Business Valuation

The key to understanding the private capital markets is to realize that valuation, capitalization, and business transfer rely on each other for definition and support. A unified private market theory is represented by triangulation, where two sides are relied upon to help understand the third side. After an overview of each side of the triangle is presented, an illustrating of how capital markets are segmented is provided.

Concept #1 – Value Worlds
Value World: A value world is a valuation construct that enables a private business value to be derived in a relevant setting that is relative to the purpose and function of its appraisal.

Private securities do not enjoy access to an active trading market. Either a private valuation must be undertaken, or a transaction must occur to determine the value of a private security for some purpose at some point in time. Purpose is defined as the intention of the involved party or the reason for the valuation. The purposes for undertaking an appraisal are referred to as giving rise to Value Worlds. Therefore, the premise of Value Relativity is: A private business value is relative to the Value World in which it is viewed.

Every private company, therefore, has a number of different and correct values at the same time, depending on the reason for the valuation. Example appraisal reasons are: determine open market value (market value); legal/tax (fair market value); economic value creation (economic value); minority dissent (fair value); secured lending value (collateral value) and so on. There are dozens of such reasons, or value worlds. And yes, even an Owner value world.

Within each value world, authorities control both access and the rules of the game within their spheres of influence. In valuation, the IRS, courts, law, investors, lenders, and other agents are in position to make the rules. Capital authorities provide money. Transfer authorities range from laws, like ERISA or estate laws, to financial intermediaries. Owners who ignore authority do so at their own risk. Authority sanctions its decisions by veto power by denying access to the market.

In summary, private company value is a function of the Value World in which it is viewed. These worlds offer a range of values for one company at the same time. Many business owners believe their company has one true value; a belief still supported by some investment bankers and business appraisers.

Concept #2 – Capital Structure (Private Investor Expectation)
Private capital markets are much less efficient than their public counterparts. Inefficiency in private capital markets is caused by information opacity. Private shareholders, as a group, do not provide outside parties with adequate information about their company’s financial outlook, current operations, or future prospects. Because information is opaque, no liquid or even semi-liquid market is possible. In fact, due to the lack of an organized market, private capital market solutions are created one deal at a time. In other words, private capital is assembled on a deal-by-deal basis.

The private capital access line (“CAL”) depicts risk and return in the private capital markets by showing how credit is rationed based on the provider’s credit quality requirements. The private capital access line captures the private return expectation (“PRE”) of private institutional capital providers based on the return required to attract funds to a particular investment.

Several simple observations describe private capital: Private companies need capital; institutional capital providers have it; somehow parties occasionally negotiate a deal. Ultimately the private markets yield two precious commodities: information and liquidity.

The value world, capital structure, and transfer method triangulation establishes the discount rate (or market multiple) used to decide business value.

Concept #3 – Business Transfer
An owner has eight transfer channels from which to choose. The channels are: Charitable trusts; Family; Employee Group; Co-owners; Management Group; Outside -retire; Outside - continue; and, Going public. The choice of channel is manifested by the owner's motives and goals. For instance, owners wishing to transfer the business to children choose the Family transfer channel. Owners who desire to transfer the business to an outsider then retire choose the Outside - retire channel, and so on.

A transfer method is the actual technique used to transfer a business interest. For example, grantor retained annuity trusts (GRATS), private auctions, management buyouts (MBOs), and recapitalizations are methods by which an interest is transferred.

Triangulation
Triangulation can be summarized in three interrelated sentences:
1. Business value is directly affected by the company’s access to capital and the transfer methods selected or available to the owner.
2. Capitalization is dependent on the value world in which the company is viewed and the availability of transfer methods.
3. The ability to transfer a business interest in conditioned by its access to capital and the value world in which the transfer takes place.

- J. Greg Kelly
Insight Business Vlauations, Inc.