PRIVATE VERSUS PUBLIC VALUATION ISSUES:
THE PUBLIC/PRIVATE VALUE RELATIONSHIP
Adam A. Bryk
Calcap Corporate Finance Limited
Presented at the Business Valuation for CFOs Conference
Toronto, November 26, 1998
Why is the public/private value relationship an issue?
Why is the difference in value between public and private companies an issue that needs to be dealt with: Are not the valuation techniques and methodologies the same regardless of what type of business it is that is being valued? The answer to this question is of course yes the techniques and the theories behind the valuations are the same, however, the split between private companies on the one hand and public companies on the other offers what appears to be a clear and natural distinction. As a result people have assumed that it must be possible to provide some clear and natural guidelines or rules that relate the values of the two types of businesses together.
Further, the availability of vast quantities of financial and valuation information regarding public companies together with the almost complete lack of similar information regarding the private sector has meant that people look to the public markets data and to these "rules" in order to estimate private company values and prices. It is for this reason that the valuation relationship between public and private companies became an issue.
When is private company value important as distinct from public company value?
The valuation of entire enterprises is not an event that is required on an everyday basis. This is especially true in the case of private companies where there may be only one owner who has no specific need for a "hard" number that represents value. On occasion, however, it does become an issue.
When there is a dispute between shareholders;
When the company wishes to allow new equity participation or ownership;
With regard to legal processes or lawsuits that hinge on the value of the business including disputes with Revenue Canada; and,
When shareholders are entering into an agreement that includes provisions for the purchase and sale of equity interests.
In each of these cases the central goal of the valuation process is one of fairness; to establish what will be for all parties involved a fair and equitable value or methodology for determining value. It is from these types of cases that the term Notional Value was created.
Notional Value: The highest price available in an open and unrestricted market between informed and prudent parties, acting at arm's length and under no compulsion to act, expressed in terms of money or money's worth
Through notional valuations, the business valuator wishes to arrive at an amount that accurately reflects the risks and the opportunities presented by the business in question. By excluding those situations, however, where the parties are under a compulsion of one form or another to act notional valuations remove themselves from the real effects of the marketplace.
When is it the public/private distinction not important?
The fact is that the public/private distinction will almost always have some importance when the business in question is privately held. This is because there are only rare cases where the use of comparable public company valuations is not required (due to the availability of directly comparable private transactions or valuations), or in transactions where there are more than one potential purchaser for a private business and competition between buyers can play a larger role in the determination of price than will the base theory. In almost all other cases one party or other will make some use of public company information and will, therefore, have to account in some fashion for the differences in value that arise.
The public/private value relationship
As a result of the above circumstances a great deal of effort has been expended over the years in an effort to firmly establish the sources of the public/private relationship and to try and provide standard estimates, formulas, or rules of thumb for adjusting known public company values to arrive at private company values.
In the remainder of this paper we will outline:
The major areas that distinguish the private company form the public company within a valuation context;
Some of the work that has been carried out to analyze those differences and discuss how the resulting views of the relationship have changed over time; and,
The public/private value relationship in the context of the public/private transaction.
The major issues that make the difference
RISK - When assessing relative value what is really being assessed are the relative risks that exist behind any two sets of cash flows. And, on a general basis otherwise similar cash flows are perceived to be riskier if they arise form a private company than if they arose from a public company. Of course there will be exceptions to this rule and each situation must be assessed on its own merits but generally speaking this will hold true for many of the reasons that we will set out below. Each of the specific issues that are discussed have come to be seen as good guides because they can be generally correlated with relative differences in the risks and opportunities between the public and the private company.
Readers will note that all of these differences can also be classified under the heading of 'comparability'. In any valuation that attempts to use data that relates to a company other than the one being valued the issue of comparability is key. And, since it is difficult enough to compare two public companies in the same business to each other it is easy to see how difficult it is to compare public and private businesses even within the same industry. This is a central caveat that must be understood with respect to all valuation guidelines: Every situation is unique and must be assessed on its own merits.
Recently it has become accepted that the size of a business may provide the best indication of its relative value. Through a number of studies it has now been fairly conclusively established that a direct correlation exists between the size of a business and its relative value as compared to a similar operation. The reasons behind this correlation relate, in fact, to many of the same general differences discussed here that distinguish public and private companies. Access to capital, market influence, ability to realize on economies of scale and the like are all factors that may reflect increased risk in smaller companies.
As applied to private companies the size effect comes into play on the basis that most private companies are smaller than their public counterparts. It is, however, only in this general sense that the size effect relates directly to the public/private relationship. Overall it impacts all businesses public or private. We will discuss this more fully later in the paper when we review some of the work that has been carried out on this specific issue.
The difference between private and public companies in the area of diversification fall into two separate areas, operational and financial.
From an operational perspective, the size of a business will often come into play with regard to its ability to diversify itself across products, customers, or regions. Larger, and mostly public companies, that operate across countries or even the world will benefit from a certain degree of diversification in that they will not be fully exposed to the localized risks faced by a smaller competitor. This lack of diversification, for the small (and perhaps private) business means that it carries a higher level of risk and is thus valued at a lower relative level than its larger counterpart.
From a financial point of view, the owner of a private business will often have a significant portion of their capital invested in the one business that they own. They are unable to benefit from the industry, country, and temporal diversification that is available to the investor who places the same funds in the public marketplace. Thus, the private investor will be exposed fully to the specific risks associated with that one business and will, therefore, value that investment at a lower level than they would otherwise.
Access to capital
Another of the size related factors, access to capital relates to a business' ability to access funds in the form of either debt or equity both quickly and efficiently. Having easy access to capital gives a business the ability to both capitalize on opportunities that arise and to weather periods of difficulty more easily than they would otherwise. As with many of the other factors it is generally the case that private businesses, because of their smaller size and their perceived higher risk profile, have greater difficulty accessing the capital markets. As a result they are faced with still greater risks than their public counterparts, who while perhaps of equal size and strength, may have ready access to the capital markets.
Management dependence and personal goodwill
Perhaps the aspect of private companies that is cited most often in both studies and discussions of the topic is that of the business' dependence on its owner or on its management. Again, due to the generally smaller size of the private business the owner and other key management inherently play a much larger role in the success of the business than would be the case in a larger public entity where management and responsibility are diversified. While this must be assessed on a case by case basis, the question that needs to be asked is whether or not the company would have the same value if the person in question left. Also to be assessed is the likelihood of this happening.
This type of situation is often referred to as 'Personal Goodwill'. The assets of the business are worth some base amount and any value above that is related to the 'goodwill' of the business. What must be assessed in both a valuation and a transaction situation is how much of the company's goodwill is directly associated with the owner or the key management. This is the personal goodwill of these people and the higher the level, the greater the risks that are associated with the company's cash flows. It is for this reason, and because of the difficulty in assessing it that you will rarely see a transaction involving a private business where the owner and or the key management are not contracted to stay on for a minimum period of time.
Marketability and liquidity
Another of the key aspects of value is liquidity. Can I realize on my investment on short notice at any time in the future or is my ability restricted? Obviously, when a person is invested in the public markets they are for the most part completely liquid and able to realize on their investment at any time, although not at any price, that they wish. An investment in a private company is much different. While most would admit going in that it is long term in nature, there is no guarantee even in the long run that any buyer will exist to purchase the business. This, obviously is one of the most significant factors that effect the value of the privately held business.
The notional valuation relies on the assessment of an investment in comparison with all other potential investments that are possible. In taking this approach the valuator is able to relate the risks of the investment with investments of comparable risks that exist to estimate a value or price that is in effect reasonable enough to attract a prudent investor.
The issue of marketability and liquidity for a private business is much less of a factor in a transaction situation where buyers have been identified. Obviously the marketability of the company has been established in this case and the final value or price may be less affected by this factor. This issue of marketability has been one of the major debating points regarding the public/private relationship over the years and we discuss it in greater detail later in the paper.
History has shown that the public markets are indeed volatile. Just the history of the last three months (August/September/October 1998) have seen huge swings in what ostensibly is the financial market's 'valuation' of public companies. Any number of circumstances, from interest rate changes to overseas crisis' can and do have a significant short-term effect on the public market place. These short-term swings, however, have not been similarly mirrored over the longer term, a case that is often made by those involved in the public markets that preach the buy and hold mantra.
By comparison, the private company market tends to be much less volatile on an overall basis with private company investors not reacting with the same degree of 'panic' that is seen in the public market place. Some of this is attributable to the fact that investments in private companies are by their nature somewhat illiquid and long term offering the investor little opportunity to act quickly and, therefore, forcing them to take a long term view of risk assessment. This aspect of the private company marketplace has the impact of lessening the overall risk differential between the public and the private market place over the very short term.
Empirical approaches to the public/private value relationship
The first problem that any one trying to study the value of privately held businesses runs across is a lack of information. As a result of the fact that private companies are generally under no compulsion to reveal any information about themselves or their activities there has, historically, been an almost complete lack of data from which to extract any value information. This fact has changed little over the years and while there may be slightly more information available today then there was a decade ago through such services as Mergerstat or Bizcomp, the comparability and accuracy of this information continues to be a significant issue. The problems that arise even when a private transaction is reported through these services include there being limited amounts of description and detail regarding the specific terms of the transactions. Were earn-outs involved? How much of the price was paid in cash? Was there a significant holdback or escrow arrangement? These types of details, all of which have a significant impact in any analysis of value, are seldom revealed in the private information that is made public.
As a result, people that have studied the issues surrounding the valuation and pricing of private businesses have mostly had to rely on an interpretation of the available public company data in combination with this limited supply of private business data in order to try and understand the private business market. This lack of ability to study the private market on its own has been the chief driving force behind the need to understand the public/private relationship.
As a result there has been no shortage of work carried out on the topic and over the years many distinct views have taken hold regarding what adjustments should be made to get from public to private value. Recently, however, (the last 4-5 years) there has been a change in the way that many of these public/private relationships have been viewed. Set out below is a review of past and current work on the topic. We have divided the discussion into three areas, (marketability, control, and size), that represent the central issues that have developed. Readers should note that there is still no definitive agreement on the issues outlined below and that they will no doubt run across a variety of different and often conflicting opinions within the business valuation and transaction advisory communities.
As discussed earlier, one of the major concerns with regard to the value of a private enterprise has always been its marketability. As there is no organized market for the purchase and sale of ownership stakes in private companies like there is with public companies there is no guarantee that an investor will be able to sell their interest either quickly or at all. The question of what effect this limited marketability had on the reasonable investor's willingness to purchase a private business, therefore became a major issue.
The first studies to be carried out relied on wide range of transaction data from transactions involving both public and private companies. The results of these studies showed that there was indeed a wide gap between the relative values that were being paid for the two types of businesses. Generally the studies showed that the drop in relative value ranged from between 30% to 50% when moving from the public to the private market. This difference was attributed to a variety of causes, but one of the central causes was thought to be the lower marketability of private businesses.
Another source of support for the idea of a marketability discount was from work carried out regarding the value of minority shareholdings in private companies. Unlike shares in publicly traded businesses that represent minority interests that are 'freely marketable', private company minority interests suffer from a myriad of issues that effect their salability. Among these are restrictive shareholder agreements and the inherent lack of control that the minority shareholder has over the cash flows of the business. Work in this area also suggested that a discount was appropriate due to the lack of marketability that existed for these minority stakes. Over time, some people began to transfer this type of discount, between private control interests and private minority interests, to the relationship between marketable but minority public shares and private control interests. 
Recently, however, this view of the marketability factor for controlling interests in private companies has come into question for two central reasons. The first reason is that more recent and more detailed studies of transactions have begun to identify with greater specificity the causes for the value differentials that have been seen. This work includes that relating to the size effect that we discuss later.
The other view that has recently been raised, however, is that the marketability factor is not in fact as significant an issue as had been believed if one is assessing a controlling or 100% interest in a private company. This view, as expressed by Christopher Mercer ASA CFA, is that while it is clear that a minority interest in a private company will have marketability issues, it is in reality the lack of control over the cash flow of the business that causes the problem . Further, he notes that buyers and sellers of privately held businesses have no expectation of immediate marketability and that for this reason alone it is of less significance. A central demonstration of this is the example of a block of shares in a publicly traded company that is for sale. Most likely they will be traded at or near the market price for that particular stock at that particular time. However, if there is a significant restriction placed on the resale of those shares then they will trade at a discount due to the difference between the expectation at which the price was set and the actual facts of the case. If, however, the price that was set in the market is based on the same level of marketability then no discount would be required.
The issue of control has also long been an area for debate with regard to the public/private relationship. As noted earlier, the issue of control revolves around ones ability to manipulate the cash flows that a business produces. If having control over those cash flows will allow you to reduce the risks associated with them and thus increase their value then a controlling interest must be worth more.
This issues arises when one is trying to make a comparison between the value of a public company as represented by the trading multiples of its common stock, whish are non-controlling interests, and the value of a 100% interest in a private business. Early studies of transaction data  looked at the differences in values that were seen in public takeovers. It was hypothesized that if on average a buyer was willing to pay x% more than the recent trading price of a stock in order to purchase a business that this percentage represented the benefits of control.
As a result many took this assumption and then proceeded to apply it to private companies. If a comparable public company stock was trading at a certain value this represented a minority interest and a premium would therefore need to be applied in order to translate this value into one for a 100% controlling interest in the private business.
Again, however, as with the issue of marketability, more recent work has indicated that the premium for control is much less than previously believed. Firstly, the studies that had been used to justify the initial control premiums were revisited. This work showed that the early studies did not account for many of the synergistic benefits that were anticipated to accrue from the mergers studied. For example most mergers were carried out in order to gain some strategic advantage that would add value to the combined companies and thus increase the combined value from the standalone value. A company being able to increase cash flows due to strategic reasons is benefiting from synergies that are not necessarily related to the fact of control.
Further, it was noted that the existence of a control premium assumed that there be some action not being carried out by the current management of a business that would increase its value if only a controlling shareholder existed. If this were the case then it could be suggested that there should be more takeover activity than is actually the case. If value could be created just through control then people would acquire control. Obviously, though this is not the case and what was once assumed to result from control is now attributed mostly to the synergies and expertise that specialized buyers can bring to an acquisition.
In his December 1997 article for the Business Valuation Review , Eric Nath ASA states:
"Acquisition premium data from the public market appears to measure very little of the control component we seek, and is almost totally irrelevant when translated into a private company setting in any case"; and,
"…Acquisition premiums paid for public companies today are almost always strategic in nature…"
Today then, there seems to be little reason to include large control premiums when using the trading value of public companies as a guide for a 'comparable' private entity.
The effect of size on the relative value of businesses was noted earlier in the paper as one of the leading causes of the perceived public/private relationship. This is of course somewhat of a false indicator as it relies on the general assumption that all private companies are smaller than all pubic companies. As this is not the case with both public and private companies ranging in size greatly, the size factor again emphasizes the need to assess each case based on the specific facts involved.
In many of the studies that were mentioned earlier size was often not factored into the analysis and therefore its effect was not noted. Again though, more recent work has pointed out the high correlation between size and relative value. Specifically, Ibbotson Associates in their recent rate of return analysis regarding the Capital Asset Pricing Model have found a specific and consistent correlation between company size and rates of return across the public markets. They have even put forward an adjustment to the Capital Asset Pricing Model that reflects this size aspect and have provided size related Beta factors as well as additional size premiums that are based on these results. The difference that they have found in the rates of return between the largest and smallest deciles of the public markets is significant with the equity risk premium for the largest decile being 6.70% while the risk premium for the smallest public firms has been calculated as 13.97%. 
Further, work by Laurence Booth of the University of Toronto has found the a similar although less extreme correlation in Canadian data. 
The size effect has also been shown to be valid whether or not a company is public, and indeed is believed to be apparent even when considering the difference between companies that most people would refer to as small businesses.
When applying public company valuation formulas to private company results then, the size factor must be given major consideration to avoid the risk of overstatement.
The transaction context
What impact does the private/public relationship have within the context of a transaction situation. While notional values, as discussed, are designed to represent the maximum amount that could be realized through the sale of the private business interest it also includes the significant condition that the parties, buyer and seller, are under no compulsion to act. This is clearly not the case within the context of most transactions.
In most cases, the vendor, the purchaser, or even both are motivated to some degree to complete a deal. If the vendor were pushing the process the price may be lower than one would expect. Similarly if the purchaser is highly motivated they may face the need to pay a higher price in order to motivate the vendor to close. If there is more than one interested purchaser, they may be highly motivated to increase the price in order to win the day. In each of these cases the value of the privately held business interest will be determined not by any formula that translates public values into private ones but through negotiation and it will be based on the facts of the specific situation:
What cash flows are being purchased?
What are the risks associated with those cash flows?
Who is the vendor and why are they selling?
Who is the purchaser and why are they buying?
How many purchasers are there?
For the purposes of this paper, however, let us address the issue of the public/private relationship in this context.
We will do this first by looking at the situation where a public company is evaluating the potential purchase of a private business. What methodology should they use to make their decision? It is our view that this decision will be made based upon what value the cash flows of the private company, when integrated into the public company's business will be worth. This will include the assessment of the risk associated with those cash flows, the potential for synergies and value added that may arise from the transaction, and the public company's own cost of capital and/or threshold expected rates of return.
Based upon this analysis the public company will be able to establish a maximum value at which they can profitably purchase the private business . This does not mean that that is what they will actually pay for the business, however. The final price will be a function of the negotiations, the number of buyers that are at the table, and the motivations of the parties involved. Ideally, the purchaser will be able to pay less than their determined maximum price and will thus reduce the risk of the investment. At no time, however, would the concept of a "private company value" be addressed in the purchaser's pricing analysis for the specific reason that once the purchase is complete the business is no longer a private company.  Readers should note, however, that there is a definite distinction to be made between the purchaser's methods of carrying out a pricing analysis and their negotiating position. In trying to get the best deal possible the purchaser may well raise issue of specific private company risks, including those discussed below, in order to support the lowest price possible.
What about situations, though, where the purchaser is not a public corporation but is instead another private company or perhaps an individual private investor? In these cases as well, we believe that the same process should hold true. The investor will assess the purchase of the private enterprise within the context of the potential investments that they can make and should assign to the business a maximum price based upon their own ability to manage the risks associated with the target cash flows. Once established it is again a function of the negotiations that will determine what the final price will eventually be.
All that said, there are however several aspects of the private company that are specific to the transaction situation. These are risks that may not manifest themselves directly to the current owner but that should be addressed by any potential buyer, public or private.
Quality of information
This is a risk no matter what type of company, public or private, large or small is being purchased. One need look no further than the business pages of the daily paper to see evidence of this as numerous legal actions have been taken recently surrounding supposedly inaccurate and/or misleading information being issued by major public corporations. This issue, however, is of particular concern in the context of the private business because of the fact that the majority of private businesses are not large enough to be required to make statutory or regulatory filings. As a result the standard of care that may be taken, and the style of reporting that is used, may or may not correspond to what the purchaser is used to. Thus the purchaser must take care in assessing the information received to ensure that they are interpreting it correctly. Further, due diligence processes should not be cut down strictly because the transaction is of a smaller size or because of the seeming simplicity of the information. A business owner who has been running a business for many years will have an information gathering system that is distinctly suited to their own style and that may or may not transfer easily, or at all, into a new corporate hierarchy.
As noted earlier in the paper with regard to the overall risk of the private business as compared to the public company, management dependence should be a major area of concern for purchaser of the private business. We mention it here again to emphasize the risk that it represents. How long will the owner stay on? How motivated will they be? Will they be able to accept the fact that they are now reporting to someone else? How easy or difficult will it be to replace the owner? How will the customers of the business react to the change? Each of these questions must be assessed before any definitive deal is agreed to. Further, this risk will generally impact on the final value equation through the terms of any final agreement of purchase and sale.
Cultural issues are often blamed after the fact for the failures or disappointments that result from the purchase of a business. Again while proper integration of cultures is important irrespective of the type of business that is purchased it is often of special concern with the purchase of a private company. This results from the fact that often a private company will have assumed a culture that is dependent on the individual owner/manager. The change from what is often a "family" atmosphere to that of a public corporation with new reporting responsibilities, new procedures, and new approval processes can be amongst the most extreme culture changes that occur in business. The buyer must therefore fully assess these cultural issues early in the process and make provisions for how they will be dealt with if they are to have any chance at all of a smooth transition and integration.
Valuation and pricing expertise
The final observation that we will make with regard to the purchase of the privately held business relates to the difference in knowledge and expertise that may exist between the representatives of the two sides. The public company, usually represented by people with finance and M&A backgrounds will often have a significantly greater understanding of valuation and pricing issues than will the representative of the private business. This is especially true if private business owner that is acting on their own behalf without the benefit of expert advisors. While at first this may seem to lead to an advantage in the negotiations for the public buyer, in reality it usually just serves to complicate the negotiation process and make the chances of reaching an agreement much more difficult. The ability of the two sides in a negotiation to discuss valuation and pricing issues in an efficient manner is one of the keys to being able to reach an agreement that will be satisfying to all involved.
In summary, there has been a change in view with regard to the application of public company data regarding value to the private business. That change has been from requiring significant adjustments based on marketability and control, to requiring smaller case specific adjustments for these issues while ensuring that the major aspects of size and specific company risk are accounted for appropriately. In essence, for a 100% interest in a private business the gap in value and in expected rates of return has narrowed with respect to 'comparable' public data. This does not, however, mean that it has become a simple process and that public company multiples are easily transferred to private business results. What has in effect occurred is a shift away from large rule of thumb adjustments for such things as marketability and control towards a need for more specific and detailed assessments of the risks and opportunities that a business presents. The key factors that need to be addressed in any comparison of public and private company value are the relative size of the businesses, the actual comparability of their risk profiles, and the valuation bases from which the relationship is being derived.
Mercer, Z. Christopher, "Should 'Marketability Discounts' be Applied to Controlling Interests of Private Companies?", Business Valuation Review, June 1994 Ibid. Readers should refer to various articles and studies that discuss the results shown in The Megerstat Review Nath, Eric W., "How Public Guideline Companies Represent 'Control Value' for a Private Company", Business Valuation Review, December 1997 Ibbotson Associates, Stocks, Bonds, Bills and Inflation, 1998 Booth, Laurence, "The Capital Asset Pricing Model + Equity Risk Premiums and the Privately-Held Business", 1998 CICBV/ASA Joint Business Valuation Conference Materials, September 1998 Campbell, Low, Murant, "The Valuation & Pricing of Privately Held Businesses", CICA, 1991
For more information on this topic readers are referred to the publication, "Mergers & Acquisitions of Privately-Held Businesses - Second Edition", W.P. Albo and R. Henderson, CICA, 1991. Further it is expected that the third edition of this text will be available early in 1999.