How External Factors Can Affect the Transaction Value of a Private Company

Valuation is the process of estimating the worth of a business based on its assets, liabilities, cash flows, growth potential, and market position. While these specific and internal factors play the primary role in determining the value of a private company, external factors such as market conditions, cost of capital, regulation, and specific industry dynamics significantly impact valuation. These external factors are not static, as they can change over time and depend on factors beyond the control of the business owners or managers. Private business owners should be aware of these external factors and their effects on the valuation of their business, particularly when they are considering a transaction.

External Factors Can Affect Valuation
Market conditions

The state of the economy, the industry, and the competition can have a significant impact on the valuation of a private company even if the company’s internal factors remain stable or constant. For example, during a recession, the demand for certain products or services may decline, creating concern about the expected future cash flows of any business affected. Conversely, during a boom, the demand may increase, boosting the growth and value of the business, and creating optimism about the expected future cash flows going forward. Similarly, the emergence of new competitors, technologies, or regulations can affect the market share, customer loyalty, and innovation potential of the business

Cost of Capital

The availability and cost of capital can also affect the valuation of a private company. For example, when a private company raises funds from external sources, such as banks, private equity groups, or strategic partners, it will have to give up some equity or incur some debt in exchange for the capital. In the world of investing, return is commensurate with risk. The greater the risk, the higher the need for return. Economic risk is measured by determining the rate of return required for an equivalent investment facing an equivalent level of risk. This rate of return is called the “discount rate”. The capital used to buy a company is typically a combination of debt and equity. Equity can be in the form of either company stock or cash, and debt is borrowed money the acquiring firm/company pays interest on. Each source of funds is obtained at a different cost, so the “weighted average cost of capital” is used to determine the “discount rate”.  As interest rates go down, present values go up, making valuations higher. A small change in the discount rate can result in significant changes in valuation.

The Regulatory Framework

The set of laws, rules, and standards that govern the operation and conduct of a private company and its industry influence valuation. Requirements and restrictions on the licensing, registration, taxation, reporting, auditing, compliance, and environmental practices of the company and its industry all factor into enterprise value. Typically, private companies that operate in highly regulated, complex, and uncertain industries have lower valuation than a private company that operates in a less regulated, simple, and predictable manner industry.

Industry Dynamics

The level of fragmentation or consolidation within an industry can also impact the valuation of a private company. In a fragmented industry, where there are many small players, a company may have more opportunities to grow through acquisitions and consolidation. This can increase the company’s market share, economies of scale, and bargaining power, leading to a higher valuation. On the other hand, in a consolidated industry, where there are a few large players, a company may face more intense competition and barriers to entry, which can limit its growth potential and reduce its valuation.

In conclusion, the valuation of a private company is not a fixed or simple calculation, but a dynamic and complex estimation that can vary depending on various external factors. Private business owners should be aware of these factors and their effects on the valuation of the business, especially when they are considering the timing of a transaction.