The Difference Between Public and Private Valuations
Understanding the value of your business is no easy feat but is vital in order to raise capital, submit a public offering or exit the business. Having a realistic expectation of your business value will help avoid undue disappointment and wasted time. But get it wrong, and the consequences can be severe.
The most prominent example of this in 2019 was the failed public listing of WeWork. The company was growing exponentially and needed to raise capital to continue to scale. The people behind the valuation structured the original deal to market at a hefty price tag of $70 billion. This was all while the company was still making a loss.
Whilst there were a number of reasons the IPO failed, the overpriced valuation of the company played a significant impact on expectations and shareholder sentiment towards the brand. This can be seen in the fact that WeWork’s valuation dropped by more than $55 billion before it eventually withdrew its listing.
What’s clear is that investment banks, founders and early investors are struggling to value businesses correctly, particularly in the tech sector. Over the last few years, we have seen a number of overpriced IPOs from Uber and Lyft to Slack and Peloton, which are all now trading well below their offer prices.
So, if huge, publicly listed companies can’t get it right, how are mid-market businesses supposed to value their business to receive the best returns and ensure it’s not struck by an overpriced valuation scenario?
How Much Is Your Business Worth?
The easiest methodology to use is a benchmark comparison of Enterprise Value (EV) / EBITA or Price / Earnings (P/E) to equivalent listed companies. Listed companies have a daily feed of transactions and can produce a real-time P/E and EV/EBITA ratios based on current share prices. By reviewing similar listed companies, private businesses can have a clearer idea of how they stack up against listed competition and what their worth is.
However, for private companies, it’s not quite so simple. Unfortunately they will always be of less value in comparison to their listed counterparts. In some circumstances, this gap can be extreme. Listed benchmarks can generate EV/EBITA ratios of more than 10 times while most private companies generate EV/EBITA of more than 5 times. This is due to a number of reasons:
Market liquidity is the biggest factor. The ability to liquidate a position within a day attracts a valuation premium from investors. It also dramatically expands the pool of capital available to invest in your company. Super funds and passive index tracking funds all become buyers of your stock and they have much lower return hurdles. This helps to push the price of listed companies up, accentuating the gap in valuation against their private counterparts.
Too Big To Fail
Earnings multiples are not evenly applied across company size. In order to be listed, you need to be of a minimum scale for the additional costs to make sense. Therefore, often when a private company is comparing itself to a listed company, they are comparing themselves to a much larger company. Larger companies are perceived to be more likely to withstand a downturn than a smaller company and consequently attract a valuation premium.
Private companies that have not had to answer to external shareholders often understate earnings to maximise tax. However, the opposite incentive exists for publicly listed companies that want to report higher earnings on a regular basis. A common example is public companies capitalising certain development expenses, meaning profit is higher and they build a large asset on their balance sheet.
Private companies, on the other hand, will (wherever possible) expense these amounts in order to reduce profit and thus their tax liability in their period. Therefore, a direct comparison of earnings is often not valid and certain normalisations should be made to the earnings line before going to market in order to attract a fair valuation.
Challenging The Public Premium
When comparing your company against listed entities, on a like for like basis, public companies generally trade at a premium to private companies even if they are extremely similar. Although listed companies offer the opportunity for private companies to benchmark themselves in the market, attracting the high valuations of listed companies is often not possible.
To overcome this challenge, there are private equity firms whose main investment thesis is aggregating private companies and delivering them into a listed environment where they can attract a higher valuation.
Rather than pursue a complete exit, entering into a capital partnership with one of these firms for the next three to five years and then pursuing a listed exit together may be a way to realise a much higher overall outcome.
In a world where valuations are seemingly becoming more arbitrary, especially in the tech sector, private companies can improve their opportunities by working with a partner that can help ascertain a fair valuation for their business.