Chapter-10-Analysis-and-Valuation-of-Privately-Hel

CHAPTER10AnalysisandValuationofPrivatelyHeldCompaniesMaier’sLaw:Ifthefactsdonotconformtothetheory,theymustbedisposedof.INSIDEM&A:CASHINGOUTOFAPRIVATELYHELDENTERPRISEWhenhehadreachedhisearlysixties,AnthonyCarnevalestartingreducingtheamountoftimehespentmanagingSentinelBenefitsGroupInc.,afirmhehadfounded.Heplannedtoretirefromthebenefitsandmoneymanagementconsultingfirminwhichhewasa26%owner.Mr.Carnevale,histwosons,andtwononfamilypartnershadbuiltthefirmtoacom-panyofmorethan160employeeswith$2.5billionundermanagement.SellingthefamilybusinesswasnotwhatthefamilyexpectedtohappenwhenMr.Carnevaleretired.Hebelievedthathissonsandpartnerswerequitecapableofcontinuingtomanagethefirmafterheleft.However,likemanysmallbusinesses,Sentinelfounditselfwithasuc-cessionofplanningchallenges.Ifthesonsandthecompany’stwoothernonfamilypart-nersboughtoutMr.Carnevale,thefirmwouldhavelittlecashleftoverforfuturegrowth.Thefirmwasunabletogetaloan,giventhelackofassetsforcollateralandthesomewhatunpredictablecashflowofthebusiness.Evenifaloancouldhavebeenobtained,thefirmwouldhavebeenburdenedwithinterestandprincipalrepaymentforyearstocome.Overtheyears,Mr.Carnevalehadrejectedbuyoutproposalsfromcompetitorsasinade-quate.However,hecontactedaformersuitor,FocusFinancialPartnersLLC(apartnershipthatbuyssmallmoneymanagementfirmsandletsthemoperatelargelyindependently).Afterseveralmonthsofnegotiation,Focusacquired100%ofSentinel.Eachofthefivepartners—Mr.Carnevale,histwosons,andtwononfamilypartners—receivedanundis-closedamountofcashandFocusstock.Afour-personSentinelmanagementteamisnowpaidbasedonthecompany’srevenueandgrowth.Themajorchallengespriortothesaledealtwiththemanymeetingsheldtoresolveissuessuchascompensation,treatmentofemployees,howthefirmwouldbemanagedsubsequenttothesale,howclientpricingwouldbedetermined,andwhowouldmakedecisionsaboutstaffchanges.Oncethedealwascomplete,theCarnivalesfounditdifficulttotellemployees,365Mergers,Acquisitions,andOtherRestructuringActivities#2012ElsevierInc.Allrightsreserved.particularlythosewhohadbeenwiththefirmforyears.Sincemostemployeeswerenotdirectlyaffected,onlyoneleftasadirectresultofthesale.1CHAPTEROVERVIEWAprivatelyownedcorporationisafirmwhosesecuritiesarenotregisteredwithstateorfederalauthorities.Consequently,theyareprohibitedfrombeingtradedinthepublicsecu-ritiesmarkets.Thelackofsuchmarketsmakesvaluingprivatebusinessesparticularlychallenging.Nevertheless,theneedtovaluesuchbusinessesmayariseforavarietyofrea-sons.Investorsandsmallbusinessownersmayneedavaluationaspartofamergeroracqui-sition,forsettlinganestate,orbecauseemployeeswishtoexercisetheirstockoptions.Employeestockownershipplans(ESOPs)alsomayrequireperiodicvaluations.Inotherinstances,shareholderdisputes,courtcases,divorce,orthepaymentofgiftorestatetaxesmaynecessitateavaluationofthebusiness.Othersignificantdifferencesbetweenpubliclytradedandprivatelyownedcompaniesincludetheavailabilityandreliabilityofdata,whichforpubliccompaniestendtobemuchgreaterthanforsmallprivatefirms.Moreover,inlargepubliclytradedcorporationsandlargeprivatelyownedcompanies,managersareoftenwellversedincontemporarymanagementpractices,accounting,andfinancialvaluationtechniques.Thisisfrequentlynotthecaseforsmallprivatelyownedbusinesses.Finally,managersinlargepubliccompaniesarelesslikelytohavethesamelevelofemotionalattachmenttothebusinessfrequentlyfoundinfamily-ownedbusinesses.Thischapterdiscusseshowtheanalystdealswiththeseproblems.IssuesconcerningmakinginitialcontactandnegotiatingwiththeownersofprivatelyownedbusinesseswereaddressedinChapter5.Consequently,thischapterfocusesonthechallengesofvaluingprivatefirms.Followingabriefdiscussionofsuchbusinesses,thischapterdiscussesindetailthehazardsofdealingwithbothlimitedandoftenunreliabledataassociatedwithprivatefirms.Thechapterthenfocusesonhowtoproperlyadjustquestionabledata,aswellashowtoselecttheappropriatevaluationmethodologyanddiscountorcapitalizationrate.Considerabletimeisspentdiscussinghowtoapplycontrolpremiums,minoritydiscounts,andliquiditydiscountsinvaluingbusinesses.Thischapteralsoincludesadiscussionofhowcorporateshells,createdthroughreversemergers,andleveragedESOPsareusedtoacquireprivatelyownedcompaniesandhowPIPEfinancingmaybeusedtofundtheirongoingoperations.Areviewofthischapter(includingpracticequestions)isavailableinthefilefolderentitled“StudentStudyGuide”onthecompanionsitetothisbook().ThecompanionsitealsocontainsaLearningInteractionsLibrary,whichgivesstudentstheopportunitytotesttheirknowledgeofthischapterina“real-time”environment.1AdaptedfromSimonaCovel,“FirmSellsItselftoLetPatriarchCashOut,”WallStreetJournal,November1,2007,p.B836610.ANALYSISANDVALUATIONOFPRIVATELYHELDCOMPANIESIII.MERGERANDACQUISITIONVALUATIONANDMODELINGDEMOGRAPHICSOFPRIVATELYHELDBUSINESSESMorethan99%ofallbusinessesintheUnitedStatesaresmall.Theycontributeabout75%ofnetnewjobsaddedtotheU.S.economyannually.Furthermore,suchbusinessesemployaboutone-halfoftheU.S.nongovernment-relatedworkforceandaccountforabout41%ofnongovernmentsales.2Privat