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welcome to another tutorial video this time around we're going to be addressing a valuation topic that we've gotten a lot of questions on and here's the typical question we receive on the topic help how do you value a private company and sometimes we get even more frantic questions such as no I really need to know how to value private companies it must be dramatically different right and we get a lot of questions on this topic we got even more questions on this topic before we added coverage of private companies and private company valuation to one of our courses the financial modelling fundamentals well so to answer this question and to explain more about the key points of private company valuation I'm going to take our 10 hour long set of tutorials and try to summarize them in 20 minutes we'll see how that goes in the course we explain private companies via two case studies the first one is about a deal between cacao and down these two Korean technology companies cacao was private at the time down was public and it was a reverse merger type of situation so we look at a larger private company there and then in the second case study we actually turn around and value this business the mergers and acquisitions and breaking in to Wall Street business using fake numbers but the principles are all the same for the starting point here I would suggest thinking about TV shows and specifically one of my personal favorites Breaking Bad now in the final season of Breaking Bad Jesse Pinkman Walter White's accomplice confronts him at one point and asks him about his true motivations for wanting to become a drug dealer mastermind and control large swathes of territory in the southwest of the u.s. is he doing it for money is he actually doing it for his family or is he doing it for his own ego and he responds with this quote you asked me if I was in the meth business or the money business neither I'm in the Empire business well this is very quotable it also is important because it touches on the three main types of private companies so the three main categories are first off what we call money business now these are small family-owned businesses or other types of firms that are heavily dependent on one person a restaurant that is owned and operated by a top chef would be an example something like a law firm with only one lawyer or a few lawyers would be another example a tax firm a barber shop other places like that that are actual true small businesses then in category number two are venture-backed startups what we call meth businesses because these companies are just like Walter White and Breaking Bad are very focused on scaling their business and getting up between much bigger size eventually examples would be Kakao Talk before it was acquired whatsapp Instagram tumblr all before they were acquired and then in category number three you have the Empire businesses now these are large companies with boards and management teams and they're not public yet but they could be if they wanted to and they might become public one day if circumstances change so when thinking about private companies you have to think about which category your company's in first because obviously a small barbershop with two employees is going to be valued very differently from Ikea yes they're both private companies but they're completely different in size scale and dependency on key peope so with Empire businesses they're really almost the same as public companies there are some minor differences you might apply some discounts and adjustments but for the most part valuation is not that much different with meThe businesses aka startups the valuation is still quite similar but you do see a few more differences for example it's often very important to look at an IPO valuation for these companies which we cover in another free tutorial in this channel and then with money businesses in other words real small businesses most of the differences actually emerge here you're going to have to adjust their financial statements you will have to adjust the valuation you'll have to adjust any DCF analysis that you run for these companies of course you rarely actually work with these companies in fields like Investment Banking and private equity unless you're at a small firm that actually advises or invests in true small businesses so what exactly is different based on those three main categories of private companies first off with accounting and the three financial statements and three statement projections you will have to make some adjustments here because often the categories are not correct often expenses are not really related to the business owners sometimes don't pay themselves and this is mostly an issue for money businesses in other words real small businesses on the valuation side private companies are often worth very different amounts to different buyers or investors so if a private company is about to go public it will be worth a very different amount versus if one individual is going to acquire it or a private conglomerate is going to acquire it for example and then beyond even that if you're using comparable public companies or precedent transactions to value a private company you're going to have to apply some discounts private companies are less liquid than public companies because you can't just buy and sell their shares easily and you may have to discount and adjust a lot of other assumptions and factors in the valuation and then finally in the discounted cash flow analysis you run into a couple problems first off private companies don't have market caps they don't have beta and so you can't calculate cost of equity and whack the weighted average cost of capital in the traditional way so look at some alternative approaches to doing that and see a few examples in Excel as well and then the terminal value assumption can also be problematic for these types of companies not for all of them but certainly for the money businesses where it's highly dependent on one person or a few key people even assuming anything for terminal value can be somewhat problematic so let's start with the first area the accounting and three statement projection differences then we'll get into the valuation differences and we'll conclude with the DCF differences now of course there are differences in other areas like merger models and leveraged buyout models and other types of transaction models but they tend to be even more minor than these differences and we just don't have time to get into them here so I'm going to focus on these three areas at least in this lesson so first off many small private companies have financial statements that don't exactly conform with gap or IFRS or the local accounting standards in whatever country you're in so you may have to change around the categories and normalize them a bit oftentimes small private companies do not actually record anything for the owners salary on the income statement or whatever the owner is paying him in the form of a bonus for example because they will take out all the money in the business in the form of dividends now the problem with this is that then when you look at the company's income statement they seem a lot more profitable than they actually are a public company wouldn't work like that you would have to record all the payments to owners and managers and everyone else who is involved with the day-to-day operations of the business on the income statement oftentimes small business owners will intermingle their business and personal expenses so we'll try to expense travel or entertainment or other things like that on the income statement and call it a business expense when it's really not and they can get away with it because your chances of getting audited are not that high unless you get to a certain size so tax authorities sort of look the other way and business owners can get off a get away with this and then finally tax rates can also be quite a bit different because at least in many countries the tax rate on small businesses will be quite different than it is on large public companies see corporations often times small businesses are taxed at the owners personal tax rate depending on how the business is set up but if another company is thinking about acquiring it or if the company wants to go public its tax rate is going to change and so at least in future projections you're gonna have to modify that and use a tax rate that is closer to what they acquire or what the new investors are thinking about so as an example of this let's take a look at an income statement from a typical money business and you can see up here we have some fairly non-standard categories this is actually a fake income statement for our business but I've listed as categories online courses product sales referred by affiliates coaching and resume editing sales to institutions commissions from other products commissions by category gross sales less commissions and then fees and refunds and then net sales after fees and refunds as you can tell it's not exactly presented in a way that's compliant with gap or IFRS and that's because for me as the business owner it's easier and more effective to look at it like this I like to see Commission's by category and I'd like to see the refund amount the amount that we're paying in fees and I pay a lot of attention to this number the net sales after fees and refunds number of course in the real world an accountant or auditor would probably reject this and tell me that I have to list gross sales and net sales and I shouldn't even be listing commissions here I shouldn't be listing payment fees it should really just be gross sales and then you subtract refunds to get to your net sales at the bottom of that the expense categories are also a little bit weird we don't have general and administrative sales and marketing research and development instead we've split things into much more granular categories down here also if you notice none of these categories actually has quite a lot in spending and that's because my own salary is not included here since I am taking money out of the business in the form of a dividend or some type of annual bonus payment I paid it myself I'm not even listing it on the income statement and I don't think of it as an ongoing business expense but of course again if we were acquired by someone else or if we eventually want to go public if we got much bigger we'd have to list that and we'd have to count my own salary somewhere here and then finally the income tax rate here is quite a bit lower than what it probably would be for a large public company the effective tax rate is around 25 to 30 percent most public companies are taxed at more like 35 to 40 percent in the US so this is something else that we'd have to adjust in future periods so those are the main problematic areas to adjust for all that and to come up with a normalized version of the statements we might have something like this where we list gross sales and net sales at the top and all we do to move from one the other is subtract refunds and allowances and then we might put all the operating expenses in more normal categories we'll take out anything that's intermingled like travel expenses we'll also add in my own salary and allocate it to these categories as appropriate we didn't change anything with the taxes in the historical period because those are historical pack taxes they've already been paid but certainly in future periods we'll probably adjust up the tax rate here so that's a quick summary of how you might have to normalize the financial statements for a true small business again you're not going to have to deal with most these items for Empire businesses or meth businesses they could come up and occasionally you will see some non-standard things but it will be far less of an issue than it will be for these true small businesses let's move into topic number two now and look at valuation for private companies so first off you have to think about the purpose of the valuation for example if you're valuing the company because it's about to go public you are probably not going to discount it as much as you would if you're valuing it because it's about to be acquired by another private company or even by a large public company or by an individual the reason is because once it's public it gets a diversified shareholder base it is run more like a public company because it is a public company and so you're not going to have to discount things quite as much as an example in one of our case studies for cacao and down here you can see that in one of our cases when the company goes public we don't actually apply much of a discount for the comparable public companies but then if it gets acquired by some other company a private company or another public company we actually apply far more of a discount fifteen percent instead of zero now that discount I just showed you is the illiquidity discount and you almost always apply it to public comps when you're using them to value private companies the logic is pretty simple any investment and a private company is less liquid than buying a public company shares it's much harder to sell and therefore you're taking on more risk and so the company is probably going to be worth less to you now the actual range for the discount might be anywhere from 10% to 30% or more sometimes less as well it really depends on the size and scale of the company and the purpose of the valuation so again if the company is large and about to go public it's going to be smaller if the company is very small and a single individual wants to buy it it's probably going to be a much higher discount so it depends a lot on a type of business and also how and why you're using the valuation with public company comparables you can still come up with a set in this case we're looking at for-profit education companies and you can still use the same types of metrics and multiples revenue multiples EBIT on multiples p/e multiples but you have to discount them by some amount if it's a true small business you're looking at because if your company has five million in revenue or five hundred thousand revenue you can't really compare to a five hundred million dollar revenue company so you have to apply some type of discount to these multiples here's an example for our valuation of this business we're applying a 30% private company discount so when we get a multiple like 6x we're not going to take that at face value we're going to have to reduce it by 30% and that's what we're going to use to get to the companies implied enterprise value and applied equity value across these different ranges now you're not necessarily going to apply the same discount for the precedent transactions because these should early reflect some type of premium paid by the buyer and once a company is acquired by definition it is now a liquid so you're not necessarily going to apply it there you could still do it if the companies that were acquired in these deals are really not comparable to your own at all you're generally not going to apply this same type of discount to Empire businesses just because they are so much larger and they're probably more similar to the precedent transactions you will probably still apply some type of small discount for the comparable public companies but again it's just going to be a lot lower than it is here you might see 5% 10% 15% depending on the tip of business for precedent transactions not too much is different but you might use some more creative metrics especially if you're looking at a tech startup for example here's our list of comparables for cacao and as you can see we're looking at monthly active users and also enterprise value to monthly active users now cacao and actually most of these companies we're generating some amount of revenue but the reason we're looking at this is because for social media and gaming and mobile companies monthly active users is a very important metric and it's useful to look at a slightly different valuation method with that said let's now move into part three and look at some of the problems with the discounted cash flow analysis the problems that emerge and some of the difference this year so the first problem is the discount rate now the discount rate should be higher for a private company because you're taking on more risk it's harder to sell your shares if you can even somehow acquire shares in the private company if there's more risk their returns need to be higher and so the discount rate needs to be higher as well of course it's difficult to calculate this when the company doesn't have a market cap or beta so you have to think about some different approaches the second problem is terminal value now it's similar for Empire businesses and for some types of venture-backed startups but it has to be discounted for money businesses because if the owner of a business that's heavily dependent on him or her dies or quits the business or retires or does something else the business may not actually last so you have to factor that in and rethink some of the assumptions that go into terminal value so with the discount rate there are a number of approaches you could take first off you could just look at the industry average capital structure or you could look at the average capital structure for the comparables you could try to look at the firm's optimal or targeted capital structure what it's moving toward in the future you could even use circular logic where you calculate the implied equity value from the DCF and then you feed it into the calculation for a whack I don't recommend this because it's unnecessary and it makes your model more complicated for no real benefit you could also even look at the volatility of earnings or dividend growth rate or something else like that and get to a number like beta from that this is a little bit questionable as well and I haven't really seen it done in real life before really the main way to get around this for all these types of businesses Empire businesses meth businesses and even money businesses is to as we do here and take the median capital structure of the comparables so what we label the optimal capital structure on this page we've really just taken the average percent debt from the comps the average percent preferred stock and the average percent equity and then we've assumed that they also apply to our company here so we don't need their current capital structure we don't need their current market cap we're just taking the industry average for these for-profit education companies and going with that now at this point you could also theoretically apply some type of additional premium to the discount rate and you could say that since it is a private company it's very small it's worthy of another premium and the discount rate should be even higher than 14 or 15% we don't think it's entirely necessary here but some people will also make that adjustment now for the second problematic part terminal value it may or may not make sense for a true small business and it sort of depends on just how reliant it is on a key person key individuals or key customers you could adjust for this by heavily discounting the terminal value you could also skip terminal value entirely and project free cash flow far into the future sort of like what you do with a net asset value model for a natural resource company or you could just assume the terminal value equals the liquidation value in the future so the business shuts down it sells off its assets it used them to repay its liabilities and then whatever is left over is the company's terminal value at that point in time there are advantages and disadvantages to each of those methods you can see them lined up side-by-side here in one of our examples but the basic advantage of simply discounting the terminal value as we do right here is that it is fairly straightforward to justify because you're still calculating it in the same way it's just you're reducing the value at the end the disadvantage is that the exact discount of course is arbitrary and so it can be harder to justify the liquidation value method is nice because then you don't have to make any assumption for terminal value but then you have to estimate how long the business is going to last and you have to project its full balance sheet going into the future and then finally these cease operations method is nice in some ways because you can avoid some of the arbitrary assumptions that go into terminal value but then once again you have to estimate how long the business is actually going to last going to the future and how much it's free cash flow is going to decline when the owner becomes less active in the business so there isn't a clear winner but there are a couple different ways to think about it and you could use any of these or all of these potentially as you're thinking about terminal value in a private company valuation the main point though is that the company is just not going to be worth as much as a public company would be particularly when you get far into the future and the owner and the key people involved with the business decide to become less active with it so that is a quick overview of private company valuation I tried to hit on all the key points here in about 20 minutes let's do a quick recap and summary now with private companies you have to ask what type of company it is and also what the purpose of your analysis is when you're dealing with an empire business a large private company there aren't that many differences you will see some minor discounts and adjustments that's about it with meThe businesses venture-backed startups that want to become big one day you'll see some greater discounts and adjustments there but in general since the end goal is to become a large business you won't see dramatic differences quite as much you will see a lot more differences with money businesses true small businesses because you'll have to discount the comps multiples significantly you'll have to discount terminal value or look at it or calculate it in a different way and so on and so forth there aren't really new methodologies or multiples with private companies they're just variations and tweaks of old ones the basic point is that private companies are generally worth less than public companies of the same size simply because they're riskier they're less liquid and so your returns expectations have to be high as well on the accounting side you often tweak and reclassify the statements especially for small businesses and then on the valuation DCF side you will often apply illiquidity discounts you'll have to make rough estimates for the discount rate and you may have to discount terminal value skip it entirely or come up with some other method of calculating it so that's it for our tutorial on private company valuation I hope you understand this topic more and can now answer some of your own questions whenever a question related to private companies comes up you