You are asked to value a private company for the purpose of a manager acquiring a stake therein. Do you multiply profits by 4 or EBITDA by 5? Elementary processes such as these completely miss the point. The important question to ask is: What is the manager buying? The answer to this question is extremely complex. Is the manager buying a right to employment? Is the manager investing in his or her store of wealth? Is the manager on an ego trip, buying the right to brag to clients, friends and family that ‘I own a share in X'? When performing a valuation it is essential to crystallise the objective to be achieved. The purpose of this article is to issue a warning about such ‘investments'. A follow-up article will address the issue of how to do such a valuation.
My second rule for creating wealth is never to acquire a minority stake in a private company. Why? Well, read on about some situations I have encountered.
A property developer acquired a 5% share in each private property investment company he developed, in lieu of his fees for managing these businesses. He figured that over time the property would increase in value, the bond would reduce and the value of the equity would go sky-high. In anticipation of retirement, he decided to cash in his investments, only to find that there were no buyers for a minority share in a private company that has never paid a dividend and has no plans to do so in future. The majority shareholders offered him 10% of the underlying value of the equity. He had to rely on his family to support him during his retirement years.
An investor acquired a 26% share in a private company. When the relationship between him and the majority shareholder broke down, the majority shareholder stripped the company of its business. When I valued the company, I found just a shell containing a small loan to an associate.
The manager of a private company acquired a minority stake based on an IFRS price earnings ratio of 4. The agreed exit strategy was that when she wanted to sell her holding, the shares would be valued on the same basis. Relationships started to deteriorate between the shareholders to the extent that they agreed to part ways. By the time the company's goodwill, plant and equipment, inventory and receivables had been impaired, profit for the year had disappeared. The value of her stake? Four x zero = zero.
A manager of a private company was offered a 10% share in the company, with the valuation done by a friend of the seller. He raised a bond on his home to pay for the shares. When the manager wanted out, I found that the original valuation was grossly overstated.
The sole shareholders of four separate companies operating in the same industry decided to merge their operations. A valuation was prepared for each company by discounting projected free cash flows for this purpose. The shareholder of the largest company ended up controlling the merged group, with the other three having minority stakes. One of the minority shareholders decided to sell his stake, only to find that it was worth a lot less than the original value of the shares he sold to the merged group. He had inadvertently destroyed wealth by agreeing to swap a controlling share in a small company for a minority share a large one.
Going into business is a great way to create wealth. However, the trick is to be in control of the operations. I believe that offering a minority share in a private company is not an effective way to motivate managers. There should be a direct link between effort and reward, e.g. commissions on the sales generated or a bonus based on clearly defined profits generated by that division. The link between effort and the increase in the value of the shares of a company is too far removed.
When the majority shareholder insists on the manager acquiring a share (I find it strange that a shareholder is prepared to dispose of such a valuable asset), I usually suggest that the majority shareholder writes a put option in favour of the manager at the entry price, less any dividends received during the period, plus a reasonable cost of borrowing. This suggestion is invariably positively received. I believe that this solution reflects a sincere offer by the majority shareholder(s). However, if you want to keep a cordial relationship with the majority shareholder(s), don't make this suggestion yourself. asa
Author: Charles Hattingh CA(SA), Chartered Financial Analyst, is the Managing Member of P C Finance Research cc.