Private Company Valuation and IPOs

Introduction

• Topic: Valuation of private companies and IPOs.
• Context: Continuation from the last session.
• Main Difference: Comparing privately owned vs. publicly traded companies.

Cost of Equity

• Key Question: Which has a higher cost of equity, a private or public company?
• Reason: Private business owners can't be as diversified as public investors.

Idiosyncratic Risk

• Private Business Owners: Worry more about idiosyncratic risk.
• Total Beta: Captures all risks including idiosyncratic risks for private business owners.
• Advice for Owners: Minimize idiosyncratic risks, which differ for profitable vs. unprofitable businesses.

Illiquidity Issue

• Traditional Approach: Applying a flat discount (20-25%) is flawed.
• Factors Affecting Discount:
  • Company's profitability
  • Buyer's time horizon and cash constraints.
  • Crisis time vs. non-crisis time.
• Alternative Approach: Analyze characteristics of different companies to tailor illiquidity discounts.

Potential Buyers

• Types of Buyers:
  • Private Owner
  • PE Fund
  • Public Company
• Best Buyer: Public companies due to lower cost of equity and improved liquidity.

Market Examples

• Historical Example: Warren Buffett's investment during the 2008 financial crisis due to less concern about liquidity.
• Long-term Trends: Shift from privately owned to publicly traded companies.

Calculating Beta and Cost of Capital

• Process: Calculate total beta for private businesses using public company data.
• Key Steps:
  • Unlevered beta
  • Adjusting for correlation with market
  • Levering the beta with appropriate debt-to-equity ratio
• Cost of Debt: Use interest coverage ratio for ratings.

Valuing Private Businesses

• Adjustment for Key Personnel: Impact of essential individuals on business valuation.
• Revenue Growth Limitation: Capacity constraints affect growth rate estimates.

Illiquidity Discount Analysis

• Traditional Studies:
  • Restricted Stocks: Noting discounts but considering the selection bias.
  • IPO Studies: IPO price versus transaction price before IPO.
• Problems: Selection biases in traditional studies.
• Realistic Approach: Using bid-ask spreads of public companies to estimate illiquidity discounts.

IPO Valuation

• Prospectus: Key document filed before IPO.
• Proceeds Utilization: Varies and affects valuation.
• Valuation: Similar to public companies but with adjusted expectations.
• Revenue and Profitability Trends: IPOs over time show larger revenues but fewer profitable companies.

Investment Banking and IPOs

• Role of Investment Bankers: Pricing, selling, and credibility.
• Pricing Issues: Tendency to underprice leading to average 15% first-day jump.

Alternative IPO Methods

• Direct Listing: Avoids traditional banking fees.
• SPACs: Collect funds without revealing target companies, but the 20% promoter cut is controversial.

Summary and Practical Takeaways

• Tailor the valuation methods for private businesses by considering individual company characteristics including liquidity and diversification issues.
• Respect market conditions and investor profiles for more accurate valuations.

Examples and Current Trends

• Case Study: Twitter's IPO and its valuation considerations.
• Market Dynamics: Examples of shifting from private to public ownership.
• Future Outlook: Potential changes to IPO processes with emerging methods like direct listings, SPACs.