Private companies, particularly private middle market companies, are prime targets for M&A dealmakers, but it’s often unclear the best way to access their value. Whether a target is a small, local store to expansive corporations yet to go public, understanding value is crucial.
There are two challenges dealmakers face when accessing private company value:
1) Scarcity of Public Data: The limited available data necessitates relying on assumptions, making valuations trickier.
2) Limited Market for Liquidity: The value of private company shares can be highly subjective, influenced by factors like personal relationships between parties involved.
Private companies, especially larger companies, influence their industry. For business owners, potential investors, stakeholders like lenders, suppliers, employees, and sometimes even customers, discerning a company's worth offers: Insights into the company’s financial health, the company’s potential growth avenues, and any associated risks of investing in a company.
Valuing companies often involve comparing them to similar entities within the same sector. For private firms, the lack of public financial data makes this method challenging. However, diligent industry research can unearth benchmarks or 'comparables' to guide a private company's valuation.
The Differences: Private vs. Public Entities
Ownership Structures
Public companies offer shares to the public via stock markets, thus spreading their ownership, often globally. While private companies retain ownership within a select group, which could include investors or the company's original founders. Limited ownership means quicker decision-making but might lack external scrutiny.
Reporting Standards
Public companies are bound by strict regulations, they ensure regular updates through quarterly financial reports, annual reports, and standardized accounting norms. While private companies can be (and usually are) less transparent. However, this shields them from short-term market pressures, allowing a focus on long-term growth strategies.
2-Step Research Process for M&A Dealmakers
The M&A process can be long and intricate: from sourcing deals and market research to in-depth due diligence on a particular target. There are primarily two significant steps in the investment process:
- Market diligence: This is where an investor studies the market space, even before considering a particular company.
- Due diligence: A more in-depth analysis that typically comes after market diligence.
Often, these two phases overlap, as market research can often lead to insights about specific companies within that market.
Market Due Diligence
Before diving deep into a private company's financials, dealmakers conduct market due diligence. This phase doesn't require involvement from any company's management, but it does require data. The primary aim is to understand the market's size, often referred to as the Total Addressable Market (TAM).
Two primary ways to calculate TAM:
- Top-down analysis: This macroeconomic approach uses broad data sources like the census or IRS to estimate the market size.
- Bottom-up analysis: A microeconomic approach, this method looks at the number of companies, customers, and other specifics in the industry to gauge the market size.
Note: TAMs are represented as a range rather than a single point, given the uncertainties and assumptions involved.
Market Fragmentation and Share
The next question dives deeper into TAM, focusing on market fragmentation and market share.
This stage answers: How easy will it be to organically grow or acquire (via M&A) share in this market?
Two essential analyses include:
- Market share analysis: This takes a look at the top companies in an industry, assessing their market dominance. This can give insights into the competitive landscape and potential for growth.
- Fragmentation analysis: Similar to market share, this approach evaluates the number of companies in a market and their respective shares. It is especially valuable for potential buy-and-build strategies.
Competitive Analysis
Before opening up a company's financial data room, investors need to ask how competitive the market is and gauge the potential risks involved.
This stage answers: How competitive is the market? What’s the risk we would lose share/revenue/profits?
This involves analyzing various companies in the market, understanding their revenue, growth, and other fundamental metrics. Moreover, it also looks into what makes each competitor unique in terms of their products, services, and market positioning.
Public Comparables
Dealmakers frequently use public comparables, often abbreviated as "public comps," to gauge a company's value. This approach is part of the broader comparable company analysis (CCA) or comparables valuation method. Public comps involve using the valuation multiples of publicly traded companies as benchmarks to value a subject company, typically a private entity or a different public company.
Investors identify publicly traded companies that are similar to the subject company in terms of industry, size, growth rate, profitability, and business risk. Public comps help,
- Gather Financial Data:
Financial information, such as revenue, EBITDA, net income, and other pertinent data points, is collected for each of the comparable companies. This data is typically obtained from financial databases, stock market filings, and earnings reports.
- Calculate Valuation Multiples:
Common valuation multiples such as Price/Earnings (P/E), Enterprise Value/Revenue (EV/Revenue), Enterprise Value/EBITDA (EV/EBITDA), and Price/Book (P/B) are calculated for each comparable company. These multiples reflect how the market values the earnings, assets, and growth prospects of companies in the industry.
The problem that dealmakers will find with public comps is that raw multiples may need adjustments to account for differences between the comps and the subject company. Adjustments might include differences in growth prospects, profit margins, market capitalization, leverage, or geographic markets served.
The adjusted multiples are then applied to the corresponding financial metrics of the subject company to estimate its value. For example, if the average adjusted EV/EBITDA multiple of the comps is 8x and the subject company's EBITDA is $5 million, the estimated enterprise value would be $40 million.
Beyond the numbers, investors will consider qualitative factors, such as management quality, brand strength, market position, and competitive landscape, which might influence the company's valuation relative to its comps.
Public company valuations and precedent transactions can provide invaluable insights. These valuation analyses are crucial because they give a ballpark estimate of an acquisition's potential price, which can determine if pursuing the deal is worth it in the first place.
Precedent Transaction Analysis
Lastly, an integral part of due diligence is understanding how expensive it is to acquire companies in a given market.
This stage answers: how expensive are the companies in this market to acquire?
Investors often use precedent transaction analysis as a method to evaluate a company's value, especially during mergers and acquisitions (M&A). This approach involves analyzing the terms and valuation multiples of previous transactions that have occurred within the same industry or sector as the target company. Here's how investors typically leverage precedent transactions in their valuation process:
Investors begin by identifying a group of recently completed transactions that involved companies similar in size, geography, and industry to the target company. These comparables serve as a relevant market benchmark.
Each selected transaction is scrutinized for its details, including:
- Purchase price
- Payment method (cash, stock, other considerations)
- Valuation multiples (e.g., Price/Earnings, Enterprise Value/EBITDA, Price/Sales)
- Terms and conditions
- Strategic rationale behind the transaction
- Market conditions at the time of the deal
Precedent transaction analysis is a powerful tool for investors because it provides real-world evidence of what the market has been willing to pay for similar companies.
However, it's important to note that every company is unique, and the context of each transaction must be carefully considered. The most accurate valuations come from a thorough understanding of both the macroeconomic environment and the specific characteristics of the target company.
The Importance of Outside-in Due Diligence
Due diligence is the backbone of any investment decision. It provides the tools and data needed to gauge the viability and potential profitability of an opportunity. So, before you dive deep into a company's financials, ensure you've done your groundwork on the market landscape, competitive dynamics, and valuation. It could be the difference between a successful investment and an expensive lesson.
Grata Can Help
While monitoring a few companies can yield more accurate value estimates, how do you accurately find the value of thousands of companies or an entire industry? In an age where data is gold, understanding private company valuation not only unveils the titans of the business realm but also guides strategic decisions, investments, and future trajectories.
Grata is the leading proactive business development and research platform for private markets. Set up a demo today.
