2. VALUING PRIVATE COMPANIES: FACTORS AND APPROACHES TO CONSIDER Dr. David Krause AIM Program Marquette University

3. PUBLIC VS. PRIVATE VALUATION: COMPANY-SPECIFIC DIFFERENCES Private FirmsPublic Firms Less matureLater in life cycle Smaller size   risk   risk premiums Larger and have access to public financing Managers often have substantial ownership position Greater external shareholder ownership Potentially  quality & depth of management Greater quality & depth of management

4. PUBLIC VS. PRIVATE VALUATION: COMPANY-SPECIFIC DIFFERENCES Private FirmsPublic Firms Lower quality of information disclosure   risk &  valuations  pressure to make timely, detailed disclosures Shareholders have a longer-term perspective More emphasis on short- term performance Greater emphasis on tax management Less emphasis on tax management

5. PUBLIC VS. PRIVATE VALUATION: STOCK-SPECIFIC DIFFERENCES Private FirmsPublic Firms Shares are less liquid  liquidity discount Greater number of shareholders Concentration of controlShare ownership and control are more diffuse Potential restrictions on sale of shares Public market for shares

6. REASONS FOR PRIVATE EQUITY VALUATIONS Transaction Related Private financingIPOsAcquisitionsBankruptcyCompensation Compliance Related Financial reporting Tax reporting Litigation Related DamagesLost profits Shareholder disputes

7. DEFINITIONS OF “VALUE” Tax reporting Fair Market Value Real estate and tangible asset appraisal Market Value Financial reporting and litigation Fair Value Private company sale Investment Value Investment analysis Intrinsic Value

8. PRIVATE VALUATION APPROACHES Based on the present value of expected future cash flows or income Income Approach Based on pricing multiples from sales of similar companies Market Approach Based on the value of the company’s net assets (assets minus liabilities) Asset-Based Approach

9. EARNINGS NORMALIZATION Reported Earnings Adjustments (For nonrecurring, noneconomic, unusual items) Normalized Earnings (Earnings capacity of the business if it is run efficiently)

10. EXAMPLE: EARNINGS NORMALIZATION ExampleAdjustment to Income Statement Private firm CEO is paid $1,200,000. Analyst estimates market rate for CEO is $800,000. Reduce SG&A expenses by $400,000. Firm leases a warehouse for $200,000/year from a family member. Analyst estimates market rate is $300,000. Increase SG&A expenses by $100,000. Firm owns a vacant building that has reported expenses of $90,000 and depreciation expenses of $15,000. The building is noncore. Reduce SG&A expenses by $90,000. Reduce depreciation expenses by $15,000. Firm may be acquired by a strategic Buyer A that expects synergies with cost savings of $230,000. Buyer B is a financial buyer. Reduce SG&A expenses by $230,000 when calculating normalized earnings for Buyer A, but not for Buyer B.

11. CASH FLOW ESTIMATION Start with normalized earnings Remove interest expense Include an estimate of income taxes on operating income Add back depreciation Subtract a provision for capital expenditures and working capital Free Cash Flow to the Firm (FCFF) Start with FCFF Subtract after tax interest expense Add net new borrowing Free Cash Flow to Equity (FCFE)

12. INCOME APPROACH: THREE METHODS Free Cash Flow -Based on the present value of future estimated cash flows and terminal value using a risk-adjusted discount rate -PV of expected future cash flows + PV of terminal value Capitalized Cash Flow -Based on a single estimate of economic benefits divided by an appropriate capitalization rate Residual Income (Excess earnings) -Based on an estimate of the value of intangible assets, working capital, and fixed assets

13. CAPITALIZED CASH FLOW METHOD Vf = Value of the firm FCFF 1 = Free cash flow for next 12 months WACC = Weighted average cost of capital g f = Sustainable growth rate of FCFF Vf = FCFF1/(WACC – gf) r = Required return on equity g = Sustainable growth rate of FCFE Ve = FCFE1/(r – gf)

14. EXCESS EARNINGS METHOD Residual income = -Normalized earnings – (Return on working capital) – (Return on fixed assets) Value of intangible assets = Value of the firm = -Working capital + Fixed assets + Intangible assets

15. Working capital$400,000 Fixed assets$1,600,000 Normalized earnings$225,000 Required return for working capital5% Required return for fixed assets12% Growth rate of residual income3% Discount rate for intangible assets18% EXAMPLE: EXCESS EARNINGS METHOD

16. 1.Return on working capital = 5% x $400,000 = $20,000 2.Return on fixed assets = 12% x $1,600,000 = $192,000 3.Residual income = $225,000 – $20,000 – $192,000 = $13,000 4.Value of intangible assets = ($13,000 x 1.03) / (0.18 – 0.03) = $89,267 5.Value of firm = $400,000 + $1,600,000 + $89,267 = $2,089,267

17. DISCOUNT RATE ESTIMATION ISSUES Size Premiums Size effect can increase discount rate Cost Debt Relative availability may be limited  increased cost of debt Higher operating risk  increased cost of debt Discount Rates in an Acquisition Context Should be consistent with cash flows, not buyer’s cost of capital Projection Risk Uncertainty associated with future cash flows Life Cycle stage Classification, early stage difficulties, company-specific risk

18. REQUIRED RATE OF RETURN MODELS CAPM Rf Βi(equity risk premium) Expanded CAPM Rf Βi(equity risk premium) Small stock premiumCompany-specific risk Build-Up Approach RfEquity risk premiumSmall stock premiumCompany-specific riskIndustry risk premium

19. Risk-free rate1.00% Equity risk premium6.00% Beta1.50% Small stock premium4.00% Company-specific risk premium1.50% Industry risk premium1.20% EXAMPLE: REQUIRED RETURN MODELS

20. CAPM 1.00% 1.50(6%)= 10.00% Expanded CAPM 1.00% 1.50(6%) 4.00% 1.50%= 15.50% Build-Up Approach 1.00% 6.00% 4.00% 1.50% 1.20%=13.70%

21. MARKET APPROACH: THREE METHODS Based on the observed multiples of comparable companies Guideline Public Company Based on pricing multiples from the sale of entire companies Guideline Transactions Based on actual transactions in the stock of the private company Prior Transaction Method

22. GUIDELINE PUBLIC COMPANY METHOD Identify group of comparable public companies Derive pricing multiples for the guideline companies Adjust pricing multiples for relative risk and growth prospects

23. GUIDELINE TRANSACTIONS METHOD Most relevant for valuing the controlling interest in a private company Transaction data based on public filings by parties to the transaction or from certain transaction databases Synergies Contingent consideration Noncash consideration Availability of transactions Changes between transaction and valuation dates Factors to consider in assessing pricing multiples:

24. PRIOR TRANSACTION METHOD Based on actual transactions in the stock of the subject company Based on either the actual price paid or the multiples implied from the transaction Most relevant when valuing the minority equity interest of a company Underlying Principle Provides the most meaningful evidence of value since it based on actual transactions in the company’s stock Advantages It can be a less reliable method if transactions are infrequent Disadvantages

25. EXAMPLE: GUIDELINE PUBLIC COMPANY METHOD Market value of debt$6,800,000.00 Normalized EBITDA$28,000,000.00 Average MVIC/EBITDA multiple 9.00 Control premium from past transactions20.00% Discount for increased risk18.00%

26. EXAMPLE: GUIDELINE PUBLIC COMPANY METHOD Public price multiple will be deflated by 18 percent Due to increased risk of private firm If buyer is strategic A control premium of 20 percent from previous transactions is applied If buyer is nonstrategic No control premium is applied

27. EXAMPLE: GUIDELINE PUBLIC COMPANY METHOD STRATEGIC BUYER Risk adjustment: 9.0 × (1 – 0.18) = 7.4 Control premium: 7.4 × (1 + 0.20) = 8.9 Value of firm: 8.9 × $28,000,000 = $249,200,000 Value of equity: $249,200,000 – $6,800,000 = $242,400,000

28. EXAMPLE: GUIDELINE PUBLIC COMPANY METHOD FINANCIAL BUYER Risk adjustment: 9.0 × (1 – 0.18) = 7.4 The control premium is not applied Value of firm: 7.4 × $28,000,000 = $207,200,000 Value of equity: $207,200,000 – $6,800,000 = $200,400,000

29. ASSET-BASED APPROACH The value of ownership is equivalent to the fair value of its assets less the fair value of its liabilities Underlying Principle Difficulty in valuing intangible assets special purpose tangible assets individual assets Rarely Used for Going Concerns Resource firms Financial services firms Investment companies (real estate investment trusts, closed-end investment companies) Small businesses with limited intangible assets or early stage companies Most Appropriate for

30. VALUATION DISCOUNTS/PREMIUMS Amount or percentage deduction from the value of an equity interest Discounts Reflects the absence of some or all control DLOC = 1 – [1/(1 + Control premium)] Lack of Control Discount (DLOC) Reflects the absence of marketability Applied when valuing a noncontrolling interest Lack of Marketability Discount (DLOM)

31. DLOC EXAMPLE Given a control premium of 19 percent

32. VALUATION DISCOUNTS Estimated Value of Equity Interest Pro rata value of equity interest Lack of control discount Lack of marketability discount Estimated Value of Equity Interest Pro rata value of equity interest x (1 – Control discount) x (1 – Marketability discount)

33. VALUATION DISCOUNTS Given a DLOC of 20 percent & DLOM of 16 percent

34. VALUATION STANDARDS To protect third party users by promoting and maintaining a high level of trust in the appraisal and valuation practice Objective To provide generally accepted and recognized standards for appraisals and valuations To establish requirements for impartiality, independence, objectivity, and competent performance Function Focus on business valuation, real estate, and tangible assets Adopted by 53 countries International Valuation Standards (IVS)

35. SUMMARY Company specific Stock specific Differences between Private and Public Companies Transactions Compliance (financial or tax reporting) Litigation Reasons for Private Company Valuations Fair market value Market value Fair value for financial reporting or in a litigation context Investment value Intrinsic value Definitions of Value

36. SUMMARY Income approach: Free cash flow, capitalized cash flow, and residual income methods Market approach: Guideline public company, guideline transactions, and prior transaction methods Asset-based approach Valuation Method Lack of control Lack of marketability Discounts Cover the development and reporting of valuations Protect users and the public Valuation Standards

37. EXCEL FILES