When a co-owner or partner in a private company wants to sell his or her shares, valuing their shares can be a problem. Public company shares are traded on a public market, so the price is clear. Private companies have to use different methodologies that can be complicated. As a result, it’s best to consult both legal and financial advisors to help determine the value of shares in a private company.
What Factors Are Relevant in Valuing Shares in a Private Company?
Private companies are often compared to public companies of the same type and size, but this is not a perfect measure and other factors must be applied for an accurate measure. How shares are valued in a private company will vary by company and industry, but some of the common issues that are considered, include the following:
Nature of the underlying assets
If a business owns real estate, the property can be appraised as a means of determining the company’s valuation. However, service businesses are more difficult to value. Typically, the purchase price is determined by looking at revenue – specifically, EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization. EBITDA indicates a company’s earnings before accounting and financial deductions. It is often considered to be a more accurate measure of profitability when comparing companies to each other.
Once EBITDA is known, a company’s value is calculated by applying a multiple of EBITDA. This multiple varies by industry. For example, in the professional services sector, the value may only be one- or two-times EBITDA. The rationale is that clients of such firms are more likely to be tied to the professionals they worked with and may leave when the business is sold. Other industries may use a higher multiple. There are widely accepted ranges for these multiples for most industries.
Likelihood of continuing income
Some types of businesses are more likely to generate a consistent income stream. They may have a strong customer base that is loyal to the product or brand as opposed to the individual owners. Those businesses will generate a higher multiple of EBITDA. In addition, market conditions must be analyzed to project future revenue.
Lack of control discount
Where a buyer is purchasing less than a majority interest in the business, the shares may be subject to a discount. The new owner may be unknown to the other owners and all of them must work together, which may be problematic if they do not have the same views on how the company should be operated. As a result, the shares are less valuable to a purchaser and they are often discounted as a result.
Lack of marketability discount
Private companies do not have a ready market for their securities. As a result, there is uncertainty in the valuation. It may be difficult to find comparable sales and there may be a limited pool of potential buyers. Accordingly, shares will be discounted for this reason.
How Can Disputes Over Valuation Be Avoided?
Often, the issue of valuation occurs when a co-owner or partner exits the business, either voluntarily or involuntarily. Other owners or the company may want to purchase the shares of the departing owner, who wants to obtain the maximum price for their interest. Best practice is to address this issue before it happens by executing a buy-sell agreement either as part of the shareholder or partnership operating agreement or as a stand-alone contract. The agreement can provide a formula for calculating the value of shares to minimize future disputes.
If you are an owner of a private company, consult an attorney about proper planning for your business. Our firm provides comprehensive business and estate planning services customized to our clients’ needs. Contact us today about your matter.