Adjusting a Valuation for a Private Company

Take two identical restaurant chains with identical cash flows. One trades on an exchange; you can sell your shares in seconds for the last quoted price. The other is privately owned; selling your stake takes months of negotiation, lawyers and a buyer willing to take your word for the numbers. A rational investor pays less for the second one even though the cash flows are the same, because the stock, not the business, is worth less when it is hard to convert to cash. Private company valuation is standard valuation plus a set of adjustments for exactly that gap.

Start from the public toolkit, then adjust

The mechanics — DCF, comparable multiples — are unchanged. What changes is three inputs.

The discount rate. CAPM needs a beta, and a private company has no traded stock to compute one from. The standard fix is the build-up method: take the beta of a similar public company, strip out its capital structure to get an unlevered (asset) beta (see unlevering and relevering beta), then re-lever it using the private company's own debt-to-equity ratio. Analysts often add a size premium on top — small companies have historically earned higher returns than CAPM alone predicts, and private companies skew small.

The discount for lack of marketability (DLOM). Because a private stake cannot be sold quickly at a known price, its value is reduced by a percentage, commonly 20-35% for a minority stake, drawn from studies comparing restricted stock to freely-tradable stock of the same issuer, and from pre-IPO transaction studies.

The (lack of a) control premium. If the stake being valued is a controlling interest — enough to hire and fire management, set the dividend policy, sell the company — it is worth more per share than a small minority stake, often 20-40% more, because control has option value the minority holder does not get. A minority stake, conversely, gets neither the premium nor full information rights, and is discounted further for that.

A worked example

A comparable public restaurant chain has an equity beta of 1.3 and a debt-to-equity ratio of 0.4. Unlevering, using a 25% tax rate, gives an asset beta of $1.3 / (1 + (1-0.25) \times 0.4) = 1.01$. The private target carries a heavier debt-to-equity ratio of 0.8, so re-levering gives $1.01 \times (1 + 0.75 \times 0.8) = 1.62$. With a risk-free rate of 4%, an equity risk premium of 5.5%, and a 2% size premium for the smaller, private business, the cost of equity is $4\% + 1.62 \times 5.5\% + 2\% = 14.9\%$ — well above the roughly 11% a similarly-geared public peer would use, purely from the size and structure adjustments.

Now suppose a DCF on that private company, using the 14.9% discount rate, produces an equity value of $80m "as if public." A buyer purchasing a 15% minority stake, with no board seat and no ability to force a sale, applies a 30% DLOM: $80m \times 15\% \times (1 - 0.30) =$ $8.4m for the stake, versus $80m \times 15\% =$ $12m before the discount.