By Leslie Harrison
Private company valuation is similar to that for public companies, though governance and share structure can materially influence valuation outcome
Private companies range widely in size and in stage of development—from local family-run shops to high-growth startups, and from multigenerational family enterprises to private equity portfolio companies.
Common traits among these firms—at least from a share valuation perspective—are the private company shareholders’ limited access to public equity markets and the high concentration of ownership among few shareholders. These features need specific adjustments when valuing private company shares.
Other considerations particular to private company valuations include: (i) cost of capital adjustments to reflect size and company-specific risk factors; and (ii) financial statement adjustments to ensure appropriate treatment of related-party transactions.
Normalizing income and cash flows
Unlike publicly traded companies, private companies are not uniformly required to prepare audited financial statements, instead they may opt for a more economical but less rigorous ‘reviewed’ or ‘compiled’ financial statements. Since a reviewed or complied financial statement undergoes a less thorough process than audited financial statements, practitioners often devote extra attention to these statements especially as it pertains to income and cash flows.
While the process of adjusting financial statements is broadly similar across company types, private companies pay particular focus to related-party transactions. These transactions include owner-manager compensation, sales or exchange between affiliated entities, and leases for business-critical assets. Adjustments may be necessary to ensure these transactions are at a market rate.
Considerations for the cost of capital
Although not unique to private companies, size-related factors tend to be more pronounced in smaller enterprises. A limited customer base, narrow product offerings, or geographic concentration can lead to greater variability of income and cash flows compared to large, diversified publicly traded companies. To account for this, practitioners commonly apply a size premium to the cost of capital: the smaller the company, the larger the premium.
Beyond size, company-specific factors—such as dependence on key personnel, uncertainty on execution, or exposure to niche industries—may also justify additional premiums. Since the traditional Capital Asset Pricing Model (CAPM) does not inherently accommodate these bespoke risks, valuation professionals turn to alternative model such as the expanded CAPM or the build-up method.
In the expanded CAPM, the traditional formula is augmented by adding both a size premium and a company-specific risk premium. Meanwhile, the build-up method constructs the cost of capital by a simple summation of a set of premia to the risk-free rate: equity risk premium, size premium, company-specific premium, and industry risk premium. Both methods aim to produce a cost of capital that accurately reflects the risk profile of private companies.
Share-level premiums and discounts
Once the equity value of the private company is determined, further adjustments are applied to the share value to reflect certain rights or restrictions of those shares. Three common discounts—or, occasionally, premium—often applied are for lack of control, lack of marketability, and lack of voting rights.
Discount for lack of control
A discount for lack of control (DLOC) reflects the absence of some or all forms of control. A controlling shareholder, for example, can influence strategic decisions—appointing board members, setting dividend policy, pursuing acquisitions or divestitures, and more. A minority investor, by contrast, cannot direct these actions, even though they materially affect value. Because control carries economic benefits, shares or interests that don’t yield any control are inherently less valuable.
Practitioners estimate the DLOC by examining the premium buyers pay in public company acquisitions, with the price premium representing the control premium. The control premium is converted to DLOC with the following formula:
Discount for lack of marketability
A discount for lack of marketability (DLOM) reflects the restrictions on the sale of shares or the absence of a liquid market in which to sell shares. Shares of publicly traded companies change hands daily on exchanges, but shares of private companies often change hands only during liquidity events—such as in initial public offerings, share buy-backs, financing rounds, or sale of company. The uncertainty around timing of a liquidity event and the limited number of potential buyers reduce the value of the shares.
Practitioners estimate the DLOM by either examining restricted stock transactions, pre-initial public offering transactions, or option pricing models. Typical DLOM rates can range from 20% to 40%, but the precise discount depends on factors such as company share restrictions, expected timing of liquidity events, among others.
Discount for lack of voting rights
A discount for lack of voting rights (DLOVR) reflects the absence of the right to vote on corporate matters. In well-governed companies the discount is generally unwarranted, but in companies with questionable governance or poor management voting shares tend to exhibit a premium and, conversely, non-voting shares would warrant a discount.
Practitioners estimate the DLOVR by examining dual-class share structures in publicly traded companies. Where warranted, DLOVR discounts are usually modest, with most observations falling below 5%.
The value of professional expertise
Valuing a private company requires informed judgement, technical knowledge, and understanding of both market context and company-specific factors. Professional valuation experts bring this perspective to the table.
Practitioners help clients navigate the intricacies of financial statement adjustments, assess appropriate discounts and premiums, and determine a defensible cost of capital. More importantly, a qualified professional can identify potential pitfalls and align the process with its intended purpose-whether for litigation, tax planning, shareholder disputes, or transactions. By engaging a valuation specialist, clients get a comprehensive analysis that supports decision making.