Public company data often serves as the basis for valuing privately held businesses, because it’s readily obtained from a public stock exchange. But there are four important differences between these types of businesses that valuation experts need to consider.
1. Size
Public companies must achieve a certain “critical mass” to justify the costs of going public and complying with the ongoing reporting requirements of the Securities and Exchange Commission (SEC). The largest public companies are multibillion-dollar conglomerates with global business operations.
By comparison, there are many small private companies with under $10 million in annual revenue and fewer than 10 employees. They often operate as pass-through entities — that are taxed at the owners’ individual tax rates — rather than as C corporations. Smaller entities also tend to be domiciled in the United States and have limited market reach. They typically operate in one industry or geographic region.
2. Level of sophistication
Public companies typically have many shareholders who expect the company to be professionally managed and profitable. The SEC requires public companies to issue audited financial statements that conform to U.S. Generally Accepted Accounting Principles (GAAP).
Private companies vary in terms of management quality. Some are run like public companies with an emphasis on maximizing earnings per share. However, many closely held businesses strive to minimize their tax obligations — or they may focus on the owner’s philanthropic or personal objectives. Private businesses also tend to engage in related-party transactions, such as below-market rental agreements or relatives on the payroll.
The quality of financial reporting also varies among private companies. It’s common for smaller businesses to issue reviewed or compiled financials — or to follow a non-GAAP method of accounting.
3. Access to capital
Banks and private equity (PE) investors may be hesitant to finance private companies, especially those without formal business plans, audited financial statements
Small business owners tend to rely on their personal savings — or friends and family — to finance business operations. Are these forms of financing considered debt or equity? Informal loans may be unrecorded or stay on the balance sheet for years without incurring interest charges.
4. Internal controls
Private businesses are often managed by individuals who play multiple roles. As a result, they tend to have fewer internal controls to prevent fraud and cyberattacks than public companies do.
For example, private companies may not have enough employees to duplicate or rotate jobs. Or they may not have enough resources to implement a fraud reporting hotline or conduct internal audits — or even to perform a physical inventory count.
The Report to the Nations on Occupational Fraud and Abuse by the Association of Certified Fraud Examiners (ACFE) confirms that weaker internal controls often contribute to bigger fraud losses among private businesses. The 2018 ACFE study found that the median fraud loss among private businesses was $164,000, compared to $117,000 for public ones.
Ready, set, adjust
There’s a wealth of public company transaction data that often serves as the starting point when valuing a private business under the income or market approach. But adjustments may be needed when using public stock data to reflect the differences of operating a smaller, less sophisticated private entity.