Creating a valuation for private firms requires more analysis and consideration than their public counterparts. Many recent private startups present rapidly evolving business models that differ from publicly traded companies, which, along with a lack of public information, can make finding comparable transactions difficult. In my experience with private firm valuations on both the buy-side and sell-side of transactions, considering multiple angles to a company’s valuation is key to maximizing the value of a deal. Investment banks and financial advisors specializing in mergers and acquisitions are invaluable partners in developing valuations. However, I have found it is critical to forming your valuation position alongside those financial partners to understand any valuation better. The financial experts can confirm, enhance, and even revise one’s valuations, but having an internal point of view is a vital first step.
While private firm valuations are commonly quantified through various approaches, ultimately, you have to determine which one best represents your firm’s current positioning and its prospects for the future. Understanding the valuation range the various approaches create will best position you for a successful negotiation, regardless of whether you are looking to raise new capital, sell the company or even acquire firms to fuel your company’s growth.
Evaluate various approaches in unison rather than independently. Together, the various methods can form a picture of the valuation, and the spread of the valuation range will provide an essential assessment of the underlying business risks and the potential financial upside.
Let’s review the most commonly used valuation methods to gain an overview of the options available in the creation of a valuation range from which, ultimately, you can draw a private firm’s value.
Discounted Cash Flow Method
The discounted cash flow method is primarily based on financial projections. Therefore, this model can best represent the company’s economic outlook and its expectations of future growth. However, keep in mind that these projections are based on a set of assumptions and estimates.
A cash flow model built on fact-based assumptions can significantly enhance how to position the valuation and keep all involved parties more honest in a negotiation.
For example, what is a realistic growth rate? How does it compare with the competition, and why does it differ? How was the weighted average cost of capital (WACC) calculated? Have working capital adjustments been considered in the financial models? Are Quality of Earnings (QOE) adjustments incorporated? Many private firms do not include the working capital and QOE adjustments until late in the process, long after valuations have set in management and shareholders’ minds, thus creating potential issues. Based on the financial projections and cash flow model, a private firm may be worth more to you than to your competitors, and similarly, your private firm may be worth more to others than to your shareholders as a stand-alone unit.
These underlying assumptions can open the door to challenges to the projections, which can be used effectively in a negotiation, either against your company on the sell-side or to achieve a better deal on a buy-side transaction.
Ultimately, it is the company’s “secret sauce, the elements that make the company stand out from its competitors, which provide the foundation in supporting the key assumptions.
Comparable Company Analysis (CCA) Based on Public Companies
Utilizing the valuation of comparable publicly traded companies is a popular approach due to the transparency of market-based information. Publicly traded companies provide essential insights, not only of the companies themselves but also quantify where the overall market stands and how valuations are trending in specific industries and business sectors. However, private firms usually have a financial profile distinct from public companies, thus skewing the valuation for the private firm even after creating adjustments and applying discount factors. After all, the elements determining why a company is still private may be difficult to quantify objectively. Most adjustment factors for this discrepancy are based or derived from market standards and may not accurately represent the positioning of the specific private company.
Nevertheless, public company comparables provide an important benchmark from which most private companies can be evaluated and against which their valuations can be anchored.
Comparable Company Analysis (CCA) Based on Private Transactions
Similar to comparables based on publicly traded companies, private sales are commonly used to peg private firm valuations. This variation of the comparable company analysis, in my experience, presents an advantage over public ones in that the comparable companies may more closely represent the private firm you are valuing. Establishing valuation benchmarks based on more representative companies allows one to create a tighter range of adjustment factors. Also, private transactions more closely represent the value of a private firm without the noise of market fluctuations that may impact publicly traded companies.
While private transactions are incredibly insightful to valuations, there are challenges associated with this approach. First, publicly available information on private transactions may be limited. The related parties themselves often report private transactions with a tendency to overemphasize the positive aspects of the deal and downplay or omit the risks. Critical elements of the transaction’s structure, such as voting rights on shares or conditions of the agreement, may also not be reported. Also, and perhaps more importantly, the volume of private transactions may not be present to support the private firm’s valuations. This issue is commonplace in emerging industries and market segments, where valuations may be most critical.
Sometimes there may not be enough private transactions to provide a consensus to value the private company.
As mentioned previously in this article, perhaps the most crucial contribution of Comparable Company Analysis may be the insights into where markets are and where they are headed. After all, timing matters a lot in the valuation of any firm. Timing also matters as it relates to the private company’s goals.
Should the company capitalize on a high valuation while the market is at its peak? Perhaps management and shareholders had not considered selling the company, but it may be beneficial to strike while the iron is hot. Or maybe a deal for a key acquisition may need to be restructured if the price is too high.
Does the private firm need to raise new capital immediately to fund growth initiatives, even if the market is at a low point? Perhaps the valuation is lower than the firm expected, but investing in itself may accelerate its future valuations.
While some valuations are based on the company’s assets, it is not an approach that I have encountered as very popular amongst private companies. This model is often employed to determine liquidation value, and in practical terms establishes a floor to valuations. This approach provides a valuable tool for understanding the gap from the company’s valuation based on its business prospects and its liquidation or exit price.
Some Final Considerations for Private Firm Valuations
Valuations are critical to quantifying what any private firm is worth. While private firm valuation models can arrive at different figures, each provides a valuable insight that, along with the other methodologies, creates a picture. Ultimately valuations are more of an art form than a scientific formula. Having a fact-based strong foundation to your assumptions and projections, along with a deep understanding of the market, will best position one to maximize the private firm’s value and use it to achieve your business goals.
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About the Author
Raul has over 20 years of experience in corporate finance across several industries, including consumer goods, e-commerce and automotive. His core competencies include operational leadership, budgeting and forecasting, and partnering cross functionally to provide insights and drive results in both public and private companies. Raul has worked in a diverse set of areas within finance, such as manufacturing and operations, product development, sales and marketing, due diligence analysis and transaction advisory. Prior to joining 8020 Consulting, he served as the Senior Director of Finance at Newegg, an e-commerce company, and served as Senior Manager at Mattel in the International Division and the Operations Division. He holds a B.S. in Economics from the Wharton School, University of Pennsylvania.