Valuation of Equity Share of Private Limited Companies

NOVEMBER 6, 2016Ankush Chattopadhyay (13LLB011)

Students of Law, School of Law, The North Cap University, Sector-23A, Gurgaon, Haryana

Acknowledgement

This research was supported by the esteemed teachers of our institution as well as all the

students we study with. We are thankful to our colleagues who provided expertise that greatly

assisted in the research, although they may not agree with all of the interpretations provided

in this paper.

We are also grateful to Prof. Ravinder Singh Sheokand for his immeasurable assistance in

teaching the subjects and in clarifying all the doubts and questions we posed.

We have to express our appreciation to the Law Faculty of The North Cap University for

sharing their pearls of wisdom with us and for making and forging us not only into better

human beings but also into knowledgeable professionals.

We are also immensely grateful to all our peers and friends for their comments and their

continuous support without which it would have been a lot harder and nigh impossible to

finish this manuscript.

Although there were numerous people and entities helping and assisting us through this

journey, any errors that have been committed are our own and should not tarnish the

reputations of these esteemed professionals.

Valuation of Equity Shares

of a Private Limited Companies

Share ownership in a private company is usually quite difficult to value due to the absence of

a public market for the shares. Unlike public companies that have the price per share widely

available, shareholders of private companies have to use a variety of methods to determine

the approximate value of their shares. Some common methods of valuation include

comparing valuation ratios, Discounted Cash Flow analysis (DCF), Internal Rate of

Return (IRR), Net Asset Value (NAV) Method, Earning Capacity Method and many others.

The most common method and easiest to implement is to compare valuation ratios for the

private company versus ratios of a comparable public company. If you are able to find a

company or group of companies of relatively the same size and similar business operations,

then you can take the valuation multiples such as the price/earnings ratio and apply it to the

private company.

This is called the Comparable Company Market Multiple Methodology. Comparable

Company Market multiple uses the valuation ratios of a publicly traded company and applies

that ratio to the company being valued (after applying appropriate discount). The valuation

ratio typically expresses the valuation as a function of a measure of financial performance or

Book Value (e.g. Turnover, EBITDA, EBIT, EPS or Book Value). A key benefit of CCM

analysis is that the methodology is based on the current market stock price. The current stock

price is generally viewed as one of the best valuation metrics because markets are considered

somewhat efficient. The difficulty here is in the selection of a comparable company since it is

rare to find two or more companies with the same product portfolio, size, capital structure,

business strategy, and profitability and accounting practices. Whereas no publicly traded

company provides an identical match to the operations of a given company, important

information can be drawn from the way similar enterprises are valued by public markets. For

analysis and results through this method parameters such as Turnover, Business Model, Trade

Volume etc. are compared.

For example, say your private company makes widgets and a similar-sized public company

also makes widgets. Being a public company, you have access to that company's financial

statements and valuation ratios. If the public company has a P/E ratio of 15, this means

investors are willing to pay $15 for every $1 of the company's earnings per share. In this

simplistic example, you may find it reasonable to apply that ratio to your own company. If

your company had earnings of $2/share, you would multiply it by 15 and would get a share

price of $30/share. If you own 10,000 shares, your equity stake would be worth

approximately $300,000. You can do this for many types of ratios: book

value, revenue, operating income, etc. Some methods use several types of ratios to calculate

per-share values and an average of all the values would be taken to approximate equity value.

DCF analysis is also a popular method for equity valuation. This method utilizes the financial

properties of the time-value of money by forecasting future free cash

flow and discounting each cash flow by a certain discount rate to calculate its present value.

This is more complex than a comparative analysis and its implementation requires many

more assumptions and "educated guesses." Specifically, you have to forecast the

future operating cash flows, the future capital expenditures, future growth rates and an

appropriate discount rate.

According to Assets Based Method, the asset values reflected in book of accounts do not

usually include intangible assets enjoyed by the business and are generally not a true

indicator of the future distributable cash/profit generating ability of the business which is

widely regarded as the true determinant of value of assets for most of the industries. The asset

values recorded in books of accounts are also impacted by accounting policies which may be

discretionary at times. However in this valuation analysis, we have computed NAV of the

Company, to do sanity check for our CCM valuation and found that the value preposition

under CCM is less than NAV (proxy for replacement cost in many cases) so, we have given

100% weight to NAV.

Valuation of private shares is often a common occurrence to settle shareholder disputes, when

shareholders are seeking to exit the business, for inheritance and many other reasons. There

are numerous businesses that specialize in equity valuations for private business and are

frequently used for a professional opinion regarding the equity value in order to resolve the

issues listed.

Under NAV all assets are taken at book value (excluding fictitious assets and goodwill) and

reduced by Net liability, then value derived is divided by number of shares to get market

Value per share.

Earning Capacity Method: - Under this method average of past few years profit is taken and

adjustment is made for any abnormal transactions occurred in those years, and then

considering future growth prospect Future Maintainable Profit (FMP) is arrived. FMP (future

maintainable profit) arrived is divided by Number of shares to get Earning per Share

(EPS).Then EPS is multiplied with P/E Ratio (market price to earnings ratio). In absence of

Market price of share to get P/E ratio Use method 100/NRR (Normal rate of return). On

multiplication of EPS with P/E ratio we get value of market value per share.

Important points to be considered while valuing share of private limited companies:-

1. Valuation of private equity share is generally subject to private understanding between

parties

2. In valuation of Pvt. Co. Equity share, any provision related to Valuation or transfer of

shares as per AOA (Article of Association) must be followed.

3. In absence of any provision in AOA, permission from other members should be obtained,

and shares should be first offered to them for allotment.