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1. In the public company world, one can pledge stock as collateral for a loan, and often receive favorable interest rates where the only cost of debt is the interest expense that is paid. In the vast majority of borrowings in the privately held company world, any type of financing typically comes with a small piece of paper called a personal guarantee. So, the cost of debt for a privately held business, is the interest expense PLUS the combined equity of all the shareholders that are personally pledged against that debt. Also, the interest expense paid by a private borrower is typically higher than that paid by a publicly traded company.
2. Publicly traded companies are required to have audited financial statements that are available for public perusal. Privately held companies, are not. In fact, many small, privately held businesses do not have a professional bookkeeper much less an accountant, and often the only financial data a business appraiser has to analyze are the tax returns. Assuming the subject business has even filed any.
Investors of any stripe, will typically assign greater risk to an investment in a privately held company, over a publicly traded one. There are exceptions, but since valuation is both a science and an art, an appraiser is able to adjust for those.
One of the most common adjustments we have in our toolbox as appraisers is the Specific Company Risk Premium (SCRP) that is used in the Build-up Method to derive an equity discount rate which is designed to be used with a business’ Net Cash Flow to Equity. Those businesses that are a higher risk investment, receive a higher SCRP (the highest SCRP I have personally used was about 25%) and those businesses that are lower in risk are typically assigned a lower SCRP. I have even seen a small negative SCRP applied that actually made sense, given the facts and circumstances of that specific case.
The Build-up Method relies on data that can be pulled from several different sources, and is modified depending on the underlying data that is being used. For example, if one is looking at the Duff & Phelps’ data, there is no Size Premium, instead one uses the calculated Equity Risk Premium Adjustment. If one is using data based on the Center for Research in Security Prices (CRSP) one will be selecting a Size Premium, assuming one believes that such a premium should still be applied. (There are now some differing opinions as to the applicability of a Size Premium, but that is a discussion for another time.) In either case, the Build-up method relies on data that comes from an analysis of publicly traded investments. That means the resulting indication of value will be derived on a Liquid or Marketable basis, as publicly traded securities are much more marketable than privately held ones. The indication of value will either be on a controlling or a non-controlling basis, depending on what normalization adjustments were made to the selected income stream.
Now, as I mentioned above, the Build-up Method derives an equity discount rate. Which is used as part of the WACC analysis since the formula required to determine the Weighted Average Cost of Capital for a privately held business requires both an equity Rate of Return, and the debt’s Rate of Return. The WACC derives a discount rate that is used to measure a business’ invested capital, not just its equity. Once both of those rates of returns are determined, the appraiser then decides what percentage of the overall capital structure of the subject business is financed by debt, and what percentage is financed by equity, does the math and arrives at the Discount Rate, or Cost of Capital. (I actually linked my video discussing the WACC above in this newsletter. Click there if you wish to see what I say about that percentage selection process.)
However, and this is one of the areas where my opinion may differ from another appraiser’s, I believe the cost of debt is actually much higher for private businesses than just the interest rate alone, and it may even be higher than the cost of equity derived under the Build-up Method due the personal guarantee that most small business owners have to sign in order to obtain said debt. The signed personal guarantee pledges personal equity to guarantee the loan, so in my mind, the Cost of Debt and the Cost of Equity are at least equal to each other. If that is the case, then the percentage breakdown of the debt and equity components of the subject business in order to accurately use the WACC analysis, are not needed as a weighted blend of two rates that are equal will always sum out to the same rate. Which means that the “equity discount rate” derived under the Build-up Method, could also be used to appraise the Invested Capital of a business, and not just Equity. Which further means that the WACC might as well just be replaced with Build-up Method. As long as the subject business is of a size where a personal guarantee must be signed to obtain financing.
As for the Capitalized Asset Pricing Model (CAPM), which has been around almost as long as there has been a finance industry, it can be described basically as the Build-up Method, but with an Equity Risk Premium that is modified by Beta. Beta, is the measure of volatility of the subject stock price as compared to the overall market. A Beta for a publicly held security can be calculated fairly easily, but the math for calculating the Beta for a privately held business…well, I don’t know how to do it. Since the discount rate used to measure the value of a privately held business includes the SCRP, which is based solely on the appraiser’s judgment, I don’t see the value (pun intended) in working through a lot of detailed math when the overall rate will include what is essentially, a made-up number. Therefore, I have not yet used the CAPM to appraise a privately held business.
There are other methods of deriving a privately held business’ Cost of Capital that do not also rely on calculating the business’ dividend paying capacity, otherwise referred to as Net Cash Flow. Some of the most commonly available methods also double as the methods available for our use under the Market Approach. For example, if we were to look at a Price to Revenues market multiple from the Deal Stats database. Let’s assume the selected P/R multiple would be 0.35x. (I do NOT recommend always selecting the median or average multiple for use.) If, we were to calculate the inverse (one divided by the multiple) of that multiple, we would have a percentage of approximately 286%. That percentage is equivalent to a capitalization rate that would be applicable to the use of the subject business’ revenues to determine an indication of value. If we were to add to that 286%, the estimate for the subject business’ Long-term Growth Rate, let’s assume that is 4%, then we would have a Discount Rate of 290%. That’s a bit larger than the discount rates of around 18 to 25% we use most of the time. That is due to the fact that this rate is to be used against a business’ revenues, instead of net cash flow. Remember that the selection of the appropriate income stream is just as important as the selection of the discount rate.
One can do this same conversion with the Seller’s Discretionary Earnings (SDE), or EBITDA or EBIT multiples as well. Perform an analysis of the selected market data, decide what multiple to use, and then do the math. However, as Robin Williams said in the role of Genie on Disney’s animated Aladdin movie, quoting William F. Buckley, “There are a few, uh, provisos, a, a couple of quid pro quos” that the appraiser needs to also consider.
The reason appraisers use different methods under different approaches is to provide a form of reasonableness check on the overall analysis. If the appraiser uses the market data to develop indications of value under one of the market multiple methods, then uses the same multiple to derive a discount rate to arrive at an indication of value under the income approach for the same business; the fact that the two methods are both arriving at the same number is simply because the same risk rate was used. That appraiser no longer has the benefit of being able to say the report is relying on two different perspectives and assumptions as they are both coming from the same set of assumptions.
Another concern, is the comparability of the subject market data. Is the subject operation actually comparable to the businesses that were sold and included in the data set under consideration? For example, I once appraised a rural mail carrier, and the closest market data I could find was from local freight hauling businesses. At first blush, those appear to be similar, but the mail carrier only had one customer, which was basically the United States Postal Service, via one of a multitude of middleman operations secured by a contract for a specific term of time, whereas general freight hauling businesses, often service a variety of customers, often with no long-term contract, and with much less risk of losing one’s entire business by being outbid for a single project. I decided that the risk of investing in a rural mail carrier was much higher than investing in a general, local freight hauling business and could therefore not rely on that market data in that valuation. (That was a fun report to write! I sanitized it and made it into a sample that I used in some classes I taught. If you are interested in seeing it, let me know.)
Business Brokers popularized the use of a Factor Rating method that determines a multiple applicable to be used with SDE. This method, in the format I am familiar with, is limited in that the highest multiple it could derive is 3.0x. Remember, the mathematical inverse of a Multiple is a Capitalization Rate. A Capitalization Rate plus the estimated Long-term Sustainable Growth Rate is the Discount Rate.
In addition to those options, we also have something called Schilt’s Tables for a discount rate applicable with a business’ Pretax Net Income. Be careful with this one as Shannon Pratt and James Schilt came up with these figures while drinking together in a bar somewhere. The article and tables were published in the American Society of Appraiser’s professional business valuation journal, several times though.
An appraiser of a privately held business needs to keep several pieces of the valuation puzzle in mind while working each project. There’s the subject financial data, how that data compares to the industry average, the economic and industry risk factors and drivers affecting the subject enterprise, the expectation or lack of a future profit, and overall valuation theory. Sometimes I am convinced that the ‘Art’ component of business valuation includes the art of juggling for all the pieces that come together to form a defendable opinion of value.
If you happen to have some valuation related questions or if you just need someone to bounce some ideas off of, feel free to reach out.
You can find me at CanyonValuations@gmail.com
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