How to value private company
By Dayo Akadiri
The market control the value of not only public entities, but also privately held entities as well. If a company had a ten prospective acquires and all the ten are making offers, definitely all the offers will be different. Each acquire would assess the risk associated with future earning slightly different. There are three major method used in value which are: Trading comparables, Transaction comparables, and discounted cash flow analysis.
- Trading Comparable:
Trading Comparable is a valuation method that use to evaluate the value of similar companies in the similar business of the target business using metrics of business.
Steps in computing Trading Comparable:
- Select a similar business, the similar business is a listing of all companies that are similar to the target company.
- Take out the financial statement data of the similar business: financial position, income statement (profit or loss), shares data. These data will be needed for the computations of multiples.
- Choose the multiples that you will be computing from.
- Evaluate the target company based on the HIGH, LOW and AVERAGE multiples of the similar business.
b. Transaction Comparable:
Transaction Comparables is a relative valuation method similar to Trading Comparables. Both methods used similar companies as a comparison of valuation.
The logic behind this is that similar entity would, of course, fetch the same valuation, more or less, with adjustments.
Stages of computing Transaction Comparables:
The process is almost the same to trading comparables.
- Select a business of merger and accusation transactions whose target involves similar companies as the company being valued.
- Get their financial data, financial position (balance sheet) and income statement items, including shares data.
- Select the multiples to be used. The multiples used for trading comparables are also the ones used for transaction comparables.
- Calculate the valuation of the target business using the multiples.
c. Discounted Cash Flows: Discounted cash flow is a method of value equity of an entity that is derived by estimating the future annual after tax cash flows of the entity.
Stages in computing DCF analysis
- Firstly, you’ll have to calculate the cost of capital which is equal to the weighted average cost of capital
- Second, what you calculate Stage 1
Follow the below step to calculate stage 2:
Stage 1 using discounted free cash flows.
The free cash flows could either be levered or unlevered.
Unlevered means that interest acquires on expenses are not used when computing.
Levered free cash flows are cash flows where interest acquire on expenses are deducted.
The discount rate must be decided. The discount rate for private companies is different from the of public companies. The discount rate can be decided by the buyer or investor.
- Thirdly, computation of Stage 2.
Stage 2 is the same as the Terminal Value after the projected period.
- Fourth, evaluate by using Enterprise Value, Net Debt, Equity Value, and Diluted EPS.
- Fifth, divide the share value by equity value by diluted EPS. Evaluate the Equity value per diluted EPS to the present market value.
If the market value is higher than the EV/EPS the private company is most likely undervalued. Otherwise, the private entity’s shares are overvalued.
Undervalued entities are likely to be subjected to acquisitions than the companies with overvalued shares.
Enterprise value is the major method used for an entities that are profitable and possess economic value beyond net asset value or its accounting book value. Enterprise vale reflects the earning generating value of an entity, therefore, Enterprise value is the economic value of an entity.
Enterprise value can be traced back to a simple formula using the company consistent pre-tax earnings performance times a multiple of those earnings. The enterprise formula is very simple to understand, the components require well thought-out evaluation in order to represent market value in a more accurate way. The prospective acquires make the value. Each of those component has definition and strength when determined in light of the company’s adjusted historical earnings, company expectation, and investor risk assessment.
Most prospective acquires determine their level of interest in an entity based on anticipated future earnings. Historical pre-tax earnings are the major indicator of future earnings. Demonstrated earning determine value today. Many professional use earnings before interest taxes depreciation and amortization (EBITDA) approach. EBITDA is represent the cash generating capability of the entity.
- Market assessment:
It is a continuing perspective, an enterprise is a company instrument that generates earning, and with this enterprise value is comprised of the underlying capital structure that generate those earning-generating tool whose value is determine by its earnings.
As such, the predictability of those future earnings is vital to the value assessment. The certainty of those future earnings is subjected to risk. In this case when an acquire considers risk he normally put in place such issues as:
- Company business model
- Unique market position,
- Product position,
- Cost position,
- Competitive position, reputation,
- Management strengths,
- Gross margin percentage,
- Operation strengths and weaknesses,
- Asset strengths,
- Customer collection,
- Barriers to competitive entry such as proprietary methods, systems, technology, relationship, brand names, customer approvals, patents used to create earnings,
- The fit with the acquiring company’s unique characteristics,
- Critical mass – size does matter
The characteristics stated above contribute to a company’s risk profile that causes the acquirer to determine the multiple of pretax earnings or acquirer will use EBITDA to calculate enterprise value.
- The multiple – investor risk appetite
The earnings multiple is more subjective. It is the assessment of risk, although charts exist, a multiple represents an expected rate of return for the investor or acquire.
Pre and Post Money Valuations
How to value a business: when valuing private equities, you would need two types of valuations: pre-money and post-money valuations.
Pre and Post Money Valuations will be used as data during the negotiation process.
Pre-money valuation is the financial value of the company before the acquisition. On the other hand, post-money valuation refers to the financial value of the company after the acquisition.
In a situation where a business is initially worth N 20M. After a successful launch, a potential investor is willing to invest N 40M for a 50% stake.
The post-money valuation of the company is N 80M (N 40M / 50%), while the pre-money valuation is N 40M (N 80M x 50%).
This means that the new investment would result in a premium of N 20M (100% of the original investment) to the old shareholders of the company.
How to improve the value of a target company
(a) Reduce leverage
A private entity can greatly improve its statement of financial position appearance by reducing liabilities. Liabilities are not a good sign for acquirers because it would reduce the acquirer’s freedom in terms of choosing the right amount of leveraging of the business.
Reduce the company’s liabilities, and let the potential acquirer decide on how much advantage the target company needs.
What to do:
- Clear liabilities to the minimum.
- Exchange high-interest liabilities with those with lower liabilities interests
- Exchange long-term liabilities with short-term liabilities.
- Convert your liabilities into equities
(b) Retain key employees
Major employees are like the heart’s beat of a business. The handing over will run more smoothly if the people who know more about the business in and out will be allowed to be part of the deal. Succession will be easier for the acquirer.
What to do:
- Part of the deal, a clause for stock-based compensation for the new company, with a vesting period of 3 years or more.
- Ask the acquirer to provide an irresistible compensation package to the major employees.
(c) Have a unique selling proposition
The private entity should avoid commoditized its products.
Commoditization happens when the company’s products are easily copied by competitors to the point that the company’s product no more has merit over any other similar products.
It creates too much competition that reduces profit margins even if the revenues are high.
The products should have or unique selling proposition that cannot be easily double by competitors.
What to do:
- Repackage your existing products to differentiate your product
- Create new exciting brands in the market
- Create designs and inventions and have them registered as intellectual properties.
(d) Increase the physical appearance of your business
A good ambiance would help increase the financial value of your entity. If an entity has a rotten office, the first impression of the acquirer would be that the company has bad operations, and in turn poor valuations.
A good and nice office and the plant often indicate a good working culture within the organization.
- Employ an interior designer. Go for a new modern look.
- Upgrade the up and running design of your manufacturing operations.
- Always keep the working place clean and with better lighting and ventilation
(e) Make your business versatile
How do you know if your company is versatile?
You can ask yourself this question, “What will the cash flows of my entity be without me?” If it’s the same, then it is versatile.
Otherwise, it’s not versatile. With the latter scenario, you will find it harder to get a better valuation.
What to do:
- Redefine your business operations. Make a what-if scenario wherein your business is operational without you.
Will it still be operating the same or better even if you’re no longer in the picture?
As much as possible, the clients base should be transmittable, Not to be personal
- There should be next-level managers.
Next level managers are those that had more experience with your organization but are still young enough to be with your company for like 10 years or more under new management.
Assess if you already have these next-level managers. If there is no one, then consider employing outsiders that have more experience in a similar business.
Negotiating is more than just mathematics. Actually, it’s more of being science and art.
The negotiation section includes non-financial factors. Dealing with private entities poses different challenges than when facing public entities.
Dealing with private entities, the focus of negotiations is usually more on a less personal level.
Since the transaction is having less public scrutiny and coverage, the communication between the seller and acquirer is more on an officer to officer, personal to personal, rather than using government agencies (SEC, CBN, and CAC) or media
One of the major issue in dealing with the private entity is that if it is family-held, it will discompose generations of family succession.
Because of this, the owner might request higher bids than the actual valuation that came up from normal valuation financial terms.
Another major concern for the seller of a family-held entity is the financial stability, financial future of his or her family.
If He or she is usually the leader of the family, so, he or she needs to take into consideration of the financial future of everyone else in the family.
He or she would be cautions in order to avoid errors because one error might plunge the future of the family into financial problems.
A Private entity is normally the brainchild of the current seller. Since it is smaller than public companies, and that the owner manages it closely and personally, there might be an issues of some resentment of letting it go.
There’s a factor of affectionate value. This would make the owner hesitate to sell. This is one of the non-financial issues that could increase the valuation or selling price of the private organization.
Since the company is daring to the owner, he would wish to see the company grow in the long-term future.
For this reason, he would want to see a successor that can achieve this. Ideally, the successor might come from his family.
In some cases, external people like external employees, or acquirer private investors would be the successor.
Sometimes, the owner can take lower valuation just so that he can be ensure that the right acquirer is capable of growing the company into the long-term future.
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