Bridging Valuations Between Private Companies, Public Companies, and Unicorns

We frequently speak with entrepreneurs looking to understand how public company valuations translate to their privately-owned businesses. The answer to this question is not clear-cut.

Investors usually characterize publicly-traded companies as having the following qualities:

• Deep and highly-qualified management teams;
• Broadly diversified portfolios of products or services;
• Scalable business models;
• Geographically diversified operations and customer base;
• Access to capital to fund growth initiatives and acquisitions;
• Shareholder access to high-quality and regularly reported financial information;
• In some instances, third-party analyst coverage, including projected financial information;
• Shareholders’ access to immediate liquidity.

The attributes of a small and niche privately-owned business rarely include the characteristics listed above. As a result, valuation multiples for smaller private companies can be significantly less than those observed in the public markets. The question then becomes, “How much lower?”

In some instances, the differences between small private companies and their larger publicly-traded peers can be vast. These differences may altogether reduce the relevance of the public markets on a private entity’s valuation. Recent transactions among similarly sized companies in the same industry or geographic markets can be more meaningful to ascertain business value.

What about unicorns?

During our conversations, the topic of industry “unicorns” (or privately-owned companies with $1 billion+ valuations) can arise, which is where the fun begins!

We live in exciting times characterized by easy access to a seeming abundance of information via the Internet. Unfortunately, the information available regarding valuations of private companies does not usually provide a complete view of all relevant valuation considerations. The result is a frequent misperception about the implied billion-dollar+ valuations and how they are determined.

Relevant to this topic, Dean Takahashi of VentureBeat recently published a fantastic article questioning valuations in the video game industry. In particular, he questions whether the valuations for unicorns in the video game industry are fair given comparable companies’ valuations in the public markets.

See also: Video Game Studio Valuations – June 30, 2021 Update.

Company valuation vs. value of investment securities

To bridge the gap between valuations of private and public companies, we need to identify the difference between a company’s overall valuation and the value of its investment securities.

A company’s valuation will typically consider all of the factors listed earlier in this article and more. Based on our experience, valuations of private companies with significant investor interest (including unicorns) contemplate several interrelated factors, including:

• Quality and depth of the management team and its ability to execute on a compelling strategic vision;
• Level of reliance on the founder(s) for leadership and innovation;
• Company’s stage of development and growth prospects, including its ability to differentiate itself in the market, the scalability of its products and services, and adaptability to changes in consumer/customer preferences;
• General attractiveness of the industry to the investor community;
• Potential for the company’s integration within a larger organization, and;
• Expectation of an exit via a synergistic buyer or a financial investor.

Other factors could be listed, but these fundamental considerations have come up most frequently in the deals we have seen over the years.

We mentioned “implied valuation” previously as we see this term used regularly with highly-publicized transactions. Implied valuations are extrapolated from the amount paid for a specific security. Here is a simplified example:

ABC Company has 10 million shares outstanding.

An investor buys in at $1.00 per share.

The implied valuation is $10 million.

Easy, right? Not so fast.

When looking at implied valuations, the nature of the investor and features of the investment security involved in the transaction can be as critical as the company’s overall valuation.

Many investors involved in private company transactions have access to a substantial amount of capital, a sophisticated deal team, and a higher level of risk tolerance than the average retail investor. This type of investor may be willing to pay a premium to invest in a company with high expected returns, especially when they believe in its business objectives.

However, the securities they invest in are often structured to mitigate a certain degree of investment risk. Let’s look at the simplified example again, this time with a real-world fact pattern.

ABC Company has 10 million shares outstanding: 9 million common shares and 1 million preferred shares, which convert into common stock at the investor’s discretion.

An investor with a significant personal interest in ABC Company’s mission statement buys the 1 million shares of convertible preferred stock at $1.00 per share.

The convertible preferred stock provides a 10% annual dividend return. The common stock pays no dividend.

The convertible preferred stockholder can elect one member to the board of directors. Common stockholders vote pro-rata for the other four members of the board.

Finally, suppose ABC Company liquidates the business. In this case, the preferred stock provides the investor with a liquidation preference of $1.00 per share. This preference guarantees that the investor will receive money before any of the common shareholders.

Is the implied valuation still $10 million with this additional detail? Likely not and here’s why.

One would likely conclude that an investor would assess higher value to one share of preferred stock relative to one share of common stock. The preferred provides an annual dividend and provides better financial security. The holder of the preferred stock also holds 20% of the voting power of the board of directors (1 of 5 total members). In addition, an investor in the preferred stock could decide to convert the preferred shares into common stock if such an action is beneficial.

If the investor paid $1.00 per share of preferred stock, then we would likely conclude that the value of each share of common stock is less than $1.00. Therefore, the implied valuation would be less than $10 million.

Controlling and non-controlling private company transactions

In our experience, many private company transactions (both controlling and non-controlling) take on structures that protect new investors against declines in business value. The general public lacks adequate information around these transactions to correctly assess the reasonableness of their valuations.

In transactions involving the purchase of controlling interests, we tend to see purchase price structures designed to mitigate risk to the buyer. For example, the deal terms might tie a portion of the purchase price to the future financial performance of the business via an earnout or require critical members of the management team to remain as employees.

For non-controlling interest transactions, we frequently see deals structured to protect the new investor against declines in business value. Newly issued securities might offer their investors seniority in the capital structure, anti-dilution rights, or “guaranteed” annual returns upon a sale. The terms associated with these securities can be highly complex (and virtually impossible for an outsider to assess their true valuation).

Finally, let’s not forget that investments in private companies usually provide additional capital to grow the business enterprise. New money allows businesses to execute on growth initiatives, fund marketing budgets, develop innovative products and services, or add high-quality employees to the team. Business valuations can improve substantially after the effective deployment of new capital.

Tying it all together

All of the points above bring us to this conclusion: there is a disconnect between valuations in the public and private markets. The multiples of publicly-traded companies may be out of reach for many smaller private companies. This disconnect is generally due to the fundamental strengths that public companies have over small privately-owned enterprises.

There is also a disconnect between the valuations of highly-publicized private company transactions (including unicorns) and the general population of smaller privately-owned businesses. The proliferation of information via the Internet has improved our visibility into major deals. While these deals make for fun water cooler conversations, the general public does not have access to the level of detail needed to assess their valuations.

An experienced valuation expert can help entrepreneurs to understand their company’s valuation. However, a good valuation advisor can provide more than just a number. We can provide insight into how a private business benchmarks against its peers, key considerations to consider in improving its valuation, and more. If you have any questions about business valuation or this article, please feel free to reach out via phone, email, or LinkedIn.