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 protected].
