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The Eye of the Beholder: Valuing a Private Company Ownership Interest
Unlike public company stock, which actively trades electronically on national exchanges at published prices, ownership interests in private companies, and minority interests in particular, are often not readily marketable. As a result, determining the value of an ownership stake in a private business can be a thorny problem. Business owners and investors who want to determine the value of their ownership interest typically need to retain an independent business valuation expert to conduct a valuation of the company from which they can then calculate the value of the ownership interest at issue.
When Business Divorce litigation takes place between majority and minority owners in private companies, the battle over the valuation of minority ownership interests is likely to be the most hard fought, and also the most costly as it will involve both sizable legal fees and steep bills by valuation experts. Given the critical importance of valuation in the private company context, this Post reviews the business valuation process and significant factors involved in conducting a reliable business valuation.
Valuation Factors
There is no one set of defining factors upon which a business valuation is based, because the factors will vary based on the specific industry at issue, the economic conditions affecting the company and the competitors that exist in the market. The following, however, are factors that generally considered by business valuation experts:
The nature of the company's business,
The company's historical financial performance,
The specific industry and economic outlook for this industry,
The company's current financial condition, including its earning capacity and its capacity to pay its debts, and
Goodwill and intangible assets of the company.
While opinions of value are based on well-recognized valuation approaches, the ways that these approaches are implemented can differ widely and result in dramatic disparities in the opinions issued by valuation experts. These valuation approaches and the disagreements that arise in the valuation process are reviewed in the remainder of the Post.
Valuation Approaches
The starting point in valuing an ownership interest in a privately-held company is to determine the value of the entire company, commonly known as its enterprise value. After the valuation expert determines the company's enterprise value, he or she can then make necessary adjustments to determine the value of the specific ownership interest at issue.
There are three major approaches used to determine enterprise value – the asset approach, the market approach and the income approach.
Asset Approach
The asset approach is a straightforward approach to valuation also known as a balance sheet approach or cost valuation, because it reflects the cost required to replace all of the company's assets. The asset approach is similar to a liquidation value for the company, and is therefore generally considered to be the minimum benchmark of value for a business that is a going concern.
Under the asset approach, the valuation expert determines enterprise value by calculating the value of the company's assets and then subtracting the value of its liabilities. The assets and liabilities of the company are adjusted from their book values (the historical values shown on the balance sheet) to their market values. In addition to adjusting the book values to market values, the valuation expert will also consider and account for the company's unrecorded assets and liabilities. Areas of conflict arise because valuation experts may disagree on: (i) how book values should be converted to market values, (ii) the value of the company's unrecorded assets and liabilities and (iii) whether or not particular unrecorded assets or liabilities should be considered in the valuation.
Market Approach
The market approach to valuation considers what similar companies are selling for in the marketplace (or what similar ownership blocks are selling for). The valuation expert therefore has to find transactions involving similar companies (or involving transactions for ownership interests in similar companies) and then compare those to the company that is being valued. The market approach is commonly used in valuing residential real estate, and both valuation experts and real estate professionals rely on recent sales of similar properties as the best indication of value. These similar residential transactions are known as "comparables," and they are used to estimate the value of the subject residential property.
Once the expert locates similar company transactions, he or she will make adjustments to address specific factors regarding the company being valued, including its market area, specific product lines, and growth factors. Valuation experts may disagree on how these factors should impact the valuation of the subject company and how they should be adjusted in determining the value of the subject company. Experts may also disagree as to whether a particular company is similar to the company being valued or whether the comparable transaction was a true arms-length transaction that makes it a valid basis for comparison.
Income Approach
The income approach is tied to the company's recent financial performance, and it is based on the projected cash flows the company will generate in the future for its owners. Therefore, in conducting the income approach to valuation, the first step is to create a model of the company's expected future financial performance to determine how much cash is expected to flow to the owners. Due to the time-value of money, i.e., that a dollar today is worth more than a dollar tomorrow, the future stream of projected cash flows is discounted.
Valuation experts may disagree about the assumptions made to project the company's future performance. They may also disagree about the discount rate to be applied to the future stream of cash flows. The discount rate applies to the entire future stream of cash flows (and the impact of the discount rate becomes greater the farther into the future the cash flow is projected to occur). Even a small change in the discount rate that is applied to projected future cash flows can produce a large change in the value of the company.
Adjustments Made for the Specific Ownership Interest
After the valuation expert determines the company's enterprise value, the expert will then make adjustments to calculate the value of the ownership interest at issue. These adjustments to the company's enterprise value include adjustments for personal goodwill, minority discounts or control premium, and lack of marketability.
Personal Goodwill
A company's value roughly divides into two primary categories: tangible value and intangible value. Intangible value includes the company's goodwill of which there are two types: enterprise goodwill and personal goodwill. Enterprise goodwill is the value created by the company's characteristics and attributes while personal goodwill is the value derived from the reputation, skills or talent of individuals involved in the company. Typically, this personal goodwill applies to and is generated by one of the company's owners.
KEY POINT: A company may seek to capture and preserve the value of personal goodwill by entering into a non-compete agreements with its key officers or salespeople, who generate substantial personal goodwill for the company. If no non-compete agreements exist with these key contributors, however, which is often the case in a small company where just one of the owners generates most of the goodwill, the valuation expert will apply a discount of some amount to the value of the ownership interests held by the other person(s) in the company.
The basis for the personal goodwill discount is to estimate the value of the company if it no longer had the benefit of any personal goodwill. Often, it is not clear why a customer or client comes to the company – whether it was because of the business brand or is due to the reputation, skills or talent of one person at the business – which causes disagreement among valuation experts.
Minority Discount and Control Premium
The ability to exercise control over a company's management is a highly valuable right, and most often, the majority owner controls, or has substantial influence over, the company's management. Conversely, the minority owners lack control over company management.
Because control over management is such a valuable right to hold in business, valuation experts will apply a premium increasing the value of owning a controlling ownership interest in the company. Similarly, because minority owners lack control over the business, experts will generally apply a discount that reduces the value of a non-controlling ownership interest.
Lack of Marketability
Minority owners who lack a contractual exit right that enables them to require the majority owner to purchase their minority interest may be in a very difficult position, because the company's governance documents likely impose onerous restrictions on transferring interests in the business. Therefore, in the absence of voluntary cooperation from the majority owner, the minority owner will be left holding an illiquid, unmarketable ownership interest. The real world difficulty in finding a buyer to purchase a minority held interest in a private company causes valuation experts to apply a "marketability discount" to the value of a minority owner interests. These discounts are often substantial, although the exact percentage of the marketability discount that applies to the interest is a subject of frequent and intense dispute among valuation experts.
Texas law recognizes that minority discounts are appropriate for valuation experts to apply in valuing a minority held interest in a private company. See Argo Data Res. Corp. v. Shagrithaya, 380 S.W.3d 249 (Tex. App.—Dallas 2012), pet. denied, (Tex. June 27, 2014).
Note: Although the term "fair market value," is commonly used in transaction documents or in redemption and buy-sell agreements, it is not well-understood. Fair market value refers to what a hypothetical willing buyer would be pay to a hypothetical willing seller for the minority held interest in the business. The valuation expert will therefore apply minority discounts (lack of marketability and lack of control) in conducting the valuation of a minority interest on a fair market value basis, but if "fair value" is used in conducting the valuation, the minority expert will remove minority discounts from the valuation formula.
The business valuation process is well-understood, but the number of factors considered, and the judgment calls that will made by the valuation experts on matters such as discount rates, the applicable minority discounts and the extent of good will in the business can result in valuation opinions that are widely divergent. The intensity of these differences will be heightened when the business valuation is being conducted in the midst of a hotly contested lawsuit matter between majority and minority owners in the business.
Majority and minority owners can take basic, proactive steps, however, to avoid this protracted, costly legal battle of valuation experts. With advance planning, business owners can eliminate business and legal conflicts that arise when an owner exits the business. The owners can negotiate and adopt "corporate pre-nup," which documents an exit plan that addresses fundamental business issues at the time an owner departs the business, including the valuation of the departing owner's interest in the company. For more discussion on "corporate pre-nups" and buy-sell agreements see links to February 5, 2015 post here and the May 8, 2015 post here.