The Private Company Discount

Abstract

When appraisers or investment bankers value a private company by reference to an otherwise similar but public company, they typically apply a discount. Most practitioners hold the view that this discount reflects the reduced value due to the relative illiquidity of private companies. They use estimates of this discount based on two types of empirical studies. One set of studies compares the prices at which publicly traded companies issue restricted shares in private placements to the publicly traded stock price. The argument is that the restricted shares are identical to the publicly traded shares but for trading restrictions and, therefore, the private placement discount must reflect their lack of liquidity. This technique to estimate the private company discount is flawed for at least two reasons. First, the private placement discount could be associated with a variety of factors, of which illiquidity is only one. Second, the private companies may be valued differently because of factors other than liquidity that have caused the firm to continue to stay private rather than choosing to list on an exchange. The other set of studies compares the prices at which companies go public with the prices at which shares were sold prior to the IPO. These studies suffer from some serious biases. For one thing, most of these private transactions are with insiders. Most importantly, we only observe these pre-IPO discounts for companies that are successful enough to go public. Unsuccessful firms never enter the sample. We present an alternative framework to estimate this discount. We compute four valuation multiples for a set of private transactions and a comparable set of public transactions. We then compare these two sets of multiples for both domestic and foreign firms and use the differences between the two as our measure of the private company discount. We find that for both the domestic transactions and foreign transactions, the discount for earnings multiples is statistically and economically significant. The discount using the book value multiples is significant only for domestic transactions and the discount using the revenue multiples is not significant for either the domestic or foreign transactions. We also estimated cross-sectional regressions to account for differences in size and historical growth rates between the private and public companies in our sample. Even after including these other explanatory variables, our results continue to indicate a statistically and economically significant private company discount.