Analyzing Privately Held Companies

1. Analyzing Privately Held Companies

2. Maier’s Law: If the facts do not conform to the theory, they must be disposed of.

3. Course Layout: M&A & Other Restructuring Activities Part I: M&A Environment Part II: M&A Process Part III: M&A Valuation & Modeling Part IV: Deal Structuring & Financing Part V: Alternative Strategies Motivations for M&A Business & Acquisition Plans Public Company Valuation Payment & Legal Considerations Business Alliances Private Company Valuation Regulatory Considerations Search through Closing Activities Accounting & Tax Considerations Divestitures, Spin-Offs & Carve-Outs Takeover Tactics and Defenses M&A Integration Financial Modeling Techniques Financing Strategies Bankruptcy & Liquidation Cross-Border Transactions

4. Learning Objectives • Primary learning objective: Provide students with a knowledge of how to analyze and value privately held firms • Secondary learning objectives: Provide students with a knowledge of • Characteristics of privately held businesses • Challenges of valuing and analyzing privately held firms; • Why and how private company financial statements may have to be recast; and • How to adjust maximum offer prices for liquidity risk, the value of control, and minority risk

5. What is a Private Firm? • A firm whose securities are not registered with state or federal authorities1 • Without registration, their shares cannot be traded in the public securities markets. • Share ownership usually heavily concentrated (i.e., firms “closely held”) 1Businesses must generally register their legal form with the Secretary of State and with the State Revenue agencies for tax purposes.

6. Key Characteristics of Privately Held U.S. Firms • There are more than 28 million firms in the U.S. • Of these, 7.4 million have employees, with the rest largely self-employed, unincorporated businesses • M&A market in U.S concentrated among smaller, family-owned firms -- Firms with 99 or fewer employees account for 98% of all firms with employees

7. Percent Distribution of U.S. Firms Filing Income Taxes in 2004 9% 72% 19%

8. Family-Owned Firms • 89% of U.S. businesses family owned • Not all family-owned firms are small (e.g., Wal-Mart, Ford, Motorola, Loews, and Bechtel) • Major challenges include: • succession, • lack of corporate governance, • informal management structure, • less skilled lower level management, and • a preference for ownership over growth.

9. Governance Issues • What works for public firms may not for private companies • “Market model” relies on dispersed ownership with ownership & control separate • “Control model” more applicable where ownership tends to be concentrated and the right to control the business is not fully separate from ownership (e.g., small businesses)

10. Challenges of Analyzing and ValuingPrivately Held Firms • Lack of externally generated information • Lack of adequate documentation of key intangible assets such as software, chemical formulae, recipes, etc. • Lack of internal controls and rigorous reporting systems • Firm specific problems • Narrow product offering • Lack of management depth • Lack of leverage with customers and vendors • Limited ability to finance future growth • Common forms of manipulating reported income • Revenue may be understated and expenses overstated to minimize tax liabilities • The opposite may be true if the firm is for sale

11. Steps Involved in Valuing Privately Held Businesses • Adjust target firm data to reflect true current profitability and cash flow • Determine appropriate valuation methodology (e.g., DCF, relative valuation, etc.) • Estimate appropriate discount (capitalization) ratea • Adjust firm value for liquidity risk, value of control, or minority risk if applicable aAdjust for specific business risk.

12. Step 1: Adjusting the Income Statement • Owner/officer’s salaries • Benefits • Travel and entertainment • Auto expenses and personal life insurance • Family members • Rent or lease payments in excess of fair market value • Professional service fees (e.g., legal or consulting) • Depreciation expense (e.g., accelerated makes economic sense when equipment obsolescence rapid) • Reserves (e.g., for doubtful accounts, pending litigation, future retirement or healthcare obligations)

13. Areas Commonly Understated • When a business is being sold, the following expense categories are often understated by the seller: • The marketing and advertising expenditures required to support an aggressive revenue growth forecast • Training sales forces to market new products • Environmental clean-up (“long-tailed” liabilities) • Employee safety • Pending litigation

14. Areas Commonly Overlooked • When a business is being sold, the following asset categories are often overlooked by the buyer as potential sources of value:1 • Customer lists (e.g., cross-selling opportunities) • Intellectual property (e.g., unused patents) • Licenses (e.g., unused licenses) • Distributorship agreements (e.g., alternative marketing channels for acquirer products) • Leases (e.g., at less than fair market value) • Regulatory approvals (e.g., permits sale of acquirer products) • Employment contracts (e.g., employee retention) • Non-compete agreements (e.g., limits competition) How might you value each of the above items? 1For these items to represent sources of incremental value they must represent sources of revenue or cost reduction not already reflected in the target’s cash flows.

15. Adjusting the Target’s Financial Statements 1Revenue is booked before product shipped or for products not ordered. Reserves must be high enough to reflect returns and uncollectable accounts. 2Cost of sales = purchased materials & services - ∆inventories.

16. Discussion Questions • Why is it often more difficult to value privately owned companies than publicly traded firms? Give specific examples. • Why is it important to restate financial statements provided to the acquirer by the target firm? Be specific. • How could an analyst determine if the target firm’s cost and revenues are understated or overstated? Give specific examples.

17. Step 2: Determine Appropriate Valuation Methodology • Income or DCF approach • Relative or market-based approach • Replacement cost approach • Asset-oriented approach

18. Capitalization Multiples • Perpetuity (zero growth) or constant growth methods commonly used in valuing small, privately owned firms for simplicity and due to data limitations • FCFF/WACC = (1/WACC) x FCFF, where (1/WACC) is the capitalization (valuation) multiple • FCFF(1+g)/(WACC – g) = [(1+g)/(WACC – g)] x FCFF, where g is the growth rate [(1+g)/(WACC-g)] is the capitalization (valuation) multiple • Assume discount rate is 8% and firm’s current cash flow is $1.5 million. Multiples in brackets. • If cash flow expected to remain level in perpetuity, the implied valuation is [1/.08] x $1.5 = 12.5 x $1.5 = $18.75 million • If cash flow expected to grow 4 percent annually in perpetuity, the implied valuation is [(1.04) / (.08 - .04)] x $1.5 = 26 x $1.5 = $39.0 million Note: 12.5 and 26 represent the capitalization multiples for the zero and constant growth models, respectively.

19. Step 3: Select Appropriate Discount (Capitalization) Rates • Capital asset pricing model (CAPM) • Estimate firm’s beta based on comparable publicly listed firms1 • Adjust for specific business risk2 • Cost of capital • Cost of debt based on what public firms of comparable risk are paying3 • Weights reflect management’s target debt to equity ratio or industry average ratio4 1Assuming private firm leveraged, estimate private firm’s leveraged beta based on unlevered beta for comparable publicly firms adjusted for private firm’s target debt to equity ratio. Alternatively, use industry average ratio assuming firm’s target D/E will move to industry average.. 2Difference between junk bond rate and risk-free rate, return on OTC small stock index and risk-free rate, or Ibbotson’s suggested firm size adjustments 3Assuming firms with similar interest coverage ratios will have similar credit ratings, estimate what private firm’s credit rating would be and base its pre-tax cost of borrowing on a comparably rated public firm’s cost of borrowing. 4Dividing D/E by (1+D/E) converts D/E into a debt to total capital ratio, which subtracted from one gives the equity to total capital ratio

20. Step 4: Adjust Firm Value for Liquidity Risk, Value of Control, or Minority Risk Discount Applied to Firm Value • Liquidity risk: Reflects potential loss in value when an asset is sold in an illiquid market • Minority risk: Reflects lack of control associated with minority ownership. Risk varies with size of ownership position Premium Applied to Firm Value • Value of control: Ability to direct activities of the firm (e.g., make key decisions, declare a dividend, hire or fire key employees, direct sales to or purchases from preferred customers or suppliers at prices different from market levels)

21. Liquidity Discount • A liquidity discount is a reduction in the offer price for the target firm by an amount equal to the potential loss of value when sold due to the lack of liquidity in the market.1 • Recent studies suggest a median liquidity discount of approximately 20% in the U.S. • The size of the liquidity discount will vary with profitability, growth rate and degree of risk (e.g., beta or leverage) of the firm. 1The offer price can be reduced by either directly reducing the target firm’s valuation as a standalone business by an estimate of the appropriate liquidity discount or by increasing the discount rate used in valuing the firm by an amount which reflects the perceived liquidity risk.

22. Control Premium • Purchase price premium represents amount a buyer pays seller in excess of the seller’s current share price and includes both a synergy and control premium • Control and synergy premiums are distinctly different --Value of synergy represents revenue increases and cost savings resulting from combining two firms, usually in the same line of business --Value of control provides right to direct the activities of the target firm (e.g., change business strategy, declare dividends, and extract private benefits) • Country comparisons indicate huge variation in median control premiums from 2-5% in countries with relatively effective investor protections (e.g., U.S. and U.K.) to as much as 60-65% in countries with poor governance practices (e.g., Brazil and Czech Republic). • Median estimates across countries are 10 to 12 percent.

23. Minority Discount • Minority discounts reflect loss of influence due to the power of controlling block shareholder. • Investors pay a higher price for control of a company and a lesser amount for a minority stake. • Large control premiums indicate high perceived value accruing to the controlling shareholders and significant loss of influence for minority shareholders • Increasing control premiums associated with increasing minority discounts • Implied Median Minority Discount = 1 – [1/(1 + median control premium paid)] Key Point: Minority discounts vary directly with control premiums.

24. Interaction Between Liquidity Discounts,1 Control Premiums, and Minority Discounts • When markets are liquid, investors place a lower value on control since investors dissatisfied with controlling shareholder decisions can easily sell their shares. • When markets are illiquid, investors place a higher value on control since shareholders can only sell their shares at a substantial discount. Minority shareholder stakes are illiquid in part because • Minority shareholders cannot force the sale of the business and • Controlling shareholders have little to gain by buying their shares • This implies that the size of liquidity discounts and control premiums are positively correlated.2 1IThe size of liquidity discounts is affected primarily by the availability of liquid markets, as well as the profitability, growth rate, and riskiness of the target firm.. 2If control premiums and minority discounts and control premiums and liquidity discounts are positively correlated, minority discounts and liquidity discounts must be positively correlated.

25. Adjusting Target Firm Value n PV = Σ FCFFi / (1+WACC)n + TV / (1+WACC)n I = 1 Where PV = Present value of projected target firm free cash flows FCFF = Free cash flow to the firm WACC = Weighted average cost of capital TV = Terminal value Adjust PV for Liquidity Discount (LD%): PVadj = PV(1 – LD%) Adjust PV for Liquidity Discount and Control Premium (CP%):1 PVadj = PV(1 – LD%)(1+CP%) Adjust PV for Liquidity Discount and Minority Discount (MD%):2 PVadj = PV(1-LD%)(1-MD%) 1Multiplicative to reflect interaction between LD& and CP%. 2Multiplicative to reflect interaction between LD% and CP%.

26. Generalizing Adjustments to Target Firm Value PVMAX = (PVMIN + PVNS)(1 + CP%)(1 – LD%) and PVMAX = (PVMIN + PVNS)(1 – LD% + CP% – CP% x LD%) Where PVMAX = Maximum purchase price PVMIN = Minimum firm value PVNS = Net synergy LD% = Liquidity discount (%) CP% = Control premium or minority discount (%) CP% x LD% = Interaction of these factors1 1Control premiums tend to be positively correlated with minority and liquidity discounts. When a stock is relatively illiquid, minority shareholders have few options, either sell to the controlling shareholder or to outside investors at a substantial discount. The inability of minority shareholders to sell their shares gives controlling shareholders significant power. In such situations, minority shareholders will apply large larger liquidity discounts and controlling shareholders large premiums to what they are willing to pay for shares of the firm. Therefore, large control premiums are associated with large liquidity discounts.

27. Incorporating Liquidity Risk, Control Premiums, and Minority Discounts in Valuing a Private Business LGI wants to acquire a controlling interest in Acuity Lighting, whose estimated standalone equity value equals $18,699,493. LGI believes that the present value of synergies is $2,250,000 due to cost savings. LGI believes that the value of Acuity, including synergy, can be increased by at least 10 percent by applying professional management methods. To achieve these efficiencies, LGI must gain control of Acuity. LGI is willing to pay a control premium of as much as 10 percent. LGI reduces the median 20% liquidity discount by 4% to reflect Acuity’s high financial returns and cash flow growth rate. What is the maximum purchase price LGI should pay for a 50.1 percent controlling interest in the business? For a minority 20 percent interest in the business? To adjust for presumed liquidity risk of the target firm due to lack of a liquid market, LGI discounts the amount it is willing to offer to purchase 50.1 percent of the firm’s equity by 16 percent. PVMAX = ($18,699,493 + $2,250,000)(1 - .16)(1 + .10)) x .501 = $20,949,493 x .924 x .501 = $9,698,023 If LGI were to acquire only a 20 percent stake in Acuity, it is unlikely that there would be any synergy, because LGL would lack the authority to implement potential cost saving measures without the approval of the controlling shareholders. Because it is a minority investment, there is no control premium, but a minority discount for lack of control should be estimated. The minority discount is estimated using Equation 10-3 in the textbook (i.e., 1 – (1/(1 + .10)) = 9.1). PVMAX = ($18,699,493 x (1- .16)(1 -.091)) x .2 = $2,855,637

28. Practice Problem An investor believes that she can improve the operating income of a target firm by 30 percent by introducing modern management and marketing techniques. A review of the target’s financial statements reveals that it’s operating profit in the current year is $150,000. Recent transactions, resulting in a controlling interest in similar businesses, were valued at six times operating income. The investor also believes that the liquidity discount for businesses similar to the target firm is 20 percent. What is the most she should be willing to pay for a 50.1 percent stake in the target firm?

29. Discussion Questions • What is a liquidity risk premium? Why is it important to adjust projected cash flows for this risk? • How might the size of a firm affect its level of risk? Be specific. • Does beta in the capital asset pricing model have meaning for a firm that is not publicly traded? Explain your answer.

30. Things to Remember… • The U.S. M&A market is concentrated among small, family-owned firms. • Valuing private firms is more challenging than public firms because of the dearth of reliable, timely data. • The purpose of recasting private company statements is to calculate an accurate current profit or cash flow number. • Maximum offer prices should be adjusted for a liquidity discount and control premium If the market for the firm’s equity is illiquid and a controlling interest is desired • Maximum offer prices for a minority interest in a firm should be adjusted for a minority discount.