Since 1990, the VIX (the Chicago Board Options Exchange Market Volatility Index) has averaged approximately 20 percent but has skyrocketed in recent years, rising to nearly 90 percent in October 2008 and fluctuating as high as 48 percent in August 2011. How can an owner of a privately held business determine the value of his or her interest in these volatile times? And what exit strategies are available?
Several different valuation techniques can be applied to determine the fair market value of a privately held entity or asset. The three major methods used by valuation specialists are the Market, Income and Cost Approaches. Valuation specialists do not usually rely on a single approach but, rather, meld the results from several approaches into a cohesive conclusion of value.
The Market Approach measures the value of a business through an analysis of recent sales or offerings of comparable investments. The valuation specialist can use value indications based on sales of private companies as well as current market multiples from comparable publicly traded entities. When considering the Market Approach, the valuation analyst must identify the best possible set of comparable guideline companies. Once this peer group is developed, the analyst must go through a formal process of comparing the subject company to each of the comparable companies and make adjustments to reflect relative growth expectations, risk profiles and profit expectations. This can be a lengthy process involving a detailed quantitative and qualitative analysis of each guideline company.
The Income Approach aims to quantify the present value of all of the entity’s expected future cash flows. A discount rate must be applied to future cash flows in order to reflect the time value of money as well as the risk related to achieving the cash flows. Preparing an income approach in volatile times can be a challenging exercise. It is important that the forecasted cash flows be tested based on current market evidence. It is also important that the discount rate reflect the real risks associated with realizing the economic benefits based on all current market and industry data.
Finally, the Cost Approach is centered on the idea that the total value of an entity can be estimated by the sum of the fair market value of its parts. Each of the company’s assets and liabilities is adjusted to its fair market value. Once the fair market value has been ascertained for all of the entity’s assets and liabilities, the liabilities is subtracted from assets, yielding the entity’s net asset value. This approach is typically used to determine the value of real estate holding companies and asset-intensive companies and is usually not appropriate to apply to determine the value of a company that provides services or products or holds significant intangible value. However, if this approach is employed, the valuation specialist must take steps to ensure the valuation of the assets and liabilities reflects current market conditions. This can be difficult in volatile times.
When planning an exit strategy for a privately held business, the following primary liquidating events are typically considered:
IPOs, if successful, can offer stakeholders exceptional returns on their investments. IPOs allow early equity-holders to dramatically increase the liquidity of their holdings, expose the company to access to cheaper capital, diversify the company’s equity base and enhance the public image of the company. However, successful IPOs require relatively high value thresholds and the rewards of going public through an IPO are generally accompanied by high costs including accounting and SEC filing requirements, investment banking fees, legal costs, and increased transparency and public dissemination of company-specific information.
A more conventional exit strategy is to sell the business to a private investor group, often a private equity or venture capital firm. In such transactions, the firm acquires all or nearly all of a company, then seeks to extract additional value by reorganizing and optimizing the operations of the company through changes in capital structure, management and strategy. Whether an asset holder wishes to exit a business entirely or merely liquidate a portion of an interest in a private company, a sale to a private investor can achieve an exit strategy without many of the costs and challenges of a public offering.
Finally, mezzanine financing allows an owner to transfer ownership and increase their personal liquidity in a non-disruptive and cost-effective fashion. Using a combination of debt, preferred equity, and derivative securities such as convertible debt or warrants, a mezzanine financing firm provides companies access to additional funds. These funds can be used to help grow the company further, or allow middle management to buyout the stock of the company’s founder to facilitate a transition of management and grant an owner an opportunity to exit the company at fair market value.
It is critical that an owner of a privately held business have a good understanding of the value of his or her business for a variety of reasons including estate, gift and strategic planning, as well as for the consideration of potential liquidity events. It is always a good idea to seek advice from a qualified professional, particularly in these volatile times.
Matthew Girard, Managing Director, provides valuation consulting services as a member of WTAS’s East Coast Valuation Services Group.