When valuing shares in a private limited company, there are several key factors to consider: how much has been invested so far into the company, what sort of returns might be expected, and whether anyone else is likely to want to buy your shares.
What are shares?
A share is an equity unit of ownership in a company. There are different types of shares for public and private companies, such as preference, ordinary, redeemable, and others. The type of share a shareholder has will determine the power he has.
What is the difference between public and private companies?
Public companies are traded on the stock market. The market value is derived from market capitalisation. To calculate the market capitalisation, multiply the share value by the number of outstanding shares. Share value is calculated based on the demand for the company's stock and how much investors are willing to pay for the company.
A private company is not traded on the exchange, and its financial information is not publicly available. This makes it hard to value such companies as they are not subject to the same rigorous accounting standard and scrutiny as publicly traded companies.
Methods of valuation
Discounted cash flow method
Discounted cash flow method looks at the value of future cash flows and discounts them to obtain today's values. This follows the concept that future cash flows are worth less than today due to time and inflation. Using this calculation method involves assuming future cash flows and discounting them to find the net present value for these cash flows. A higher discount rate can be applied to a start-up due to a higher risk of failure in the company's infancy stage.
This method is prevalent however, limitations do arise when trying to choose an appropriate discount rate or forecast cash flows a few years into the future, especially for a start-up when things change drastically daily. Assumptions have been realistic however, the further you forecast, the less reliable the data gets, as many factors can impact future cash flows, such as the state of the economy, cost of materials and demand for the product, just to name a few.
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Net book value method
The book value involves valuing the fixed assets in business. You would take the original cost of the tangible or intangible assets and remove any depreciation (wear and tear costs) or amortisation.
What is depreciation and amortisation?
Depreciation is the wear and tear associated with using the asset. The best example would be a vehicle. The moment you drive a brand-new car, its value significantly decreases. Over the years, the vehicle's depreciation would eat away at the original cost reducing its value.
Amortisation is used to write off an asset during its useful life gradually. An example of this could be a patent with a life of 20 years. The closer the patents get to their expiration date, the less value it has. This must be reflected in the balance sheet using amortisation.
The net book value method can be an excellent way to value a private company in an asset-intensive industry like manufacturing, automobile or mining. It can get complicated when you are valuing a saas company as fixed assets won't reflect the potential future earnings. Therefore this method of valuation will almost always give a lower figure compared to others.
Price-to-earnings multiple represents the share price in relation to the company's earnings per share. For public companies, you would take the market value of a share and divide it by the earnings per share. Analysts use this standard ratio to establish if a company is under or overvalued in relation to its competitors and the industry average.
For example, if a company is trading at £20 per share and the earnings per share are £2 (earnings per share are calculated by dividing net profit by the number of shares issued), you would have a P/E multiple of 10 (£20/£2). This suggests that the market is willing to pay 10 times the current earnings per share.
When valuing private companies or start-ups, one could conduct comparable company analysis by taking the P/E multiple of a publicly traded company in the same industry and similar offering and applying it to the net profit of a privately traded company or start-up.
The hardest part of this method is finding a comparable company. If you are a start-up, it might be challenging to find a similar comparable company. Your offering might differ from an equal company in your industry due to a different offering, intellectual property or many other factors.
While there are many different methods of valuing a private company, and you will get a different valuation with each technique. Choosing the correct valuation method can depend on many factors, whether you are an asset-heavy company or a service provider, the aim of the valuation and how easy it is to find a comparable company. Valuing a private company won't be easy as it involves a lot of estimates and assumptions, which can result in being far from reality.
The UK accounting standards have a prudence concept that promotes being cautious and conservative when valuing revenue, expenses or other components. Although this can result in a less attractive valuation, the benefit is that valuations are more realistic and less risky for potential investors and shareholders.