In this tutorial, you’ll learn how private companies are valued differently from public companies, including differences in the financial statements, the public comps, the precedent transactions, and the DCF analysis and WACC.
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Table of Contents:
1:29 The Three Types of Private Companies and the Main Differences
6:22 Accounting and 3-Statement Differences
12:04 Valuation Differences
16:14 DCF and WACC Differences
21:09 Recap and Summary
The Three Type of Private Companies
To master this topic, you need to understand that “private companies” are very different, even though they’re in the same basic category.
There are three main types worth analyzing:
Money Businesses: These are true small businesses, owned by families or individuals, with no aspirations of becoming huge. They are often heavily dependent on one person or several individuals.
Examples include restaurants, law firms, and even this BIWS/M&I business.
Meth Businesses: These are venture-backed startups aiming to disrupt big markets and eventually become huge companies.
Examples include Kakao, WhatsApp, Instagram, and Tumblr – all before they were acquired.
Empire Businesses: These are large companies with management teams and Boards of Directors; they could be public but have chosen not to be.
Examples include Ikea, Cargill, SAS, and Koch Industries.
You see the most differences with Money Businesses and much smaller differences with the other two categories. The main differences have to do with accounting and the three financial statements, valuation, and the DCF analysis.
Accounting and 3-Statement Differences
Key adjustments might include “normalizing” the company’s financial statements to make them compliant with US GAAP or IFRS, classifying the owner’s dividends as a compensation expense on the Income Statement, removing intermingled personal expenses, and adjusting the tax rate in future periods.
These points should NOT be issues with Meth Businesses (startups) or Empire Businesses (large private companies) unless the company is another Enron.
The valuation of a private company depends heavily on its purpose: are you valuing the company right before an IPO? Or evaluating it for an acquisition by an individual or private/public buyer?
These companies might be worth very different amounts to different parties – they *should* be worth the most in IPO scenarios because private companies gain a larger, diverse shareholder base like that.
You’ll almost always apply an “illiquidity discount” or “private company discount” to the multiples from the public comps; a 10x EBITDA multiple is great, but it doesn’t hold up so well if the comps have $500 million in revenue and your company has $500,000 in revenue.
This discount might range from 10% to 30% or more, depending on the size and scale of the company you’re valuing.
Precedent Transactions tend to be more similar, and you don’t apply the same type of huge discount there for larger private companies.
You may see more “creative” metrics used, such as Enterprise Value / Monthly Active Users, especially for private mobile/gaming/social companies.
DCF and WACC Differences
The biggest problems here are the Discount Rate and the Terminal Value.
The Discount Rate has to be higher for private companies, but you can’t calculate it in the traditional way because private companies
don’t have Betas or Market Caps.
Instead, you often use the industry-average capital structure or average from the comparables to determine the appropriate percentages, and then calculate Beta, Cost of Equity, and WACC based on that.
There are other approaches as well – use the firm’s optimal capital structure, create a giant circular reference, or use earnings volatility or dividend growth rates – but this is the most realistic one.
You use this approach for all private companies because they all have the same problem (no Market Cap or Beta).
You’ll also have to discount the Terminal Value, but this is mostly an issue for Money Businesses because of their dependency on the owner and key individuals.
You could heavily discount the Terminal Value, use the company’s future Liquidation Value AS the Terminal Value, or assume the company stops operating in the future and skip Terminal Value entirely.
Regardless of which one you use, Terminal Value will be substantially lower for this type of company.
The result is that the valuation will be MOST different for a Money Business, with smaller, but still possibly substantial, differences for Meth Businesses and Empire Businesses.