investor
Entrepreneur is typically a long-term investor planning to continue much of his
pre-exit equity stake in the firm even after an IPO listing whereas the VC may
often be a short-term investor planning to liquidate much of his pre-exit stake
soon after the IPO.
Exit conundrum???
Disagreement between entrepreneur and VC on the preferred means ofexit in equilibrium
O l d / d l d IPOS
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Facebook Stock price
140
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Speciality RestaurantsStock price
Reasons of Overvaluation:Pricing and not valuation Incorrect underlyingassumptions Willing to pay control premium
Restricted stock studies
Price Band : 34-38 $Issue Size : $104 billion
Price Band : 146-165 Rs.Issue Size: Rs. 171.4 - 182.0 Cr.
Reasons of Undervaluation:Excess reliance on Mainland China
brand name Difficulty in recouping certain capitalimprovement costs
Volatility in earningsInability to accurately forecast
Overvalued v/s undervalued IPOS
Ch i V l i h i b d i
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Valuation for sale to
a private entity
Valuation for sale to
a publicly traded firmor an IPO
Cost of Equity Based on Total Beta Based on market betasince owner is diversified
Cost of debt May reflect additionalspread since it isassociated with being aprivate business
Based upon syntheticratings, obtained bylooking at comparablepublicly traded firms
Operating Cash Flows Tax rate should be usedof private business
Corporate marginal taxesmust be used
Firm life Finite life terminal valueor liquidation value
Perpetual value
Illiquidity discount Should be discounted No illiquidity discount
Change in Valuation techniques based on motive
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Approach
Respondents
DDM1 DCF2 EVA3 APV4 Other(LBO)
DependentAdvisors
45.5 100.0 45.5 9.1 9.1
IndependentAdvisors
14.3 85.7 7.1 0.0 21.4
PrivateEquity
0.0 78.6 14.3 0.0 57.1
Total 17.3 87.2 20.5 2.6 30.8
Notes: 1. DCF = Discounted cashflow model2. DDM = Dividend discount model3. EVA = Economic value added4. APV = Adjusted present valuex2 of equal use of present value approaches: p-value = 0.001Fisher's Exact test of equal use of present value approaches across the three groups of participants (dependent =independent = private
equity) = 52.03, p-value = 0.002Source: Issues in Valuation of Privately Held Firms by CHRISTIAN PETERSEN, THOMAS PLENBORG, AND FINN SCH0LER
Present value approaches for valuation
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Respondents 1 year 1 5 years 68 years 9-12 years + 12 yearsAverage(years)
Dependent 0.0% 46.2% 33.3% 23.1% 0.0% 6.1
Independent 0.0% 27.3% 36.4% 36.4% 0.0% 7.2
Privateequity 0.0% 64.3% 21.4% 7.1% 0.0% 4.2
Total 0.0% 42.9% 42.9% 14.3% 0.0% 5.8
Average forecasting horizon
One consequence of using a short forecasting period is a significant under-valuationof a firm, or it requires heroic long-term growth assumptions.The value of a small business often depends on the presence of the owner. As soonas he/she retires, the firm's most valuable asset disappears.
The intermingling of business and private expenses is particularly problematicin small businesses This problem of lack of clarity in expense allocation is found to be positively
correlated with the level of ownership concentration.
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Thank You
Group 2Akshayita SaxenaPrerna LotlikarRhea MainiSai Sunil
Bhrugumalla