APPLIED FINANCE CENTRE
Faculty of Business
and Economics
Applied Business Valuation
Small unlisted private companies vs listed public companies
Introduction
• As a general rule, small unlisted private companies are worth
less than similar listed companies
• The million dollar question is: Why and by how much?
• Possible explanations for a private company discount include:
– Size – size of company may be positively correlated with
valuation multiples
– Quality of accounting – public companies are subject to
more stringent audit and reporting requirements and
generally engage better recognised accounting firms
– Exposure to market – public companies have greater
exposure to the market via public quotation systems, stock
exchange filing, analyst reports etc.
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Typical Characteristics of Listed
Companies
• Size – normally significantly larger than private companies
• Corporate governance
• Management – typically separate from ownership and greater
depth
• Diversification – generally better diversified across multiple
product/service categories, industries, geographies
• Economies of scale
• Access to capital
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Valuing Private Companies –
Capitalisation of Earnings
• Determining future maintainable earnings
• Not just an arithmetic exercise
• History is only a guide, should be forward looking
• Need to consider accounting policies e.g. unearned revenue, work in
progress etc.
• Normalisations e.g. owners’ remuneration, rent to related parties etc.
• Determining capitalisation multiple
• Art vs. science
• Availability of comparable companies
• Access to and quality of information
• Public company research should just be a starting point and may require
adjustment
• Sources of information
• Use broker consensus forecasts if available
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Valuing Private Companies – DCF
Valuations
• Sense-checking forecasts
• Reasonableness of key assumptions
• Sensitivity analysis
• Growth rates
• Converting P&L forecasts to cash flow forecasts
• Tax
• Changes in working capital
• Capital expenditure
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Valuing Private Companies – DCF
Valuations
• WACC calculation
• Sourcing betas
• Gearing and re-gearing betas
• Supportable/target debt level vs. actual debt level
• Accounting for entity specific risks
• Incorrect matching of cash flows and WACC
• Nominal vs. real
• Pre- vs. post tax
• Pre- vs. post interest
• Double counting risks in cash flows and WACCs
• Half year vs full year discounting
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Valuing Private Companies -
Premiums & Discounts
• Can be very significant to overall value; could reduce value by as much as 50%
or 60%!
• Often disputed due to inherent subjectivity. Therefore very important to review
empirical evidence, but refrain from using broad averages
• Two categories of premiums / discounts:
– Entity level premiums / discounts
– Equity level premiums / discounts
• Entity level premiums / discounts are those that affect the business e.g. key
person risk, customer concentration risk etc.
• Equity level premiums / discounts are those that reflect the characteristics of
ownership e.g. minority shareholders, non-marketable shares
• In this topic we are focusing on premiums / discounts that fall mainly in
the domain of small private company valuations
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Valuing Private Companies –
Premiums / Discounts
When valuing private companies, it is important to consider
adjustments for the following:
Enterprise Value Level
• The size effect
• Key person risk
• Other business risks e.g. customer/supplier concentration risk, contingent
assets/liabilities
Equity Value Level
• Control premium / minority discount (if warranted – refer Topic 3)
• Marketability discount
Enterprise value level adjustments are generally factored into the
valuation multiple or discount rate via adjustment to the cost of equity
Equity value level adjustments are generally made by discounting the
equity value at the end
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The Size Effect
• Risks faced by small private companies are generally greater than the risks faced by
comparable listed companies due to their smaller size and scale of operations
• The “size effect” is the concept that the smaller the company, the greater the risk and,
therefore, the higher the company’s cost of capital
• Studies show that the greater risk of smaller companies does not fully account for their
higher returns over the long term. In the CAPM only systematic (beta risk) is rewarded.
Small company shares have had returns in excess of those implied by their betas
• In practice, we therefore have to make adjustments to our valuations (at the enterprise
value level) to account for the size effect
• The courts have not been consistent in their treatment of risk premiums for small
companies
• When adjusting a valuation for size, you must be able to substantiate that the size effect
does in fact apply
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Criticisms of the Size Premium
• If size was the driving force behind the higher returns for small
companies, then why don’t large companies simply break themselves
up and divest to become small?
• It is not known whether size per se is responsible for the effect or
whether size is just a proxy for one or more factors correlated with size
• Whilst there are a number of potential explanations other than size, it is
near impossible to isolate each
• Other main criticisms relate to issues with the underlying data e.g.
measurement of beta, composition of deciles used, survival bias etc.
• Out of interest, the size effect has been found to be seasonal. Studies
show that virtually all of the small size effect occurs in January. There is
no generally accepted explanation for this
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Potential Explanations for the
Size Effect
• Market inefficiency
– The market misprices small firms and investors can earn a better than
normal rate of return by investing in these securities
• Systematic experimental errors
– Beta is measured with error e.g. non synchronous or thin trading
– Beta or risk is unstable over time
– The time period used to estimate beta is wrong
– Entry/exit returns are measured with error
– Survival bias exists in the data thereby overestimating returns
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Potential Explanations for the
Size Effect
• Economic explanations
– Beta is not the appropriate measure of risk e.g. it should be the
standard deviation or co-skewness
– Small firms have small prices therefore both transaction costs are
higher (larger bid ask spread) and tick size relative to price is large,
leading to a ‘price per se’ effect
– Small firms are illiquid relative to large firms, therefore there is a reward
for illiquidity
– There is little or no information available about small firms e.g. they are
not followed by brokers and analysts thus there is information risk or,
alternatively a reward for investing in information search
Source: Bishop, Steven, “Capital Asset Pricing and Size Premiums: Does Size Matter?”, presented at Institute of Chartered
Accountants Business Valuation & Forensic Accounting Conference, 14 September 2006
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Dealing with the Size Effect in
Practice
• There is very little guidance for valuation practitioners as to an appropriate
quantum for size premiums to apply in the valuation of small companies, yet
the effect can be material
• This is one of those areas where the valuer’s experience and judgement is
essential
• Most commonly practitioners add a premium in the range of 1% to 4% to the
CAPM estimate of their cost of equity, taken from the Ibbotson SBBI
Valuation Yearbook
• To adjust for the size effect in valuations utilising the market approach:
– Focus the selection of comparable companies to companies that are similar in size; or
– Adjust the multiple: P/Esubject = 1/(1/P/Epublic + ΔRisk + ΔGrowth)
• Essential to do valuation cross-checks to ensure reasonableness of position
adopted
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Ibbotson Data on Size Premiums
The Ibbotson data is based on US market information where micro-caps are
defined as companies with a market capitalisation of up to $431 million. This is
clearly much larger than the private companies we might be valuing in Australia!
Applying the Ibbotson data requires you to know the size category of your subject
company which is circular in itself
Australian published studies show that the abnormal return in Australia is
substantially higher
The table below summarises the Ibbotson data from 1926 to 2009. Note that the
Ibbotson data is split into size deciles
Size Category Size Range CAPM Adjustment
Mid-cap $1.6 b to $5.9 b 1.08%
Low-cap $432 m to $1.6 b 1.85%
Micro-cap $1 m to $431 m 3.99%
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Key Person Risk
• Many businesses are reliant on one or more key individuals and in
the event that those key individuals were no longer there, added
risks would attach to an investment in such a business
• Examples of key person attributes include: expertise, capability,
customer relationships, staff loyalty, supplier relationships, ability to
source capital e.g. via personal guarantees
• Key person risk is generally more common/pronounced in private
companies, particularly where there is little or no separation
between the ownership and management of the company and the
company is typically closely held
• The need for key person discounts has been recognised by the
courts and various tax authorities
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Larson/Wright Study on Key
Person Risk
• Compared equity value 10 days before and after death of
“President”, “CEO” or “Chairman” of small listed companies with less
than 500 employees over a decade (1990-2000)
• Key person discount existed in less than 50% of all identified cases
• Negative reactions resulted in mean and median declines in the
range of 4% to 6%
• Positive reactions resulted in mean and median gains of circa 7%
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Bolten/Wang Study on Key
Person Risk
• Reviewed 101 observations of senior management changes above the rank of vice
president as published in the Wall Street Journal from 1 August 1996 to 28 November 1996
• Results were stratified by company size (capitalisation) and number of senior
management personnel
• Smaller firms had the larger average percentage change with an average negative impact
of 8.65% for companies with a capitalisation of less than $280 million
• The average negative impact for the larger companies was 4.83%
• Increases in value were also observed when management changes were presumably
perceived as favourable
• The impact of management changes was greater as the number of people on the
management team decreased, with discounts as high as 9% observed for companies with
less than six senior management personnel
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Dealing with Key Person Risk in
Practice
• In theory, the key person discount should be the difference between the PV of the expected
cash flows with and without the key person, multiplied by the probability of the key person
remaining in the business
• In practice, key person risk is reflected in valuations (at the enterprise value level) via an
adjustment to the discount or capitalisation rate
• The challenge lies in determining the appropriate magnitude of the adjustment. This is
another area where the valuer’s experience and judgement is essential
• Factors that should be considered in determining the magnitude of the key person discount
include:
– Job scope of the key person and degree of dependence
– Existence of employment and/or non-compete agreements
– Likelihood of key person being lost e.g. due to age, health
– Quality and size of the rest of the management team
– Ability to source a replacement
– Level of compensation e.g. could be significantly above/below market
– Potential disruption to business if key person was lost
– Existence of key person insurance
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Other Business Risks
• Apart from the size effect and key person risk, there may be other unsystematic
risk factors that are specific to the subject company e.g. customer/supplier
concentration risk
• In practice these risks are dealt with by increasing the cost of equity capital
calculated under the CAPM. The quantum of the adjustment would depend on
the specific circumstances of the case
• There may also be specific contingent assets or liabilities e.g. remediation costs
at business premises, court cases, product liability etc.
• To the extent that the value of contingencies can be estimated, they should be
used to adjust the balance sheet and any associated benefit streams
• An alternative way to value a contingent liability could be to adjust the
marketability discount to take account of the reduced marketability of the shares
in the company resulting from the contingent liability
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Marketability Discounts
• Investors are generally, all things being equal, willing to may more for an
investment that is liquid than an investment that is illiquid e.g. a minority share in
a public listed company vs. a private company
• We therefore need to apply a discount to valuations of shares where those
shares lack liquidity. This discount is often the largest discount in the valuation
of a share (in dollar terms), particularly for a minority interest
• This is commonly referred to as a marketability or liquidity discount
• There is a large amount of empirical data available as to appropriate levels of
discounts to apply for lack of marketability
• Most of the empirical data has been derived from restricted stock studies and
pre-IPO studies
• The need for marketability discounts has been recognised by the courts and
various tax authorities
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Marketability Discounts
Controlling Interests
in Public Companies
Minority Interests
in Public Companies
LOW Marketability HIGH
Minority Interests in
Private Companies
Controlling Interests in
Private Companies
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Restricted Stock Studies on
Marketability Discounts
• Some public companies have shares that are not listed or, if listed, restricted from trading
e.g. when conducting an IPO, often the pre-IPO shares are escrowed after listing for a
period of time to prevent the original owners from selling out
• Restricted shares are similar to listed shares in all respects apart from their lack of
marketability
• Because restricted shares are not listed, they can only be sold in blocks, typically via
private placements
• These trades provide an insight as to the level of marketability discounts that are implied in
market transactions i.e. the difference between the private placement price and the listed
share price
• There have been many restricted stock studies, mainly in the US as it has the most liquid
markets and is therefore the benchmark for marketability
• The range of average discounts observed in these studies (pre-2000) range from 13% to
45%, with most clustered between 31% and 36%
• Critics of the above restricted stock studies suggest that the perceived “marketability
discount” is in actual fact attributable to the cost of gathering information incurred by the
investors, who were typically large institutions
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Restricted Stock Studies on
Marketability Discounts
• The results of a number or restricted stock studies published since
2000 are summarised below:
Author Source Years Discount
Alex W. Howard Valuation Issues in Estate 2003 21%-25%
Planning - Study
Aswath Damodaran Illiquidity in the Market 2003-2005 25%-35%
Michael A Paschall Banister Financial Inc - 2004 26%-36%
Newsletter
Russel T Glazer The CPA Journal 2000-2005 30%-35%
Phil Williams & John FFECT Winter Journal 1997-2002 25%-40%
Linder
Source: Pittorino, Mark, “Discounts for Lack of Marketability and Control”, presented at Institute of Chartered
Accountants Business Valuation & Forensic Accounting Conference, 9 March 2011
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Pre-IPO Studies on Marketability
Discounts
• In the US, when a company goes public, it needs to disclose details of all
transactions in its shares in the three years prior to listing
• It is therefore possible to compare the share prices achieved in these
transactions to the ultimate IPO price to derive an implied marketability discount
• The average discounts observed in two such studies by Emory (1980-2000) and
Willamette Management Associates (1975-1995) came in around 45%
• Critics of pre-IPO studies argue that IPO share prices are affected by new issue
hype that temporarily inflates the price and by the behaviour of underwriters who
often support near term IPO prices and are prone to making overly optimistic
earnings expectations
• One of the Emory studies were also specifically criticised as a large part of the
sample reviewed comprised stock options given to management prior to an IPO,
in circumstances which may deflate the prices
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Pre-IPO Studies on Marketability
Discounts
• The results of a number or pre-IPO studies published since 2000 are
summarised below:
Author Source Years Discount
Shannon Pratt Pratt 2000-2003 37.5%-56.4%
Michael A Paschall Banister Financial Inc - 1980-2006 46%
Newsletter
Russel T Glazer The CPA Journal 2000-2005 45%
Phil Williams & John FFECT Winter Journal 1997-2002 35%
Linder
Source: Pittorino, Mark, “Discounts for Lack of Marketability and Control”, presented at Institute of Chartered
Accountants Business Valuation & Forensic Accounting Conference, 9 March 2011
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Selection of Marketability
Discount
In determining the appropriate level of marketability discount to apply, you
need to consider:
• Whether any form of market exists in which the shareholdings could be
traded
• The size of the shareholding
• Whether there is any prospect of the shares becoming more marketable
e.g. via IPO or any other form of exit in the foreseeable future
• The impact of any provisions of the constitution and/or shareholders’
agreements e.g. restrictions on transfer of shares
• How the valuation to which the discount will be applied has been
derived in the first place
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Marketability Discounts for
Controlling Interests
• Whether or not marketability discounts should be applied to controlling interests seems to
be a contentious issue
• Some argue that if you control a company you are able to initiate/force a trade sale or IPO
and therefore your shares are marketable
• However, to achieve a trade sale or IPO takes time and costs money
• It can be argued that a marketability discount is justified because of:
– Uncertainty around timing of completion of a sale/IPO
– Costs to prepare for and execute the sale/IPO can be significant
– Risks concerning the eventual sale price
– Sale/IPO proceeds sometimes non-cash in nature and/or deferred
– Inability to use the business as collateral for loans
• Very little empirical evidence is available as to the appropriate level of marketability
discount to apply to controlling interests, however the level of discount is generally smaller
than for minority interests
• Marketability discounts allowed in the US tax court for controlling interests range from 3%
to 33%
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Dealing with Marketability
Discounts in Practice
• Ideally valuers should not simply cite average or median results of
studies to support the level of discount for marketability adopted
• There are databases in the US (e.g. LiquiStat) that enable valuers to
select transactions that have similar characteristics as the subject
company in terms of size, profitability, size of block relative to shares
outstanding, dividend payments, potential for IPO etc.
• In Australia, valuers generally adopt a marketability discount in the
range of 10% to 30% which is consistent with the treatment adopted
in court and the range advocated by the Australian Private Equity
and Venture Capital Association
• In practice, it is rare to see an explicit marketability discount applied
in the valuation of 100% of a private company
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Other Private Company Valuation
Considerations
• Corporate structure – often use trusts / partnerships
rather than companies
• Shareholder agreements
• Non-voting shares
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Q&A
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