welcome to another tutorial video this
time around we're going to be addressing
a valuation topic that we've gotten a
lot of questions on and here's the
typical question we receive on the topic
help how do you value a private company
and sometimes we get even more frantic
questions such as no I really need to
know how to value private companies
it must be dramatically different right
and we get a lot of questions on this
topic we got even more questions on this
topic before we added coverage of
private companies and private company
valuation to one of our courses the
financial modelling fundamentals well so
to answer this question and to explain
more about the key points of private
company valuation I'm going to take our
10 hour long set of tutorials and try to
summarize them in 20 minutes we'll see
how that goes
in the course we explain private
companies via two case studies the first
one is about a deal between cacao and
down these two Korean technology
companies cacao was private at the time
down was public and it was a reverse
merger type of situation so we look at a
larger private company there and then in
the second case study we actually turn
around and value this business the
mergers and acquisitions and breaking in
to Wall Street business using fake
numbers but the principles are all the
same for the starting point here I would
suggest thinking about TV shows and
specifically one of my personal
favorites Breaking Bad now in the final
season of Breaking Bad Jesse Pinkman
Walter White's accomplice confronts him
at one point and asks him about his true
motivations for wanting to become a drug
dealer mastermind and control large
swathes of territory in the southwest of
the u.s. is he doing it for money is he
actually doing it for his family or is
he doing it for his own ego and he
responds with this quote you asked me if
I was in the meth business or the money
business neither I'm in the Empire
business well this is very quotable it
also is important because it touches on
the three main types of private
companies so the three main categories
are first off what we call money
business
now these are small family-owned
businesses or other types of firms that
are heavily dependent on one person a
restaurant that is owned and operated by
a top chef would be an example something
like a law firm with only one lawyer or
a few lawyers would be another example a
tax firm a barber shop other places like
that that are actual true small
businesses then in category number two
are venture-backed startups what we call
meth businesses because these companies
are just like Walter White and Breaking
Bad are very focused on scaling their
business and getting up between much
bigger size eventually examples would be
Kakao Talk before it was acquired
whatsapp Instagram tumblr all before
they were acquired and then in category
number three you have the Empire
businesses now these are large companies
with boards and management teams and
they're not public yet but they could be
if they wanted to and they might become
public one day if circumstances change
so when thinking about private companies
you have to think about which category
your company's in first because
obviously a small barbershop with two
employees is going to be valued very
differently from Ikea yes they're both
private companies but they're completely
different in size scale and dependency
on key peope so with Empire businesses
they're really almost the same as public
companies there are some minor
differences you might apply some
discounts and adjustments but for the
most part valuation is not that much
different with meThe businesses aka
startups the valuation is still quite
similar but you do see a few more
differences for example it's often very
important to look at an IPO valuation
for these companies which we cover in
another free tutorial in this channel
and then with money businesses in other
words real small businesses most of the
differences actually emerge here you're
going to have to adjust their financial
statements you will have to adjust the
valuation you'll have to adjust any DCF
analysis that you run for these
companies of course you rarely actually
work with these companies in fields like
Investment Banking and private equity
unless you're at a small firm that
actually advises or invests in true
small businesses
so what exactly is different based on
those three main categories of private
companies first off with accounting and
the three financial statements and three
statement projections you will have to
make some adjustments here because often
the categories are not correct often
expenses are not really related to the
business owners sometimes don't pay
themselves and this is mostly an issue
for money businesses in other words real
small businesses on the valuation side
private companies are often worth very
different amounts to different buyers or
investors so if a private company is
about to go public it will be worth a
very different amount versus if one
individual is going to acquire it or a
private conglomerate is going to acquire
it for example and then beyond even that
if you're using comparable public
companies or precedent transactions to
value a private company you're going to
have to apply some discounts private
companies are less liquid than public
companies because you can't just buy and
sell their shares easily and you may
have to discount and adjust a lot of
other assumptions and factors in the
valuation and then finally in the
discounted cash flow analysis you run
into a couple problems first off private
companies don't have market caps they
don't have beta and so you can't
calculate cost of equity and whack the
weighted average cost of capital in the
traditional way so look at some
alternative approaches to doing that and
see a few examples in Excel as well and
then the terminal value assumption can
also be problematic for these types of
companies not for all of them but
certainly for the money businesses where
it's highly dependent on one person or a
few key people even assuming anything
for terminal value can be somewhat
problematic so let's start with the
first area the accounting and three
statement projection differences then
we'll get into the valuation differences
and we'll conclude with the DCF
differences now of course there are
differences in other areas like merger
models and leveraged buyout models and
other types of transaction models but
they tend to be even more minor than
these differences and we just don't have
time to get into them here so I'm going
to focus on these three areas at least
in this lesson
so first off many small private
companies have financial statements that
don't exactly conform with gap or IFRS
or the local accounting standards in
whatever country you're in so you may
have to change around the categories and
normalize them a bit oftentimes small
private companies do not actually record
anything for the owners salary on the
income statement or whatever the owner
is paying him in the form of a bonus for
example because they will take out all
the money in the business in the form of
dividends now the problem with this is
that then when you look at the company's
income statement they seem a lot more
profitable than they actually are
a public company wouldn't work like that
you would have to record all the
payments to owners and managers and
everyone else who is involved with the
day-to-day operations of the business on
the income statement oftentimes small
business owners will intermingle their
business and personal expenses so we'll
try to expense travel or entertainment
or other things like that
on the income statement and call it a
business expense when it's really not
and they can get away with it because
your chances of getting audited are not
that high unless you get to a certain
size so tax authorities sort of look the
other way and business owners can get
off a get away with this and then
finally tax rates can also be quite a
bit different because at least in many
countries the tax rate on small
businesses will be quite different than
it is on large public companies see
corporations often times small
businesses are taxed at the owners
personal tax rate depending on how the
business is set up but if another
company is thinking about acquiring it
or if the company wants to go public its
tax rate is going to change and so at
least in future projections you're gonna
have to modify that and use a tax rate
that is closer to what they acquire or
what the new investors are thinking
about so as an example of this let's
take a look at an income statement from
a typical money business and you can see
up here we have some fairly non-standard
categories this is actually a fake
income statement for our business but
I've listed as categories online courses
product sales referred by
affiliates coaching and resume editing
sales to institutions commissions from
other products commissions by category
gross sales less commissions and then
fees and refunds and then net sales
after fees and refunds as you can tell
it's not exactly presented in a way
that's compliant with gap or IFRS and
that's because for me as the business
owner it's easier and more effective to
look at it like this I like to see
Commission's by category and I'd like to
see the refund amount the amount that
we're paying in fees and I pay a lot of
attention to this number the net sales
after fees and refunds number of course
in the real world an accountant or
auditor would probably reject this and
tell me that I have to list gross sales
and net sales and I shouldn't even be
listing commissions here I shouldn't be
listing payment fees it should really
just be gross sales and then you
subtract refunds to get to your net
sales at the bottom of that the expense
categories are also a little bit weird
we don't have general and administrative
sales and marketing research and
development instead we've split things
into much more granular categories down
here also if you notice none of these
categories actually has quite a lot in
spending and that's because my own
salary is not included here since I am
taking money out of the business in the
form of a dividend or some type of
annual bonus payment I paid it myself
I'm not even listing it on the income
statement and I don't think of it as an
ongoing business expense but of course
again if we were acquired by someone
else or if we eventually want to go
public if we got much bigger
we'd have to list that and we'd have to
count my own salary somewhere here and
then finally the income tax rate here is
quite a bit lower than what it probably
would be for a large public company the
effective tax rate is around 25 to 30
percent most public companies are taxed
at more like 35 to 40 percent in the US
so this is something else that we'd have
to adjust in future periods so those are
the main problematic areas to adjust for
all that and to come up with a
normalized version of the statements we
might have something like this where we
list gross sales and net sales at the
top and all we do to move from one
the other is subtract refunds and
allowances and then we might put all the
operating expenses in more normal
categories we'll take out anything
that's intermingled like travel expenses
we'll also add in my own salary and
allocate it to these categories as
appropriate we didn't change anything
with the taxes in the historical period
because those are historical pack taxes
they've already been paid but certainly
in future periods we'll probably adjust
up the tax rate here so that's a quick
summary of how you might have to
normalize the financial statements for a
true small business again you're not
going to have to deal with most these
items for Empire businesses or meth
businesses they could come up and
occasionally you will see some
non-standard things but it will be far
less of an issue than it will be for
these true small businesses let's move
into topic number two now and look at
valuation for private companies so first
off you have to think about the purpose
of the valuation for example if you're
valuing the company because it's about
to go public you are probably not going
to discount it as much as you would if
you're valuing it because it's about to
be acquired by another private company
or even by a large public company or by
an individual the reason is because once
it's public it gets a diversified
shareholder base it is run more like a
public company because it is a public
company and so you're not going to have
to discount things quite as much as an
example in one of our case studies for
cacao and down here you can see that in
one of our cases when the company goes
public we don't actually apply much of a
discount for the comparable public
companies but then if it gets acquired
by some other company a private company
or another public company we actually
apply far more of a discount fifteen
percent instead of zero now that
discount I just showed you is the
illiquidity discount and you almost
always apply it to public comps when
you're using them to value private
companies the logic is pretty simple any
investment and a private company is less
liquid than buying a public company
shares it's much harder to sell and
therefore you're taking on more risk and
so the company is probably going to be
worth less to you
now the actual range for the discount
might be anywhere from 10% to 30% or
more sometimes less as well it really
depends on the size and scale of the
company and the purpose of the valuation
so again if the company is large and
about to go public it's going to be
smaller if the company is very small and
a single individual wants to buy it it's
probably going to be a much higher
discount so it depends a lot on a type
of business and also how and why you're
using the valuation with public company
comparables you can still come up with a
set in this case we're looking at
for-profit education companies and you
can still use the same types of metrics
and multiples revenue multiples EBIT on
multiples p/e multiples but you have to
discount them by some amount if it's a
true small business you're looking at
because if your company has five million
in revenue or five hundred thousand
revenue you can't really compare to a
five hundred million dollar revenue
company so you have to apply some type
of discount to these multiples here's an
example for our valuation of this
business we're applying a 30% private
company discount so when we get a
multiple like 6x we're not going to take
that at face value we're going to have
to reduce it by 30% and that's what
we're going to use to get to the
companies implied enterprise value and
applied equity value across these
different ranges now you're not
necessarily going to apply the same
discount for the precedent transactions
because these should early reflect some
type of premium paid by the buyer and
once a company is acquired by definition
it is now a liquid so you're not
necessarily going to apply it there you
could still do it if the companies that
were acquired in these deals are really
not comparable to your own at all you're
generally not going to apply this same
type of discount to Empire businesses
just because they are so much larger and
they're probably more similar to the
precedent transactions you will probably
still apply some type of small discount
for the comparable public companies but
again it's just going to be a lot lower
than it is here you might see 5% 10% 15%
depending on the tip of business
for precedent transactions not too much
is different but you might use some more
creative metrics especially if you're
looking at a tech startup for example
here's our list of comparables for cacao
and as you can see we're looking at
monthly active users and also enterprise
value to monthly active users
now cacao and actually most of these
companies we're generating some amount
of revenue but the reason we're looking
at this is because for social media and
gaming and mobile companies monthly
active users is a very important metric
and it's useful to look at a slightly
different valuation method with that
said let's now move into part three and
look at some of the problems with the
discounted cash flow analysis the
problems that emerge and some of the
difference this year so the first
problem is the discount rate now the
discount rate should be higher for a
private company because you're taking on
more risk it's harder to sell your
shares if you can even somehow acquire
shares in the private company if there's
more risk their returns need to be
higher and so the discount rate needs to
be higher as well of course it's
difficult to calculate this when the
company doesn't have a market cap or
beta so you have to think about some
different approaches the second problem
is terminal value now it's similar for
Empire businesses and for some types of
venture-backed startups but it has to be
discounted for money businesses because
if the owner of a business that's
heavily dependent on him or her dies or
quits the business or retires or does
something else
the business may not actually last so
you have to factor that in and rethink
some of the assumptions that go into
terminal value so with the discount rate
there are a number of approaches you
could take first off you could just look
at the industry average capital
structure or you could look at the
average capital structure for the
comparables you could try to look at the
firm's optimal or targeted capital
structure what it's moving toward in the
future you could even use circular logic
where you calculate the implied equity
value from the DCF and then you feed it
into the calculation for a whack I don't
recommend this because it's unnecessary
and it makes your model more complicated
for no real benefit you could also even
look at the volatility of earnings or
dividend growth rate or something else
like that and get to a number like beta
from that this is a little bit
questionable as well and I haven't
really seen it done in real life before
really the main way to get around this
for all these types of businesses Empire
businesses meth businesses and even
money businesses is to as we do here and
take the median capital structure of the
comparables so what we label the optimal
capital structure on this page we've
really just taken the average percent
debt from the comps the average percent
preferred stock and the average percent
equity and then we've assumed that they
also apply to our company here so we
don't need their current capital
structure we don't need their current
market cap we're just taking the
industry average for these for-profit
education companies and going with that
now at this point you could also
theoretically apply some type of
additional premium to the discount rate
and you could say that since it is a
private company it's very small it's
worthy of another premium and the
discount rate should be even higher than
14 or 15% we don't think it's entirely
necessary here but some people will also
make that adjustment
now for the second problematic part
terminal value it may or may not make
sense for a true small business and it
sort of depends on just how reliant it
is on a key person key individuals or
key customers you could adjust for this
by heavily discounting the terminal
value you could also skip terminal value
entirely and project free cash flow far
into the future sort of like what you do
with a net asset value model for a
natural resource company or you could
just assume the terminal value equals
the liquidation value in the future so
the business shuts down it sells off its
assets it used them to repay its
liabilities and then whatever is left
over is the company's terminal value at
that point in time there are advantages
and disadvantages to each of those
methods you can see them lined up
side-by-side here in one of our examples
but the basic advantage of simply
discounting the terminal value as we do
right here is that it is fairly
straightforward to justify because
you're still calculating it in the same
way it's just you're reducing the value
at the end the disadvantage is that the
exact discount of course is arbitrary
and so it can be harder to justify the
liquidation value method is nice because
then you don't have to make any
assumption for terminal value but then
you have to estimate how long the
business is going to last and you have
to project its full balance sheet going
into the future and then finally these
cease operations method is nice in some
ways because you can avoid some of the
arbitrary assumptions that go into
terminal value but then once again you
have to estimate how long the business
is actually going to last going to the
future and how much it's free cash flow
is going to decline when the owner
becomes less active in the business so
there isn't a clear winner but there are
a couple different ways to think about
it and you could use any of these or all
of these potentially as you're thinking
about terminal value in a private
company valuation the main point though
is that the company is just not going to
be worth as much as a public company
would be particularly when you get far
into the future and the owner and the
key people involved with the business
decide to become less active with it so
that is a quick overview of private
company valuation I tried to hit on all
the key points here in about 20 minutes
let's do a quick recap and summary now
with private companies you have to ask
what type of company it is and also what
the purpose of your analysis is when
you're dealing with an empire business a
large private company there aren't that
many differences you will see some minor
discounts and adjustments that's about
it with meThe businesses venture-backed
startups that want to become big one day
you'll see some greater discounts and
adjustments there but in general since
the end goal is to become a large
business you won't see dramatic
differences quite as much you will see a
lot more differences with money
businesses true small businesses because
you'll have to discount the comps
multiples significantly you'll have to
discount terminal value or look at it or
calculate it in a different way and so
on and so forth there aren't really new
methodologies or multiples with private
companies they're just variations and
tweaks of old ones the basic point is
that private companies are generally
worth less than public companies of the
same size simply because they're riskier
they're less liquid and so your returns
expectations have to be high
as well on the accounting side you often
tweak and reclassify the statements
especially for small businesses and then
on the valuation DCF side you will often
apply illiquidity discounts you'll have
to make rough estimates for the discount
rate and you may have to discount
terminal value skip it entirely or come
up with some other method of calculating
it so that's it for our tutorial on
private company valuation I hope you
understand this topic more and can now
answer some of your own questions
whenever a question related to private
companies comes up
you