“I would like to help my dad sell his company,” said another student, whose father owns an institutional pharmacy company serving nursing homes and assisted living facilities in the Midwest. “The price he is willing to accept is much lower than the value of his similar public competitors. The appraisal advisor told him that a 30 percent illiquidity discount is the norm that applies to private firms.”
Questions like these are raised frequently by the internationally diverse MBA students I have met at INSEAD and Wharton. In spite of the national specificities of each market for corporate control, these concerns seem to be universal. And for good reason. Sixty to 70 percent of U.S. acquisitions-even more in Europe and Asia-are private, yet there has been little research on M&A activity involving private firms. “My dad should not accept this sharp discount,” argued the pharmacy owner’s son. “Why should illiquidity of shares matter, since he is selling his entire company and not just a minority interest? Shouldn’t he just focus on the expected value of the future cash flows?”
My student had a relevant point. Most appraisers agree that a minority interest in a privately held company typically sells for less than a minority interest in a similar publicly traded company (a difference known as the discount for lack of marketability or “illiquidity discount”), and ample evidence exists to support the illiquidity discount for minority transactions. At the same time, appraisers disagree on whether such a discount should be applied to controlling interests of private companies.
Limited research on the subject has not yet suitably explained why private companies would sell under these disadvantageous terms. Among existing empirical studies, some fail to provide adequate support to explain this phenomenon, while others suggest there is more to the problem. In other words, this is not just an “illiquidity discount” but a “private firm discount” due to the specific unattractive qualities (greater risk, lack of transparency, lower visibility, higher transaction costs) of a private target in comparison with their otherwise similar public targets.
Several studies have found that owners of private companies normally sell their shares at a 20 to 30 percent discount during mergers and acquisitions. The private firm discount is one reason the stock market reacts more favorably to a private acquisition than to one whose target is a publicly listed firm.
In a study I conducted with Jung- Chin Shen, assistant professor of strategy at York University, on 101 acquisitions of private firms made by public acquirers, we found that the stock market reacts more positively to the acquisition of private targets, about plus-4 percent, while the average reaction to the acquisition of publicly listed targets tends to be negative.
The discrepancy is even more noteworthy because private acquisitions tend to be smaller than the average public acquisition, so the target’s weight in the combined equity is smaller, yet the effect is bigger. Beyond the numbers, what matters most for sellers of private firms is to understand the drivers of the “private firm discount” in order to capture a fair share of the value to be created by the acquisition.
Two main factors drive the “private firm discount” in an acquisition deal:
Cash flows of private firms are typically harder to estimate and are therefore discounted to reflect this higher risk.
The negotiation game is different with private sellers, who are less visible and often pursue non-value maximizing objectives.
Cash flows of private companies are typically discounted by most buyers who have conducted enough diligence to confirm a potential ambiguity in the actual cash flows versus potential cash flows post-acquisition. Cash flows are harder to estimate because less information is available on private targets. Many privately owned firms do not have accounting information as complete and organized as public firms. There is also ambiguity on the nature of the reported cash flows. Most private company discounts are indeed explained due to the fact that the financials always include an element of SDCF (“Seller’s Discretionary Cash Flow,” also known as “Owner’s Discretionary Cash Flow”). Many small business owners pay a lot of bills that are purely discretionary because they are deductible to the business but not to the individual. Private companies more frequently mix personnel-related expenses, compensation and gain sharing with corporate spend. Hence when a sale occurs, a lot of add-backs to the bottom-line have to be done to realign the financials, which is often a source of dispute over the fair value of the businesses, which leads to discount.
When estimating cash flows, difficulties increase in cross-border transactions, notably in cases where geographic, cultural and corporate distance is high. “On the cross-border front, many privately owned Chinese companies keep two sets of books,” notes Johann Tse, CEO of Aquarian Capital, LLC, and a middle- market investment banker focusing on cross-border M&A activity between the U.S./Europe and China. “When international companies make acquisitions of such firms, there is often a heavy discount on the value based on real numbers given the risks associated with noncompliance, change of business practice and the lack of systematic and transparent management information.”
Besides those issues associated with SDCF, it is also difficult to estimate the impact of the owner-manager’s departure on the capacity of the target firm to generate its future cash flows. Sooner or later, owner-managers leave the company after an acquisition, at which point the company loses the owner’s experience, contextual knowledge, resources and contacts. Many cases highlight additional latent resource and development costs that will be required to support the business when the founder retires- along with the risk that those additional resources might not make up for the loss in value associated with the owner’s departure.
Financials also need to be realigned to take into account the costs of those additional resources needed to ensure smooth transition and management continuity, which is also a source of dispute over the fair value of the business. “Most owner-operators of closely held businesses often do not clearly differentiate between the €˜sweat equity,’ opportunity cost of the management team in the company and the fair market value of the cost of the effort and involvement of the management team,” says Prashant Pathak, managing partner of ReichmannHauer Capital Partners, a private investment firm based in Canada.
“We have seen evidence in businesses where the founder-entrepreneur is his €˜own boss’ and has successfully built a commercial venture that paid him a €˜salary’ into a business. In one case, the founder-entrepreneur of an automotive technology components company continued to head innovation and product development as president and CEO. A superficial look at €˜normalized’ EBITDA understated the true costs of innovation even after adding costs of new resources, due to the €˜learning curve’ the founder had exploited in the business.”
Another important source of the private firm discount has a lot to do with behavioral finance issues. The negotiation game is often very different with private sellers (notably small family firms). While public targets are often bought and sold in an auction atmosphere, private targets are typically bought and sold through negotiations. Many private sellers stop the search after they find the first bidder. They typically lack financial resources, social connections or simply the mindset to use financial advisors who can help locate potential sellers and set up a competitive bidding process. Therefore, private sellers typically end up with a narrower pool of potential bidders. For instance, in the study mentioned above, we find that only 8 percent of private targets were bought by an acquirer outside of their own industry, while 24 percent of public targets were outside the acquirer’s core business.
In contrast with public sellers, private sellers are free from the pressure of the market to accept the highest bid, which allows them to have other priorities. Typically, private sellers negotiate for concessions rather than financial ones because they care a lot for employment retention and the community and, therefore, tend to accept a much lower price. Sellers of private firms tend to have weaker negotiation skills or at least lower acquisition experience than their public counterparts and pay a high price to obtain those “psychological benefits” for themselves or their employees. And one of the issues is that, for the most part, the acquirers do not live up to their promises after the deal.
In the case of succession planning and retirement-oriented exits, private sellers are more focused on maximizing the benefits to themselves (such as “in-pocket” money, deferred tax treatment, succession and retirement plans) as opposed to maximizing the company value. “We call this a result of €˜mismatched risk-reward time horizons’ and hence the seller and buyer end up being on different curves,” says Prashant Pathak. “In one case, the actual difference we observed between the cash value for a business and enterprise value was as high as 40 percent. The reason being the seller was genuinely indifferent between a 40 percent lower purchase price up front and a fully valued offer, adjusted for time value that was real and tangible but delayed over three years.
“For some sellers, buyers should not focus on the time value of money since it’s less important to the seller than the €˜money value of time.’ “
As a rule of thumb, private sellers should not accept a 20 to 30 percent discount to a private target. The discount, if a discount is there, has to be an important part of the negotiation and can be reduced by acting upon the different drivers I described earlier.
How can a business owner reduce the “private firm discount” in an M&A negotiation? Private sellers can first make efforts to reduce the uncertainty associated with the cash-flow evaluation. “We have worked with privately owned companies to help them prepare and present information as professionally as public companies and adopt internal control, accounting and financial systems similar to public companies so that their perceived value can be significantly improved,” says Tse. “This also applies to management systems so that owner-managers run their businesses as professional career managers and have HR systems that recognize and reward externally hired management to ensure sustainability.”
Sellers of private firms should strive to find mechanisms to enhance their visibility and convey the value of their assets through the use of several alternative mechanisms such as patent activity, formation of alliances and IPOs. Sellers of private firms should also be more proactive when searching for potential buyers for their firms and be careful not to be too naÃ¯ve when they trade their “psychological benefits” in exchange for a lower acquisition price. After the acquisition, acquirers are likely to implement restructuring measures they need irrespective of the “psychological benefits” negotiated during the deal.
Private sellers can certainly make efforts to increase their market – ability. If the burden of increasing the marketability of the target is on the private seller’s shoulder, there is no reason for the private firm to accept a discount of 20 to 30 percent of its estimated value. This discount varies across firms and industries and depends to a great extent on the difference in the risk of buying assets of a private firm versus those of a public firm. If the target spends considerable resources to reduce that risk by increasing its transparency, the rule of thumb of setting the private firm discount at 20 to 30 percent of the estimated value-used by many analysts and financial advisors-is useless. Thus, private firms should be cautious when they sell their companies not to take for granted that rule of thumb.
Private sellers have to find the optimal trade off between the amount of the resources they want to allocate to increase their firm’s marketability and the extent to which they want to eliminate the remaining discount of their firm in order to make their shareholders better off. There comes a point at which the additional expense of increasing the firm’s market – ability does not increase the value of the company.
Laurence Capron is professor of strategy at the international business school INSEAD and research director of the INSEAD-Wharton Alliance.