Reasons for Performing Valuations

Reasons for performing private company valuations are categorized into:

1. Transaction related.
2. Compliance related.
3. Litigation related.

1. Transaction-Related Valuation 

   Transactions are events that affect the ownership or financing of a business. Private company transactions include the following:

   • Venture capital financing

     Early-stage and venture capital firms often secure equity investors through multiple financing rounds linked to significant company milestones. In cases of high uncertainty in future cash flows, informal valuations guide negotiations between the company and potential investors.

   • Private Financing

     Investors typically invest through multiple rounds of financing tied to achieving critical milestones. Valuations are done to determine the level of investment required for an equity stake in a private company. Due to uncertainty regarding private company' cash flows, valuations are often informal and based on negotiations.

   • Debt financing

     Private companies and lenders may conduct valuations to assess the company's capacity to use existing operating cash flows for repaying debt or taking on more debt for purposes like restructuring, expansion, or acquisitions.

   • Initial Public Offering (IPO)

     Investment banks prepare valuations as part of the IPO process. IPO valuation depends heavily on the company’s future growth projections. 

   • Acquisition

     The target and buyer may perform acquisition-related valuations. Smaller companies may be sold with the assistance of a business broker, while investment banks are used for larger companies.

   • Bankruptcy

     Valuation of a business and its underlying assets under bankruptcy protection may help assess whether a company is more valuable as a going concern or in liquidation.

   • Share-based Payment (Compensation)

     Share-based payments, including stock option grants and restricted stock grants, have accounting and tax implications for the issuer and the employee. These payments provide an incentive for improved employee performance.

2. Compliance-Related Valuation 

   Compliance encompasses actions required by law. Financial reporting and tax reporting are the two primary focuses of this type of valuation.

   • Financial Reporting

     Impairment of goodwill is an important application of valuation. Components of public companies are valued using private company valuation techniques. For private companies, stock option grants will frequently require valuations.

   • Tax Reporting

     Tax-related reasons for valuations include corporate and individual tax reporting. Some corporate activities like restructuring, transfer pricing, and property tax may require a company valuation.

3. Litigation-Related Valuation

   Legal proceedings like damages, shareholder disputes, lost profit claims, and divorce require valuations. Each of the three areas requires specialized skill and knowledge, and the transactions usually involve investment bankers. Compliance valuations are performed by professionals with tax or accounting knowledge.

Private company valuation areas of focus

When valuing private companies using the FCFF discounted cash flow method, analysts must address three crucial adjustments:

1. Cash Flow and Earnings Adjustments: Private vs. public company variations require balance sheet and income statement adjustments to estimate normalized earnings, impacting the valuation numerator.
2. Discount Rates and Rate of Return Adjustment: Private companies often necessitate different assumptions for discounting future cash flows due to the lack of observable market prices for debt and equity. This affects the denominator in the valuation.
3. Discount/Premium Valuation: Private company-specific adjustments should consider stock-specific factors related to control benefits or drawbacks, reflecting the impact of illiquidity and minority interests in the valuation.

Question

Which of the following is least likely a transaction-related reason for valuing private companies?

1. Bankruptcy.
2. Acquisition.
3. Financial reporting.

Solution

The correct answer is C. 

Financial reporting is a compliance-related valuation reason. This is particularly important when testing for impairment of goodwill.

A is incorrect. Bankruptcy is a transaction-related valuation reason. This is when a company is not expected to continue being in operations in the future, and the value of its underlying assets need to be valued. 

B is incorrect. Acquisitions are transaction-related valuation reasons. These valuations are done by the target and the acquirer. This can be done with the help of investment banks

Reading 27: Private Company Valuation

LOS 27 (b) Describe uses of private business valuation and explain applications of greatest concern to financial analysts