Private vs. Public M&A Deals: Got Divested Assets and a Stepped-Up Tax Basis?
When you start working in investment banking, you need to make a difficult decision that almost everyone overlooks…
No, not what types of toys you should buy with your signing bonus.
I’m talking about the types of companies you work with – not just the industries they’re in, or whether you work in an industry group or a product group, but something else entirely: whether your clients are public or private.
You might get a completely different experience and skill set depending on the type of company you focus on, and you might set yourself up for very different exit opportunities… or it might not make much of a difference.
But it’s usually not a “decision” at all.
The one you focus on depends mostly on your bank, group, and industry, and it’s something you get thrown into without much input – with consequences.
What’s the Difference?
You already know the basic difference: public companies are traded on the stock market, and anyone can buy and sell their shares relatively easily.
Private companies, by contrast, are not traded on the stock market (unless you count Second Market and similar exchanges) and liquidity is much lower as a result.
Unless you founded the company, work there, or invested in it at a PE or VC firm, you simply can’t buy shares.
Public companies disclose far more information, they’re tracked and covered by equity research analysts, and it’s much easier for you to invest in them.
But the more interesting question is what differences this distinction creates for you, the entry-level or aspiring financier:
Public companies tend to be run by seasoned, professional managers who have worked at many different companies before.
You may see a strong personality or the Founder at the top (Larry Ellison, Mark Zuckerberg, Jeff Bezos, etc.), but on the whole they tend to be less Founder-dominated.
By contrast, at private companies the quality of the team may be all over the place; you might see solid executives, or you might see a company that’s run entirely by a single family and the Founder’s brother and sister might be the “CFO” and “COO.”
Public companies are generally much bigger, revenue-wise, than private companies.
These days, it’s difficult to even be a public company without at least $50 million USD in revenue – but most businesses are small, private companies with revenue many times lower than that.
There are some exceptions (e.g. SAS Institute – the biggest private software company in the world, and many PE-owned companies), but private firms tend to be smaller.
The “culture” at many private companies tends to be quite random and is heavily influenced by the people at the top, whereas it’s more group-dependent at sizable public companies.
A lot of the “oddities” you saw in Cost of Capital at IonX, for example, are common at private firms where one person or a few key people are driving everything.
Yes, technically all companies above a certain size should have financial statements… but the quality varies widely.
Public companies almost always produce financial statements audited by the Big 4 firms and that are in-line with GAAP / IFRS (well, except for “companies” like Enron).
By contrast, you see more “quirks” on many private companies’ statements.
For example, very small firms might use cash accounting rather than accrual accounting, which is almost unheard of for large public companies.
They might also use non-standard revenue and expense recognition policies, and the Founders might apply “business expenses” in “creative” ways (use your imagination).
We’ll get into more details on valuation below, but the short version is that the methodologies (public comps, precedent transactions, and the DCF) are the same, but you have to make extra adjustments due to the lack of liquidity and publicly available market caps.
Private company sales are more likely to turn into extended auction processes, whereas public companies are bigger and require more discretion, and therefore use more limited and quicker processes most of the time.
Also, some types of deals simply aren’t applicable – a public company can’t “go public” in an IPO, and a private company can’t do a “follow-on” equity offering unless you count private placements in this category.
Some deal structures make little sense for private companies – for example, it’s almost impossible for a private buyer to use stock in an M&A deal unless it’s a high-profile private company that’s already worth a lot.
Asset purchases are more common with private companies, but are more difficult to pull off with public companies.
Believe it or not, everything above is just the “short version” of the differences that exist between public and private companies.
“Private Companies”: The Most Unhelpful Term Ever?
Further adding to the confusion is the fact that the term “private company” could refer to so many different types of companies and assets.
For example, you could argue that everything below is technically a “private company” since none is publicly traded on the stock market:
- Venture-Backed High-Tech or Biotech / Pharmaceutical Startups: The likes of Pinterest, Twitter, Foursquare, and so on. High-growth, high-risk ventures that could turn into massive corporations… or fizzle and fail.
- “Family” or Other Closely-Held Businesses: This runs the gamut – everything from bootstrapped guys in a garage that haven’t accepted outside funding yet to small businesses like bars or restaurants to massive conglomerates like Koch Industries and large companies in a specific industry, like SAS.
- Private Equity-Owned Companies: These also tend to be on the large side; examples include Freescale Semiconductor and Del Monte Foods, after their PE buyouts.
- Real Estate Assets: You could even argue that an apartment or office building is a “private company” of sorts, since it has employees, it generates revenue and has associated expenses and taxes, and there’s limited liquidity since you can’t just buy “shares” of a building (well, aside from investing in REITs).
- Oil & Gas and Mining Assets: The same logic applies here: is a large gold mine a “private company”? Well, sort of… in that it’s worth something, it generates revenue and has expenses, and there are employees required to operate it. And you can’t acquire shares on the public markets.
We might cover these examples in the future, but our focus here will be on the first two categories: startups and larger, privately held businesses.
So, Which One Will You Work With?
Your chances of working with a public vs. private company depend greatly on the type of bank (or other firm) you’re at and the industry or product group you’re in:
- Bulge Bracket Banks: You’ll rarely work with private companies unless they’re huge, PE-owned, and are thinking about exiting via an IPO or M&A deal.
- Boutique and Middle-Market Banks: Private companies are more common here since deal sizes tend to be smaller.
- Product Groups: You will rarely work with private companies in DCM or Leveraged Finance unless they are PE-owned and they’re looking to refinance debt. In ECM, you will only encounter private companies in the context of firms about to go public via an IPO. It’s a mixed bag in M&A and you’ll see both public and private companies, but buyers are far more likely to be public.
- Industry Groups: You’ll work with private companies more in groups like technology investment banking and healthcare investment banking because there are so many startups in those industries; clean tech and anything else with lots of VC investment is also a prime candidate.
So if you’re working at a technology M&A boutique, there’s a 99.9% chance that you’ll work with private companies at some point.
Types of Deals
There are dozens of different deal types: spin-offs, split-offs, split-ups, divestitures, equity carve-outs, asset sales, “plain vanilla” acquisitions, mergers, mergers of equals, sales of minority shares, and so on.
Here’s what’s relevant for this topic: “standard” deals such as 100% acquisitions tend to be more common with public companies, while you see more “off the beaten path” deals with private companies.
Some public companies do sell 10% or 20% of their shares to specific investors sometimes, but it’s more common to see this with private companies that raise venture capital or do a private placement.
Since public companies have thousands (or more) of shareholders, it’s difficult to get everyone behind the more unusual deal types.
But if a single person (or even a small group) owns 100% of the company, he or she can effectively do anything he/she wants: sell off specific assets, divest certain divisions, raise funds via a bank loan, or accept an equity investment for 10% of the company.
So What About Valuation?
And now we get to the fun part.
Public company valuation is well-known and is covered in all our courses, so I’m not going to repeat that here.
Before you even begin to value a private company, you may have to adjust many of the expenses and “normalize” them to industry-standard levels.
You might see highly over-compensated Founder-CEOs at many private companies – especially if the business is being run for income rather than growth.
On the flip-side, you may see the opposite problem as well: the company’s margins may be artificially inflated because the Founder/CEO doesn’t “pay himself” much, or anything.
This works because most private companies are “pass-through entities” (e.g. S-corporations, so there’s no corporate-level income tax) – so effectively the company’s profits simply flow through to the owner and he pays his personal income tax rate on them.
And then there are all the problems we mentioned above with non-standard revenue and expense recognition policies, non-business expenses being counted as business expenses, and so on.
So you need to look into these issues and make sure that your financial statements are accurate first – otherwise, the valuation will always be off.
Now for the actual valuation:
- Public Company Comparables: You still pick public companies and use them to value a private company… but you often apply a 10% up through a 20-30% discount to the values because of the private company’s lack of liquidity.
- Precedent Transactions: You don’t apply a liquidity discount here because Precedent Transactions already reflect the control premium paid to acquire the company – plus, the transactions might already include a mix of public and private sellers.
- DCF: Here’s where it gets fun, because it’s tough to calculate Beta, Cost of Equity, or WACC for a non-public company. Normally you use the comps to estimate values for all of these, and you might make further adjustments to account for smaller companies with less diversified businesses.
For many private start-ups, you wouldn’t even bother to use a DCF at all because it’s completely meaningless; it’s more common in healthcare and bio-tech, where multi-stage DCFs to value firms based on the potential market for new drugs are more common.
The DCF also tends to work better for larger, more mature private companies that are sponsor-backed and/or that have very solid comparables that you can use to calculate some of the numbers above.
Most of the other modeling differences arise depending on whether the buyer is public or private.
With a private buyer, a traditional merger model based on EPS accretion / dilution no longer makes sense because… there is no EPS.
And a private buyer also can’t issue stock or even raise debt as easily.
It doesn’t matter too much whether the seller is public or private for merger modeling purposes: the standard model still works, but you use a lump-sum total for the purchase price of a private company rather than assuming a premium and a per-share price and using that to calculate the total value, as you would for a public company.
The Deal Process
So what’s different if you’re working to sell a private company vs. a public company?
The normal M&A process we’ve described many times before still applies, and you still create marketing materials such as the CIM or OM, create a list of potential buyers, approach them, and share additional information in each round of the process.
The differences lie in the number and type of buyers you approach and at the end of the process where you work to close the deal and negotiate the purchase agreement.
Your buyer pool is more limited when selling a public company because the larger the company, the fewer potential buyers there are.
Also, discretion is much more important because news of an impending sale could cause the company’s stock to jump up, reducing the chances of a deal getting done.
Of course, few people take that seriously and so news of public companies being sold leaks quite frequently.
Banks tend to use a more extensive process for private companies and approach a wider range of financial sponsors and strategic buyers – because there’s no publicly traded stock and there are no institutional shareholders to answer to.
The End of the Process: Purchase Agreements and Closing the Deal
Most of the differences come at the end of the deal when you’re negotiating the final agreement.
Here’s an overview:
Almost all public companies sell themselves via stock purchases – the buyer acquires all assets and assumes all liabilities, including anything off-Balance Sheet, because there’s no one “owner” that can answer up to any trouble post-transaction close.
By contrast, you see asset purchases more often with private companies for both legal and tax reasons.
The buyer can step up the tax basis of the seller’s assets in an asset or 338(h)(10) deal and therefore deduct additional D&A, saving on taxes.
Legally, any buyer would prefer to pick and choose the assets and liabilities it acquires to prevent anything “toxic” from entering its possession.
In private company sales, it’s very common to see earn-outs where a portion of the purchase price is awarded only if the management team hits a certain financial goal.
You may see other forms of deferred payment as well.
Reps and warranties are also stronger since disclosures may be lacking, and there’s indemnification in case something goes wrong.
On the other hand, there’s no “fiduciary out,” where the seller is required to consider higher offers that come in, and there is generally no break-up fee.
You see both of those more frequently in public deals.
You rarely, if ever, create a Fairness Opinion for a private company sale since the legal requirements are less stringent and you don’t have thousands of shareholders to answer to.
This is great news for you, the analyst or associate, unless you really enjoy combing through filings searching for obscure information and non-recurring charges to obsess over.
There are 2 main methods of completing an acquisition of a public company: a tender offer, where the buyer offers to acquire shares directly from all the shareholders at a premium to current market price, and a “one-step” proxy statement where all the shareholders simply approve the deal after it’s already negotiated.
You can’t use a tender offer for the sale of a private company most of the time, because there are fewer shareholders and the control is concentrated in a few groups.
If the points above bore you to tears, don’t worry: the lawyers have to deal with most of this.
I almost feel bad for them: even consultants (the other group we love to poke fun at) don’t have it this bad.
The Work Itself
Beyond the valuation, how does your role as an analyst or associate differ?
You still complete many of the same tasks: creating / reviewing the marketing materials, management presentation, answering due diligence questions, and so on.
The difference is that you spend more time on some tasks and less time on others:
- Public Companies: More time spent on modeling hypothetical deals and a rigorous valuation for the Fairness Opinion; less time spent interacting with management and assisting with due diligence, since so much information is public.
- Private Companies: More time spent on “nitty-gritty” tasks like adjusting the financial statements and digging up information; more time also spent interacting with management and assisting with due diligence, since information is scattered and random.
You could make the argument that you do more “real work” with public deals, but that’s a bit of a stretch since it’s more dependent on the M&A deal type – broad process vs. targeted – than the public vs. private distinction.
Which One is “Better”?
This one depends on what you enjoy doing and your future goals.
The enjoyment angle is easier to explain: if you like more hands-on interaction with executives and managers, you’ll get more of that with private company work.
But if you hate finding obscure data and doing lots of grunt work making scattered information easy to understand, well, maybe you should “stay public.”
For venture capital, private company experience is much more relevant because VCs deal almost exclusively with private companies.
For private equity, both experiences are relevant and it depends more on the type of firm and the PE strategy it uses: public company deal experience will be more relevant at the mega-funds, and private company experience will be more relevant at smaller place.
With corporate development, it comes down to the type of firm you’re at and the companies they tend to acquire.
If you’re at a giant tech company like Google or Facebook that acquires or “acqui-hires” lots of small tech start-ups, private company experience helps a lot.
If you’re at a company that mostly focuses on consolidation plays such as merging with other huge companies, public company experience helps more.
On the public markets side (equity research, asset management, hedge funds, and so on), it’s an easy answer: you only deal with public companies, so experience following, valuing, and modeling public companies helps the most.
(Yes, there are exceptions and some hedge funds may operate more like PE firms, but those cases are rare.)
And if, for some unfathomable reason, you actually want to stay in investment banking for the long-term, it doesn’t matter too much which company type you focus on.
Your industry focus and deal focus will determine that for you.
And now we get to the obligatory “exit opps” section, where I resist the urge to slap myself repeatedly, poke out my eyes, and then dive into a pool of lava.
The short answer here is that working with public vs. private companies doesn’t make a huge impact on your own exit opportunities.
Those are determined mostly by your bank, group, and deal experience – yes, if you’ve worked in the Goldman Sachs TMT group, you won’t work with smaller private companies too frequently, but you’ll still beat out most others for positions at top VC firms anyway.
Your industry focus factors into this much more, plus how aggressively you network outside of work and how much you go beyond the usual headhunter route.
If anything, you should point to your public vs. private deal experience more in the context of your “story” and explaining why you’re interested in a certain firm, especially if you have to stretch the truth to say something convincing.
Should You Go Private? Or Stay Public?
It’s good to get exposure to both deal types if you can, just to compare and contrast and get as much material for your future “stories” as possible.
So just act like those companies that get taken private, go public, and get acquired and go private again.
But definitely keep all your own wheelings and dealings inside and outside of work “private,” unless you want to end up like certain 4-star generals who weren’t careful enough to do the same…
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