Reasons for Performing Valuations

Reasons for performing private company valuations are categorized into:

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

I. Transaction-Related Valuation 

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

Private Financing

Investors typically invest through multiple rounds of financing tied to the achievement of key 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’s cash flows, valuations are often informal and based on negotiations.

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.

II. 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 corporate restructurings, transfer pricing, and property tax matters may require a company valuation.

III. Litigation-Related Valuation

Legal proceedings like damages, shareholders disputes, lost profit claims, and divorce requires 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.

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 a transaction-related valuation reason. 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.