There is a popular belief that there is one primary U.S. capital market that drives our economy: the public stock
market where ownership is exchanged in liquid markets and stockholders can check The Wall Street Journal to find out what a company is worth. However, small and middle-market businesses in the private sector far outnumber those publicly traded entities and employ more people in the U.S. For the owners of private companies, the rules are significantly different when it comes to valuation, access to capital, cost of capital and the variety of transaction structures available in exchanging ownership interests.
“The valuation of a private business is dictated by the particular purpose of the valuation and is significantly influenced based on who the parties to the transaction are,” says Mario O. Vicari, CPA, CVA, director, Kreischer Miller. Most importantly, “There is no one value to a private company it can vary depending on the circumstances.”
Smart Business spoke with Vicari about how private capital markets operate versus the public markets and why this difference matters during the transfer of a private business ownership interest.
What are private capital markets?
Private capital markets include small and middle-market companies, family businesses and entities that are not publicly traded. These markets are far less regulated and exchanges of ownership are driven by a unique combination of valuation, access to capital, transaction structure and tax planning, with the ultimate purpose to create value for the owners.
What is the difference between public and private capital markets and valuations in these two sectors?
Almost nothing about these two markets is the same. To highlight some key theoretical differences, private companies do not have a single value that you can look up each day, and they do not have ready access to relatively inexpensive public capital. Their ownership interests are illiquid and inefficiently traded, and the ultimate goal of owners is wealth creation after tax dollars.
Valuations of private companies can vary greatly depending on the answers to two important questions: What is the purpose of the valuation and who are the parties to it? For instance, if an owner wants to value the business so he can make a gift to his children, the parties involved are the owners and the IRS, which has no strategic interest in the business and, essentially, is a benign party. This valuation would be conservative compared to a valuation done for the purpose of an acquisition by a competing company. In the latter, there may be strategic reasons for the purchase that would drive up the business’s value. A third scenario may be a financial buyer, such as a private equity fund, who would assess the business based on providing a return to its investors. A valuation in that case would typically be more conservative since it would be done for financial, rather than strategic, reasons. There are many reasons for a private business to be valued, and each of those circumstances would dictate a different approach and yield a different number.
How is access to capital different for public and private capital markets?
Public companies have ready access to capital at a relatively inexpensive price, while private companies do not have an abundance of capital and, therefore, typically have to pay more for it. This is mainly due to the fact that the public markets are liquid and, because of the size of the players in that market, there are a number of inexpensive sources of capital.
On the other hand, a shareholder in a private company does not have the ability to easily make shares liquid. Most private companies’ capital comes from two sources: the owners and borrowed funds that often carry personal guarantees of the owners. When considering the cost of capital to a private company, one has to understand that it is often tied to the personal assets of the owner, which makes it very expensive. There is an opposite correlation between the cost of capital and valuation. If cost of capital is high, then valuations are typically lower.
In other words, owners of private companies cannot afford to overpay in an acquisition because they cannot afford to be wrong, or they risk losing personal assets and their livelihood. This direct connection between owners’ assets and business assets in private companies is one of the reasons that capital costs are so high because the stakes are high.
What is the spectrum of choices on a private company transfer?
In private companies, the most important issue in determining the right approach to a business transfer is the owner’s motives. If the owner cares most about maximizing his or her cash in a transaction, then the transfer channel may be a sale to a third party. On the other hand, an owner who wants to pass on the family legacy through the business would take a different transfer approach. This owner would sacrifice value for the sake of passing on a legacy, which is OK if that is the owner’s intent. The overall advantage that any private company has is the total flexibility to design a transaction structure to accommodate owners’ goals.
MARIO O. VICARI, CPA, CVA, is a director at Kreischer Miller in Horsham, Pa. Reach him at (215) 441-4600 or email@example.com.