VALUING A CLOSELY HELD BUSINESS USING PUBLIC COMPANY COMPARABLES
Issue: Is it valid to use public company comparable companies as a benchmark to the valuation of closely-held companies? Revenue Ruling 59-60 states that the sales of comparable publicly-traded securities should be considered in the valuation process for private companies. Furthermore, various court cases as well as current valuation theory suggests that such an approach has significant validity. But, does it make sense – common sense?
Discussion: The use of the public company comparable, in my view, grew out of the real estate appraisal industry. Probably the most valid of all real property appraisal methodologies is the comparable approach. After all, what better proof of the value of property than to compare it with recent sales of similar properties. In real estate, this is relatively easy to accomplish. Sales occur somewhat regularly and properties can easily be compared in terms of physical attributes. In addition, it is easy to exclude sales that occur outside of the immediate market area. The concept of comparability is, therefore, theoretically and operationally valid.
The relevance and appropriateness of this approach, however, depends heavily (if not entirely) on one word, comparability. Furthermore, the word comparable leads one to the assumption of substantial comparability. It would make no sense to use, as a base from which to determine value, an asset that was only somewhat comparable to the subject asset. One would naturally rely on assets which were substantially comparable. The concept of comparability, therefore, as it relates to private and public companies, is the focus of this discussion.
Consider the comparability of closely-held companies to public companies:
- Private companies are considerably smaller.
- The capital structure of private companies is simpler and more straight forward. Public companies can have debentures, preferred stock, different classes of stock and even bonds. Private companies usually have only one class of common, voting stock.
- Public companies generally have greater depth and experience in their management team.
- Public companies are more diversified geographically and in terms of products and services.
- Public companies typically enjoy a higher lever of legal and accounting expertise.
- Public companies typically enjoy greater access to bank lines of credit.
- Public companies enjoy economies of scale that impact all areas of the business.
In addition to these issues of comparability, closely-held companies and the people who buy them exhibit certain characteristics:
- Interested buyers are interested only in a 100% control position. This differs greatly from the minority purchaser of a public company stock.
- The market for private companies is typically limited to a buyer who knows the business and is also interested in buying a job.
- The seller of a private company values his business based on Intrinsic Value, while the buyer is interested in Fair Market Value. Public companies trade only on Fair Market Value.
- Intermediaries for the sale of private companies include lawyers, accountants and business brokers. Therefore, the cost of consummating a sale is high. Intermediaries for the sale of public company stock are stock brokers, whose commission is comparatively low.
Conclusion: The above clearly suggest that the theoretical concept of comparability, while appealing intellectually, is often lacking in practical application. At the very basis of any business valuation must be common sense, or “street smarts”. Do not be dazzled by pedantic and ethereal concepts that have little application in the cold reality of the business world. While public company comparisons are sometimes appropriate, reason and sound judgement should rule the day.