By Maria Perinan Herrera, Associate Consultant, Valuation services
and Jean-Pascal Kretz, Managing Consultant, Risk Advisory services
Why adjusting valuation output?
There is no shortage of valuation methodologies for private companies. Textbooks, websites and forums with detailed explanations on income-based (DCF) and market-based approaches (multiples) are readily available. When valuing companies with stable growth in revenues, positive EBITDA and cash flows, these methodologies are rather easy to apply.
However, the situation can be quite different when considering illiquid stakes, companies at an early stage of development for which future cash-flows are very uncertain, or companies past the startup phase, but without significant revenues and with negative EBITDA.
In this article, these particularities are highlighted, as well as the possible adjustments and methods that can be used when valuing private companies. We assume that, since you are at the stage where you are looking for elements to adjust your valuation output, you already are at an advanced stage of your valuation process.
It is therefore expected that you have at least performed a complete analysis of the financials, that you have a thorough understanding of the company characteristics and its environment and also that you have performed a market-based and income-based valuation approach.
Particularities
Lack of marketability
There are different ways to address this challenge, but the simplest one is to calculate the value of an at-the-money (ATM) put option. An investor holding the underlying and purchasing such an option would have the right to sell the underlying at the market price chosen as strike price of the option at some other time in the future, effectively “buying” the future marketability of the underlying asset.
The value of the put option can then be seen either as a premium on the cost of equity or a discount applicable to the multiple from comparable companies. The result is intuitive since we expect the cost of capital for privately held companies to be higher than for listed companies, or, put alternatively, that the final enterprise value will be lower to account for the additional risk represented by the lack of marketability of private companies.
The calculation is relatively straightforward, using a Black & Scholes model where the strike price is equal to the spot price – in this case, to the value of the privately held company at valuation date.
Other inputs for the formula are on the one hand the risk-free rate, obtained from a well-rated sovereign bond with a maturity matching the number of years in the projection, and on the other hand the volatility based on comparable, publicly traded companies. Given its relevant impact on the final price, this last element must be carefully considered.
This is where we leverage on the preparatory work performed: we can use the comparable companies identified previously to calculate the annualized standard deviation on the returns observed historically (similar range of time as the one of the projections) and use the median value. Because comparable companies have characteristics akin to the company we are valuing, we can assume that the observed volatility is a suitable proxy of the volatility of the company’s value over the same period in the calculation of the put option.
In a broader context, it is also possible to take the standard deviation of the returns of an index that represent the company’s sector. There are several approaches to calculate the volatility. These are often subjective and analyst-dependent; we will discuss our favorite options in a later article.
Small size compared to listed companies
Private companies tend to be smaller than listed ones. It is important to take this attribute into account as it represents a source of risk that will impact the final value. Certain resources allow you to obtain a pre-calculated adjustment, ready to incorporate into your valuation (i.e Duff & Phelps). The alternative method described here, making use of relative returns of indices, is useful when there is no direct access to a ‘ready -made’ option.
We will first extract historical information from two indices: a representative index that includes large market capitalization companies and a small market capitalization index. It is important to mention that the indices should be cautiously selected, as not choosing the correct indices will give biased results (comparing apples to oranges), but this topic could be also discussed in the future.
The period of observation will be chosen to match the period over which the financial projections of the company are provided. We then calculate the annualized returns over the period for both indices. By deducting the annualized historical returns of the reference large cap index from the small cap index, we estimate the premium return between companies of different sizes.
Finally, we apply this premium to the cost of equity, increasing the total cost of capital. Once again, the result is intuitive.
Early stage of development (startups)
The stage of development of the company is another important aspect. In many cases, private companies are in their infant stages; in these cases, their financial statements are not showing results that can be used in the most common valuation methods. An alternative valuation approach that can be used in this situation is based on milestones.
Milestones valuation has a much higher proportion of subjectivity than other methodologies; this particular method is based on specific objectives that have to be reached by the company. Different scenarios with attached probabilities of occurrence are defined by the management predominantly using industry benchmarks. These objectives can be divided into financial, technical, marketing and sales ones among others.
The initial price paid per stock is seen as fair because it came from the transaction between two knowledgeable market participants. This initial fair value is increased or decreased according to the actual results attained by the company in the allocated time. If the results have surpassed the objectives, this will be reflected by an increase in value; conversely, results below expectations will drive a decline in value.
Negative EBITDA, no relevant revenues
These – not very desirable - particularities do not leave many options for valuation. In such situations, the ‘last resource’ is the asset-based approach, which can still be a good methodology to apply in this scenario.
In this approach, we are subtracting the fair value of liabilities from the fair value of the assets. The concept of fair value is crucial here. In financial markets, fair value can be broadly described as the price agreed between a knowledgeable buyer and a seller that enters in a transaction freely (not due to financial distress).
Certain assets are readily considered at fair value (e.g. cash, and other current assets easily convertible into cash). For other non-current assets, the calculations are subject to the valuator’s experience and knowledge. There are different accepted practices in the market, either adding back the value of depreciations and amortizations, or including discounts due to the illiquidity of the assets (e.g. non-current assets that will be difficult to sell) or discounts due to credit risk (e.g. receivables that would not be recovered).
No matter what option is chosen, bear in mind that determining the fair value of the assets is a key point in this methodology and will massively drive the final valuation. As an example: current assets accounted in the balance sheet for 10 EUR, non-current assets 100 EUR and liabilities 80 EUR. If non-current assets are considered already at fair value, the company valuation will be 30 EUR. On the other hand, if adjustments are made to non-current assets and the fair value is taken as 80 EUR, the final value of the company will decrease to 10 EUR.
On the liabilities side, most of the time the value presented in the balance sheet can be taken as ‘fair’ and no additional adjustments are expected. Once the value of the assets and liabilities is determined, it is easy to calculate the enterprise value by deducting liabilities from assets.
There is a lot of controversy around the asset-based approach, it is considered a valid methodology to value private companies, but it is also criticized because its lack of robustness. However, it does give an indication of value when there are poor financial results and a limited view on the future cash flows of the company.
Conclusion
Although there is a high degree of subjectivity surrounding private equity valuation, it is important to identify its particularities and to use a methodology that best reflects the inherent characteristics of any type of investment in order to find the actual value. Following industry-accepted guidelines such as the one of the IPEV will help the participants to reach a common understanding and a justifiable price. At the end of the day, due to all the subjectivity involved, the correct valuation will be the one that can be justified based on the information available and best market practice. Even when not legally required, institutions should seek a third party’s valuation to make sure that the subjective assumptions are made without prejudice to any counterparty’s views.