CFA Level 1 Alternative Investments - Closely Held Companies

Closely held companies

LOS

m. explain how the legal environment affects the valuation of closely held companies;

n. describe alternative valuation methods for closely held companies and distinguish among the bases for the discounts and premiums for these companies;

Reference/Reading" Solnik and McLeavey

Closely held companies are those that are not publicly traded. Inactive traded securities are securities that are infrequently traded; Normally, they are securities traded on minor stock exchanges.

Limited information availability is an issue for analysis of such companies. Illiquidity is an obvious issue. In the valuation of such securites minority ownership issue needs to be brought in.

So the analysis of these securities require evaluation of legal, financial, ownership and illiquidty issues.

Legal Issues:

Closely held companies may be organized in a variety of ways. The options include: special tax advantaged corporations (subchapter S corporations in US), regular coprorations, general partnerships, limited partnerships, and sole proprietorships.

Case law defines terms such as intrinsic value, fundamental value an fair value. Valuation of closely held and inactively traded securities requires extensive knowledge of concerned law and the purposes of valuation.

[Reference: Pratt, s.P., Reilly, R.F., and Schweihs, R.P. Valuing a Business, 3rd ed., Chicago; Irwin, 1996]

Alternative Valuation Methods Applicable

The cost approach: Determining what it would cost to replace the assets of the firm or company in their present form and state.

The comparables approach: This approach involves developing a bench mark value based on the market price of similar but actively traded company, or the average or median value of the market prices of similar companies, in transactions made in the period close to the time of appraisal.

To derive the value of the firm or security or company concerned, the benchmark price/value needs to be adjusted for market conditions (there is a possibility that tbere is mispricing either on the lower side or higher side) and the unique features of the firm that differ from benchmark.

The income approach: Methods that Estimate any anticipated future economic income stream and discount them to find the value fall under this approach.