Corporate Finance
Jun 7, 2023
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This guide explains how private company valuation works in M&A deals. We explain what valuation is, the primary reasons to value a private company, the difference between valuing private and public companies, as well as the most common methods used in private company valuation. We also address how this valuation is both an art and a science and the rationale behind approaching a valuation. Here are some key takeaways about private company valuation:
Valuation is how we determine what a business is worth. As we will see, valuation is both an art and a science and there are different methods used to value businesses.
It’s important for both buyers and sellers to understand private company valuation and how it comes into play in the M&A process.
From the buyer’s perspective, the ability to determine a range of what a business is reasonably worth is important for determining if a deal makes sense or not. Without a valuation, how will a buyer make the seller an offer? From the seller’s perspective, they need to know how to value the company they have built so they know what a fair offer is when they receive one.
There are three main reasons why private company valuation is important to understand. First, this valuation is essential for determining the value of the target business in M&A deals. Second, private company valuation is important for litigation in instances such as lawsuits or divorce. Third, private company valuation is important for compliance with taxation and for financing purposes such as term loans and asset secured debt.
Valuation is a complex subject. It's important to clarify that valuations will be different based on the intended purpose of the appraisal, which in turn, will be determined by different authorities. This guide is focused on private company valuation as it pertains to merger and acquisition deals. Here, we're looking at market value—which aims to find the highest value a business will sell for in the open market.
For context, before we look at the methods used in private company valuation, we’ll look at how to value publicly traded companies. Publicly traded companies are more easily valued than private companies because we can easily lookup a company’s current stock price and see the total number of shares outstanding. When we multiply the number of shares outstanding by the company’s current stock price, we can see the company’s market capitalization—the total value of that company’s stock. While stocks can still be perceived as "under" or "over" valued, the stock market values publicly traded companies every trading day through the current share price.
This method of valuation will not work for privately held companies for several reasons.
Private company valuation is more challenging than valuing a publicly traded business because private companies don’t release detailed financial statements to the public, and because their financial statements may prove to be inconsistent since they are not scrutinized the way that financial statements for public companies are.
Accounting standards leave room for interpretation and without more detail, financial statements can be misleading.
Normally, if the seller intends to sell their business, they will make an effort to present as accurate of a financial picture as possible. However, the buyer still needs to confirm that the financials are accurate.
Here, we’ll look at how the M&A process works and how private company valuation fits in.
The M&A process attempts to minimize the drawbacks arising from the fact that the seller doesn’t want their financial information made public (confidentiality) and the fact that their financial statements may be inconsistent (asymmetric information), by design.
First, the seller’s confidentiality is initially protected both through a series of documents that reveal more about the target company as the deal progresses and through the use of intermediaries that help facilitate the deal. So, everyone is not immediately privy to detailed financial information about the company and confidentiality is maintained. These intermediaries also assist the seller with the valuation of their business from the beginning, helping them to present an accurate picture of their business in the best light possible.
This normally begins when the seller drafts a teaser—a short one- or two-slide document revealing key information about the company but keeping the seller’s identity anonymous. This document is normally distributed by the intermediaries to prospective buyers.
Next, if the prospective buyer likes what they see and wants more information about the business for sale, they will typically sign a non-disclosure agreement. This is another measure taken to protect the seller’s confidentiality. The buyer will typically receive a confidential information memorandum (CIM) in return that gives more insight, not just into the financials, but into how the company operates as well. The buyer will use the information in the CIM, as well as what they learn through some initial talks to conduct their initial valuation of the private company and then they will typically progress to more formal negotiations.
At this stage, the prospective buyer will draft a letter of intent—a partially-binding document intended to formally summarize what has been discussed up until this point and to give the buyer a period of exclusivity to conduct their due diligence.
This due diligence phase is when the prospective buyer will have more opportunity to look at how financials may be inconsistent and have the ability to adjust their projections or valuation of the business if necessary. The due diligence phase is where the buyer has the opportunity to visit the business’ headquarters, observe business as usual, and gain as much insight into how the company operates as possible.
The due diligence phase is designed to address the fact that the seller has asymmetric knowledge of their business and how it operates compared to the prospective buyer—who knows much less about the company they’ve just attempted to value.
In reviewing what we’ve just learned about the M&A process, we can see how it is designed to address two of the larger issues in private company valuation—the fact that the seller doesn’t want to make detailed financial information available to the public, and the fact that there may be inconsistencies in financial reporting due to the room for interpretation that accounting standards leave.
Now that we understand the challenges in private company valuation, the next section of this guide will introduce you to four common methods of valuing private companies.
"Price is what you pay, value is what you get." - Warren Buffett
There are four common methods used to determine the value of private companies:
Each of these valuation methods will give us a price point that makes sense from the perspective of how we do the valuation. Remember, we will use these valuation methods to give us a price range that might make sense to pay for a business. It’s important to try and see how different perspectives of the valuation produce different numbers. To learn more about this and the rationale behind each of these valuation methods, we recommend our guide: Football Field Valuation.
Now that we understand the challenges of private company valuation, and the common methods used in the valuation of these businesses, we will look at how private company valuation is both an art and a science.
First, the goal of valuation is not to come up with a pinpoint, exact number that tells you precisely what a business is worth. As we will see, there are a number of approaches to valuing businesses that are each based on a slightly different thought process.
Instead of searching for an exact number, the goal in private company valuation is instead to come up with a range of valuations that might make sense to pay for a business based on different valuation methods, so that we can reasonably estimate what a company is worth from different perspectives.
Normally, in private company valuation, an analyst would perform each type of valuation separately and then compare those together on a chart that shows the price that each valuation method justifies side-by-side. This chart is commonly referred to as a football field chart.
With this football field chart, a prospective buyer can approach a seller and begin negotiating on a purchase price that makes sense based on their understanding of what a reasonable price range is for the business.
