Private Company Valuation Explained
Private company valuation is the process by which a private company is assessed for its current worth.
Investments in enterprises depend on how much they are worth as a business. A thorough company valuation is thereby essential for investors to see how much of the company their funds are worth. But for private companies not traded on the market, it can get tricky and the valuation methods vary with the format of company operations.
Private company valuation
A company valuation determines the per-share value of its equity. Equity value in turn indicates how well the company is performing in the market. The higher the share value, the more stable and profitable the company is. And investors look for these features to find assurances in their investments.
Public companies are easy to value owing to the public availability of their financial statements. But private company valuation is tricky and requires an experienced and meticulous approach with valuation methods. Let us explore.
What is private company valuation?
Private company valuation is the process by which a private company is assessed for its current worth. Though every company initially starts as a private firm before an IPO, there are broadly 4 categories of private companies in the United States:
- Sole proprietorship – Owned by an individual
- Partnerships – Owned by at least two individuals
- Limited Liability Company (LLC) – Owned by multiple people without the need for incorporation
- S Corporations – Ownership shared by a maximum of 100 people
- C Corporations – Unlimited ownership
Irrespective of its ownership model, a company requires funds for growth and expansion. Publicly traded companies release their financial statements periodically but private companies do not have any such obligations. Neither are they listed on any stock exchange or bound by SEC filing procedures. Though this provides flexibility to grow and expand in a competitive business, it also limits private companies from accessing public financial markets to raise capital as information supporting their share values and the number of shareholders are restricted.
In this situation, the next logical step for a private company is to involve private equity firms and venture capitalists who will invest in exchange for equity in the company. Private company valuation reports that determine the estimated per-share value of the company are the basis of such equity financing. Investors evaluate funding proposals based on these reports. However, they provide only an estimate as a lot of the metrics are based on assumptions. It is in the best interest of a private company to involve a professional business valuation firm to predict its best possible valuation, and then compare it with another independent report from a contemporary firm.
Advantages of issuing shares for private companies
Private companies can raise capital by two means: equity finance (by issuing company shares to investors among friends, family, angels, venture capitalists, etc.) or debt finance (loans, bonds, etc.). Private company valuations are affected by this choice. Loans in any form attract interest rates which only piles up debt. This being an obvious drawback, here are some clear reasons as to why issuing shares is the more preferable option:
Collaterals and guarantees are inevitable requirements for any form of business loans. Private companies, especially early-stage startups, do not have much of these. Since they operate in a private scenario, their credit ratings might not be attractive either. By issuing shares to private equity investors and VCs, private companies manage to raise capital on a one-on-one basis, from a niche circle, disclosing their financial information only to those involved. In addition, these investors have immense entrepreneurial experience themselves and come on board in exchange for equity, more often than not; they have a direct participation in the company’s strategic decisions. Apart from capital investments, these interventions are a valuable add-on.
No debt or repayments
Selling company stocks is essentially giving away part ownership of the company. Unlike loans, shareholders invest in equity with the fair knowledge that their profits will align with the company’s performance. They are well aware of the risks involved, in case the company does not turn a profit. In the worst case scenario, if the private company fails to perform (due to market forces despite all efforts), they do not owe shareholders any repayment on their investments.
Handling equity is in the hands of the management. They can decide when and how many shares to issue. Based on its market performance, the company can also decide the selling price of their shares. Except for select asset classes, the management does not owe dividends to their shareholders either. The company also reserves the right to buy back issued shares which in turn increases share prices when necessary.
Provide different rights to buyers by issuing different class of stocks
Company stocks are of two types, ordinary stocks and preferred stocks. Based on their choice of stocks, investors are granted varying rights. Some of their basic rights are mentioned below:
- Common shareholders – The most commonly issued shares are ordinary shares, otherwise known as common stock. Common shareholders have the right to vote, participate in strategic matters affecting the company’s future, and are paid limited or no dividends. One share equals one vote. But they are also high-risk investments as in case of solvency, they are last in line for settlements.
- Preferred shareholders – This type of equity in many ways functions like debt. The company owes these shareholders regular dividends on profits. In the case of solvency, these shareholders are entitled to settlements well before common shareholders. Mostly they do not have voting rights in the company.
Common Private Company Valuation
Let us now look at some common valuation methods used for private companies. These valuation methods look at different aspects of the company to determine its value.
Of the many that are available, the following three methods have proven to be most reliable:
Comparable Company Analysis (CCA)
This is the most commonly used private company valuation method. CCA operates on the principle of comparing specific metrics of the target private company with those similar to its size, operations, and industry in the public domain. A comparison of metrics yields a valuation ratio. A high ratio indicates the target company is overvalued and a lower ratio suggests the opposite.
Analysts begin by identifying definitive metrics of the target company. Meanwhile, a ‘peer’ group of companies sharing similar characteristics from the same industry are shortlisted. ‘Multiples’ are calculated for these peer groups of companies followed by the industry average. Private company valuation methods use various multiples depending on the industry and the company’s growth stage. EBITDA is a commonly used multiple. EBITDA is an estimation of the company’s free cash flow and is usually predicted for 12 months. Thus,
Where by: Multiple (M) = Average of enterprise value / EBITDA of comparable firms
Discounted Cash Flow (DCF)
This private company valuation method is based on the principle of estimating the target company’s future discounted cash flows. It is a step ahead of the CCA method and similar to it uses the financial metrics of the target company’s peer enterprises in the public domain.
Analysts first calculate the average growth rates of shortlisted peer companies. This is followed by making projections of the target company’s revenues, taxes, expenses to generate its free cash flow (FCF). FCF estimation is usually done for the next 5 years.
The weighted average cost of capital (WACC) is a reliable discount rate used in these valuation methods. WACC gives a sense of the cumulative cost of capital inclusive of equity and debt.
Thus valuation of the target firm is:
First Chicago Method Valuation
This private company valuation method is a combination of the ‘multiples’ and DCF methods. It is commonly used by Angels and VCs as this method provides a fair idea of the best case as well as the worst-case scenario of a dynamically growing company. Let us take a look step-by-step:
- Analysts begin by projecting three scenarios – best case, base case, and worst case, where the worst case is synonymous with complete loss of investment. Next, they forecast financial scenarios of the target company such as its earnings, cash flow, exits, etc. for each of the three situations. This first step involves several metrics that must be used in the right combination to arrive at reliable conclusions. Engaging the services of professional business valuation firms is advised.
- The next step is to use the ‘multiples’ method to determine the terminal value of the target company. Terminal value is a forecast of the company’s value when the investor plans to exit. The selection of the ‘peer-group’ companies is crucial to the multiples method, and is broadly based on the target company’s industry, size of operations, stage of growth, and country or state of incorporation.
- Finally, the valuation of each of the three cases is determined by the DCF model. The final valuation of the target company is arrived at by taking the probability-weighted average of all the three scenarios. Alternatively, angels and VCs may have their internal calculations as concepts such as WACC may change due to a lack of reliable financial data of private companies.
Get Your Private Company Valuation from Experts
Private company valuations are based on their performance metrics as compared to similar companies in the market. Most of the analysis is based on estimates and future projections with industry benchmarks as reference. Many factors affect valuation calculations and it is in the company’s best interest to work closely with professional business evaluators.
Eqvista prides itself on being one of the best in the valuation field. Our expert team of analysts will guide you through your company’s 409a valuation. Also, our automated, sophisticated and user-friendly software makes it easy for entrepreneurs to manage cap tables, company shares, valuations, and many more.