Appendix A

Corporate Finance Theory: Application to Private Capital Markets

Until the first edition of this book appeared in 2004, private market players had only corporate finance theories to explain the behavior of private capital markets. They were left to assume that corporate finance theories explain and predict actions in private markets. This book demonstrates otherwise. Left unsaid by academics is that corporate finance theories explain and organize public capital markets but were never intended to explain nonpublic capital markets. Private markets must be explained using theories tailored to experience in those markets.

Private Capital Markets is a Lewis and Clark–type survey of the theories and methods of middle-market finance. It is concerned with the manner in which these concepts relate to each other, to larger bodies of knowledge, and to what extent they may be mutually exclusive or internally limited. It connects the theoretical with the practical but never loses sight of its primary use in serving as a road map. For example, there is a valuation methodology developed in the world of market value. While we all know the world exists, standard valuation methods have not developed tools to chart or capture it.

A premise of this book is that middle-market finance theory holistically describes behavior in the private middle market. Further, much like corporate finance theory, middle-market finance theory emanates from meta-financial theory. Exhibit A.1 graphically represents the influence of meta-theories on corporate finance and middle-market finance theory.1

Thus, public and private capital market theories are theoretical siblings. Obviously, this assertion is not easily accepted by the academic community. Until the first edition of this book was released, private markets had not been viewed as stand-alone markets that required unique market theories to explain and predict behavior. Most academics still view private markets as the offspring of public markets and middle-market finance theory as the child of corporate finance theory. This book demonstrates otherwise.

Meta-Financial Theory

Meta theories are pervasive all-encompassing financial theories from which lower-level theories, methods, and tools are derived. Considered individually, they are powerful. Collectively, they reinforce one another and provide an open, systematic construct for the development of both corporate finance theory and private capital markets theory. Meta-theories are the theoretical parents of lower-level market theories. From a theoretical perspective, corporate finance theory and private capital markets theory are siblings. However, each capital markets theory is designed with particular needs and particular markets in mind.

Rational Man/Rational Market

Economists base a good deal of thought on the theory that rational men act in rational markets and make rational decisions. They posit that given timely and accurate information, individual economic actors, taken as a whole, will arrive at cogent, coherent decisions isomorphic with economic reality. This is the inherited tradition of economic thought derived from David Hume, Adam Smith, and John Stuart Mill.

Rational expectations take many forms. If one assumes that prices are not completely nonsensical, arbitrary, and unrelated to anticipated future value, then one is left to assume that investors base their decisions on anticipation or probability of those returns. Their assessment of the actions of others is relative to that judgment. If assets are systematically valued relative to future payouts, prices will be determined by individual assessment of the intrinsic value of those payouts. The highest form of the rational expectation argument is that prices form on the basis of expected future payouts.

The rational actor assumption powerfully enables economic analysis; however, it prevents economists from explaining large parts of human behavior.

Risk and Return

The concept of risk and return permeates all finance theory. Firms operate in an uncertain environment, and any calculation of return on investment must take the level of risk into account. To justify risky investment, there must be a commensurate level of return. The basic concepts are intuitively available; however, the formal linkages between them are a bit more difficult.

Risk and return analysis can be used in relation to a single asset or in relation to a group of assets. More specifically, return is defined as the realizable cash flow earned during a specified period of time, normally stated as a percentage. Risk is a statistical concept derived through applying knowledge of probabilities. Return is an estimate of the probability distributions of certain outcomes. All finance theory concerns itself with quantifying and analyzing the elements of risk and return. Risk and return taken collectively form the boundary around finance theory.

Private return expectations and public return expectations each form a foundation and a boundary for their respective disciplines.

Utility Theory

Utility theory, originally developed by the utilitarian philosophers, is central to major theories of finance. It is integral to understanding the concepts of risk and return and expected rates of return in relation to the goals of investors. Utility theory provides a framework for describing decision making under uncertain conditions.

Marginal utility is the additional utility an investor receives from an incremental change in wealth. It is a measure of the increase or decrease in utility derived from a change in total wealth by one unit. Investors make decisions using the concept of diminishing marginal utility. That is, investors derive less and less incremental utility from each additional increment in total wealth. Perhaps this is why beer is sold in-six packs.

Most people invest to make the best use of their resources. They hope to maximize their utility by investing in risky investments that increase wealth and contribute to their happiness. In short, they seek the maximum utility for their investment. The capital asset pricing model (CAPM) and Private Cost of Capital Model developed in the first part of this book are derived from utility theory.

General Equilibrium Theory

General equilibrium theory can be traced back to the work of Leon Walras (1837–1910). He developed a mathematical theory of general equilibrium that is a major tenet of current economic thought. His model demonstrated the exact conditions under which equilibrium might be achieved, with everyone acting on individual self-interest, in a perfectly competitive market with complete flexibility in shifting resources from one use to another. In this theory, an economy is in equilibrium when production is matched with consumer preferences, and the highest level of benefit is achieved given existing resources and technology.

The Walras equilibrium theory led to a theory of supply and demand in a system of equilibrium similar to Adam Smith's but on stronger theoretical and empirical footing. For example, when funds are allocated between savers and investors, at a price commensurate with the risk involved, that is an efficient market because risk and return are in equilibrium. In equilibrium, the supply of funds equals the demand for funds, or the supply of business for sale equals the demand for these businesses.

An efficient market is a market in equilibrium. Levels of market efficiency are discussed throughout this work. Capital market efficiency is concerned with the behavior of prices in a free market system. This leads to the fundamental question of the efficient market theory, a pillar of corporate finance theory: Do prices of assets in a particular market accurately reflect all of the necessary information available? Better and more timely information renders the public capital markets more efficient than the private markets. It is less clear, however, what role asymmetric information plays in determining private market pricing efficiency.

Equilibrium theory pervades all financial theories. It is found in the principle of substitution necessary for market theories of value comparison. For the concept of substitution to work, substituted values must be equivalent. Failure to meet this equilibrium or substitution principal may subject an argument to the logical fallacy of irrelevance.

Irrational Man

Motives of individual owners ground private capital markets theory. Occasionally those motives are not easily accessible through rational explanation. Since the time of Aristotle, thinkers have focused on the dichotomy sometimes identified as the mind/body problem and other times cast as rational/irrational man. Irrational behavior also can be studied, but doing so requires different approaches and methods.

Some economists offer rational choice theory as an assumption. But it is a huge assumption adopted in order to make economics more like the physical sciences in terms of explanatory and predictive power. The assumption entails a normative assessment as to how people should act as opposed to how they actually act. Adam Smith chose a narrative approach to the subject rather than a strictly analytical approach and developed useful insights. Charles Kindelberger, in Manias, Panics and Crashes, presents a brilliant description of man as an economic actor when he is acting less than rational.2

An active school of economic theory now is reflected in recent Nobel Prizes in Economics. In 2002 Vernon Smith and Daniel Kahneman received the Nobel Prize for their work in experimental economics. Their major contribution was developing experimental methods for explaining why people do not behave as economic theory suggests they should. In his 2001 Nobel Prize acceptance speech, George Akerlof brought to economics insights from other disciplines, including fairness, reciprocity, loss aversion, and procrastination, to help explain why real economic actors do not always do what general equilibrium theory predicts they will do.

Motives set economic processes in motion. For the individual owner of a middle-market business, motives initiate the process of triangulation, whether those motives are rational and well considered or not. Motives can be studied even if they are in blatant disregard to economic theory.

A number of meta-theories other than those just named influence public and private capital markets theories. Several deserve mention. Information theory is central to all markets. Availability, accuracy, and access to information shape market mechanisms and directly affect market efficiency. Decision theory explains how people acquire and analyze information before making decisions. In its capitalist form, decision theory argues that preferences among risky alternatives can be described by maximizing expected monetary value. Obviously this is the basis for investor decision making. Game theory explains decision making in conflict situations, involving two or more decision makers. Game theory illustrates the behavior of decision makers with different objectives or those who share the same resources. In other words, it studies how players act in a market. Further, mechanism design theory, or market design theory, asks about the consequences of different sets of rules. The design of certain market mechanisms, such as auctions or credit allocation devices, affects players’ ability to meet goals.

Corporate finance principles and theories are taught in all business schools. A great deal of work and research has been done in all areas of corporate finance theory and the applications of that theory. Much of the methodology at work within public capital markets is directly derived from, or conditioned by, these corporate finance theories.

Middle-market finance theory, and its related methods and practice, is currently taught in universities around the world, but to a much lesser degree than corporate finance. Although there are hundreds of thousands of individuals working in private capital markets as appraisers, financing sources, or various intermediaries, little academic attention is provided to the area. Therefore, only a scant body of organized theoretical knowledge is available. This book addresses that situation.

The remainder of this appendix describes various corporate finance theories and shows the implications and applications of these theories to the private capital markets.

Corporate Finance Theory

Numerous theories comprise corporate finance theory. Summaries of some of these theories are discussed next.

Net Present Value

Net present value (NPV) is an elementary concept for treating the time value of money. A dollar received immediately is preferable to a dollar received at some future date. As a capital budgeting technique, it is necessary to determine the expected net cash flows of an investment, discounted at the marginal (or some risk-adjusted discount rate) cost of capital, then subtract from that the initial cost outlay of the project. A project would meet the selection criteria if its NPV were greater than or equal to zero. A project with a positive NPV earns more than the required rate of return. In this circumstance, equity holders earn all excess cash flows because debt holders have only a fixed claim. Equity holders’ wealth increases by exactly the NPV of the project. It is this direct link that renders NPV important in financial decision making.

Capital Asset Pricing Theory

Capital asset pricing theory is a fundamental financial theory that defines the opportunity cost of a firm's capital budgeting decisions. It is designed to specify the expected relationship between rates of return and risk where the required return is the risk-free rate plus a risk premium. This theory, and the models derived from it, provides useful estimates of the rates of return required on risky public securities.

Developed in the 1960s, capital asset pricing theory, or the CAPM, is an extension of Harry Markowitz's portfolio theory. Measuring total risk is accomplished by determining the variance of portfolio returns. Measuring risk in an individual security in equilibrium is accomplished by determining its contribution to total risk. Two individuals, Sharpe and Linter, demonstrated that this relationship to total risk is measured by the covariance of the individual return on the portfolio of all assets. Systematic risk is the term given to describe this risk measure. Asset pricing theory analyzes the opportunity cost of capital for the firm's capital budgeting decisions. The CAPM concept can also be applied to an arbitrage pricing model. First developed by Ross in 1976, the arbitrage pricing model allows the use of multiple factors to explain security returns.

Efficient Market Theory

The efficient market theory is an analysis of the behavior of prices in a free market system. It is concerned with whether prices accurately reflect all of the necessary information to determine that scarce resources are efficiently allocated among a variety of competing uses. In a perfectly efficient market, it would be impossible to make an excessive profit by trading on information not available to all interested parties. In a perfectly efficient market, the net present value of a transaction is zero. The immediate availability of inexpensive relevant information is a linchpin of the efficient market theory. According to the theory, when markets reach this efficiency, they are said to be in equilibrium.

The efficient market theory is among the most extensively studied theories in all of corporate finance, particularly as it relates to equity prices in the public markets. Often it is separated into three levels of strength according to the strength and timeliness of the impact of information availability on prices: strong-form efficiency, semi-strong efficiency, and weak-form efficiency. The efficient market theory indicates that prices should fully reflect all relevant information, but it does not necessarily describe the process for arriving at efficiency.

Portfolio Theory

Portfolio theory is built on the premise that the risk inherent in any single asset, when held in a group of assets, is different from the inherent risk of that asset held in isolation. Rumor has it that portfolio theory is like the bookie at the racetrack who “lays off,” or hedges, a bet in order to bring total risk to a level he is comfortable with. The basic concept of portfolio theory is intuitively available and has been used for centuries. The specific applications discussed here rely on the development of probability theory and modern statistics.

Harry Markowitz introduced the basic concepts of portfolio theory in the 1950s. He developed an analysis of how it is possible to select the optimum combination of assets to maximize return while minimizing risk. Assuming an efficient market, that is, that all relevant information is available, Markowitz's portfolio theory demonstrates that by using two parameters of distributions—the mean or expected value, and the variance or standard deviation—it is possible to assemble a portfolio that achieves maximum utility. The analysis provides a formal approach to the measurement of diversification. Mean variance analysis is used to measure the contribution of the covariance among returns and risks and establishes rules for building an efficient portfolio.

Portfolios are combinations of assets that offer the advantage of reducing risk through diversification. Portfolio theory analyzes the relationship between the diversified components, so that positive standard deviation levels are available at every level of expected return. Through this analysis, it is possible to develop accurate understandings that range beyond financial assets such as stocks and bonds. The analysis is applicable to physical assets and other capital budgeting questions and is also used in a variety of other applications.

Option Pricing Theory

Option pricing theory builds on the CAPM linking current asset prices with expected economic benefit streams. Many decisions faced by managers involve knowledge of the value of assets that are contingent on the value of other assets. Call options are options that give the holder the right to buy a stipulated number of securities at a given price for a fixed time. In 1973, Black and Scholes developed a model to value call options. Their theory indicates that a risk-free position is possible by maintaining a hedge between an option and its stock when the hedge can be adjusted continuously over time. Under the Black-Scholes model, the return to the hedge must equal the market risk-free rate yielding an expressed value for the equilibrium call price.

Extending the Black-Scholes analysis, assuming a firm's cash flow distribution is fixed, option-pricing analysis can be used to value other contingent assets, such as equity and debt of a leveraged firm. The equity of a leveraged firm could be treated like a call option on the total value of a firm's assets, with an exercise value equal to the value of the debt and an expiration date equal to that of the maturity of the debt. The Black-Scholes model could be used as a valuation model for a firm's equity and debt. This covariance indicates that an increase in a firm's asset value increases the economic benefit stream to the equity and also increases the debt coverage, thus increasing the current value of both. Conversely, an increase in the value of the debt increases the debt holder's claim in the firm's assets, thus increasing the value of the debt while reducing the value of the equity. Time is the third covariant; increasing the repayment schedule of the debt increases the riskiness of the debt and lowers its return.

Agency Theory

Agency theory is that area of corporate financial theory that is concerned with examining the relationship that occurs when principals engage other individuals to perform some service on their behalf, and it involves delegating some decision-making authority. It examines the costs to owners when others manage the firm. It includes questions such as monitoring expenditures to restrict inappropriate behavior by managers while providing sufficient incentives for them to perform. In the case of large public companies, agency theory analyzes the relationship between those who manage the firm on behalf of those who own the equity of the firm. The theory is concerned with aligning the incentives of owners and managers to overcome the inherent conflict in the situation.

Modern agency theory developed in the 1970s with the work of Jensen and Meckling, who defined agency costs as the sum of all costs involved in structuring contracts including bonding costs, expenditures by the agent, compensation including bonuses and warrants, and all residual costs. Jensen and Meckling indicate that the agency analysis can be used to resolve conflict of interest between owners or principals and managers or agents. Inherent in the agency theory is the modern theory of the firm where management and risk sharing are often separated.

Application of Corporate Finance Theory to Private Capital Markets

Exhibit A.2 compares the application of a number of corporate finance theories to the private capital markets. Since public and private theories have the same parent, they share many similarities. For instance, private capital providers use the tenets of portfolio theory to manage their portfolios and diversify risk. Conversely, portfolio theory does not uniformly explain behavior in the private capital markets. For example, private owners cannot use portfolio theory to diversify their ownership risk because they have nearly all of their wealth tied to one asset.

EXHIBIT A.2 Application of Corporate Finance Theory to the Private Capital Markets

Corporate Finance Theory	Application to the Private Capital Markets
Net present value	Theoretically correct for all firms. Used primarily by public companies. Less than 10% of private companies use NPV to make investment decisions. Research shows this is mainly because small companies are unaware of the tool.
Capital asset pricing theory	Measuring risk and return is a core concept for all markets. The use of beta and other assumptions lessen the utility of the capital asset pricing model for private companies.
Efficient market theory	Applies to both private and public markets. Private capital markets are much less efficient than public markets.
Portfolio theory	Value worlds view the firm as a portfolio of risky assets and liabilities, each with an expected return that can be calculated. Requires diversification of assets to minimize portfolio risk, which is impossible for a private owner-manager. Portfolio theory is widely used by private capital providers to manage risk and return.
Option pricing theory	Options theory is primarily used for corporate finance. Since private companies do not trade on an exchange, volatility, the degree to which stock price changes exceed their historical average, cannot be measured to support the theory. Used by private firms to assess business options, including stock options, lease options, and buy/sell provisions. A version of options theory helps explain the valuation of transfer alternatives faced by private owners.
Agency theory	Agency theory explains how to best organize relationships in which one party determines the work, which another party undertakes. Strong management adds to the value of a private firm. Issues exist even for owner-managed private firms. Authorities in the private capital markets can be viewed as agents that provide constraints and rules to the parties.

Net Present Value

Net present value incorporates the time value of money into the investment decision process. There is no dispute about its theoretical utility. Do private companies use NPV to make investment decisions? The answer is usually no. Obviously, no matter how great the concept, its usefulness is limited if not applied.

Researchers Walker, Burns, and Denson studied 213 private manufacturing firms with fewer than 500 employees. They found only 9% used discounted cash-flow techniques, of which NPV is the major tool.3 The other 91% use simpler methods for making investment decisions, including project payback, accounting rate of return and, of course, gut feel.

The Walker research found 66% of small firms studied are unaware of the NPV method. This figure is surprisingly high and probably will improve as more business school graduates flock to small, private companies. Interestingly, they found 26% of small firms familiar with NPV decide not to use it for several reasons.

The authors found perceived success rates in capital budgeting of non-NPV users were higher than the rates of NPV users. The authors think that this may be misleading, since the smallest firms in the survey may not collect data in a manner that would enable them to make such a claim accurately.

Regardless of the reasons, small private companies do not routinely use NPV analysis. It is possible successful business owners, who shun NPV, normally compensate with an excellent gut feel for return on investment. Even project payback is a reliable analysis of return on investment if the payback period is less than two years.

Capital Asset Pricing Theory

The capital asset pricing model measures the rate of return required on risky securities. There are several difficulties in using the CAPM to measure risk in the private capital markets. Notably, none of the assumptions listed next supporting the CAPM are usable in the private capital markets. Further, the only way to test the CAPM directly is to see whether the market portfolio is efficient. Unfortunately, because the market portfolio contains all assets (marketable and nonmarketable, human capital, coins, houses, bonds, stocks, options, etc.) it is impossible to observe directly.4 Seven of the assumptions behind the CAPM are:

Beyond the difficulties with the assumptions, there are a handful of problems with measuring beta (the measure of market risk):5

• There is no single accepted source of data or method for measuring beta. Various services report different estimates of beta for the same industry and even the same individual stock.
• Betas are typically measured infrequently; therefore, they can be out of date.
• Betas are not available for many stocks, particularly for thinly traded securities. Stocks of thousands of public companies are not followed by a financial reporting service.

The most troubling assumption about investors in private companies is that they behave in the same manner as investors in public companies with well-diversified portfolios. Owners of private firms usually have most of their personal wealth invested in the business and therefore are not well diversified. CAPM is not strictly applicable for cost of equity or required return estimates for private companies. Therefore, it is incorrect to assume that investors have diversified all other sources of risk, both systematic and nonsystematic, and face only systematic risk that cannot be diversified. This fact alone destroys the CAPM's direct applicability to the private capital markets. Clearly, owners of private companies face both systematic and unsystematic risk, and risk/return models appropriate for private equity required returns should reflect this fact. The private markets apparently do not respond to CAPM.

Finally, the assumption that the market has perfect liquidity (assumption 7 listed earlier) is particularly troubling, given the lack of marketability for private stocks discussed in the next section.

Efficient Market Theory

The efficient market theory is an analysis of the behavior of prices in a free market system. An efficient capital market means security prices accurately reflect available information and respond rapidly to new information as soon as it becomes available. The private capital markets are far less efficient than their public counterparts. The primary difference is that pricing for private company securities occurs in a static market. Efficient market pricing depends on a dynamic market where information immediately impacts pricing. With no public exchange to ascertain current pricing, the private capital markets offer no such dynamism.

In fact, not only is there a substantial pricing efficiency difference between public and private stocks, there are built-in differences in their pricing. These differences make any direct pricing comparison between private companies and their public cousins problematic.

Price Difference: Stock Marketability

Investors are most interested in the marketability of an investment. It is difficult to sell an existing investment without an established trading market. The more difficult it is to liquidate an investment, the longer the implied investment holding period. In a long-term investment, the risk is greater. That greater risk requires a lower price to attract investors. According to many studies, the lack of marketability for private stocks, when compared with public stocks, should be a discount of at least 35% and probably considerably more.

Ready marketability adds value to a security. Conversely, lack of marketability diminishes its value. Private businesses do not enjoy the ready market of publicly traded stock. This difference must be considered when evaluating an interest in a private business with reference to prices of publicly traded stocks. Risks associated with illiquidity include the inability to dispose of an interest in the face of deteriorating company or industry conditions as well as the inability to sell the interest if the investor's personal situation demands it. The lack of marketability for a private company's stock can be examined from either restricted stock studies or pre–initial public offering (IPO) studies. A number of studies quantify the marketability difference between public and private securities.

Restricted Stock Studies

Restricted stock studies examine the issuance of restricted common stock of companies with actively traded public shares. The restricted shares issued are identical to the freely traded common shares of the public companies in every way except marketability. These restricted shares have some legal limitations related to their marketability.6

In 1977, the Internal Revenue Service took a position on this matter in the form of a revenue ruling (Rev. Rul. 77-287, 1977-2, C.B.319). This ruling, based on a study conducted by the Securities and Exchange Commission, states: “This research project provides some guidance for measuring the discount in that it contains information, based on the actual experience of the marketplace.” The ruling outlines four factors for guidance on the amount of discount that should be taken relative to the price of the registered counterparts of the stock in question.7

The factors outlined in the ruling include earnings, sales, trading market, and resale agreement provisions. In general, lower total sales or earnings of the issuer result in a higher discount to the registered stock. The more active the market in which the stock trades, the lower the discount. Nonreporting, over-the-counter issues demonstrated the highest discounts, while stocks with counterparts traded on the New York Stock Exchange had the lowest discounts.

In the Securities and Exchange Commission study, approximately 44% of over-the-counter companies experienced discounts over 30%, and almost 60% experienced discounts over 20%. Because of their smaller size, companies traded over the counter are more comparable to private businesses than the companies listed on the New York Stock Exchange.

A number of studies examine the magnitude of the discount for lack of marketability applicable to the appraisal of private stock:

• Milton Gelman studied 89 purchases of restricted shares by four closed-end investment funds over a two-year period; the discounts averaged 33%.8
• Robert E. Moroney studied 146 purchases of restricted securities sampled from 10 investment companies; the discounts ranged up to 90%. Most letter stock purchases were discounted between 15% and 35%.9
• J. Michael Maher studied the prices of restricted stocks compared with market prices of unrestricted stocks. The mean discount for lack of marketability was approximately 35%.10

There are a number of other restricted stock studies from the late 1960s and early 1970s. The studies provided average discounts from freely traded values of issuing companies ranging from 23% to 45%. The average of the nine major studies is 33%.

Pre-IPO Studies

A stock valuation's marketability discount can be determined by analyzing the relationship between share prices of companies whose shares initially were offered to the public in IPOs and the prices at which their shares traded immediately prior to their public offerings. John Emory conducted the first comprehensive study of this type.

Emory studied private transactions occurring within the five months prior to 593 IPOs completed from January 1, 1980, to December 30, 2000. The 593 companies used in the study were later-stage companies and were financially sound prior to the offering. Private sales and transactions took place at a 47% average discount from the price at which the stock subsequently came to market. Marketability discounts ranged from 3% to 94%, with a median of 48%.11 As the Emory studies show, even private companies that could go public suffer from a serious lack of liquidity.

Willamette Management Associates, a major appraisal firm, also analyzed pre-IPO studies using data from 1975 to 1993. It concluded that average discounts varied from time to time but were higher in all cases than the average discounts shown for restricted stocks of companies with an established public trading market. That is exactly the result one would expect. Of the hundreds of transactions analyzed, the discounts ranged from 24% to 55%, with a median of 46%.12

The evidence from the Emory and Willamette studies taken together is compelling. The studies covered hundreds of transactions over 19 years. They discovered that average differentials between private transactions prices and public market prices varied under different market conditions with a range from about 40% to 63%, after eliminating the outliers. This finding strongly supports the hypothesis that fair market values of minority ownership interests in private entities are greatly discounted from their publicly traded counterparts.13

In conclusion, private companies suffer from a lack of marketability because there is no ready market for their shares. This is the single biggest built-in difference between public and private stock valuation.

Price Difference: Cost of Liquidity

The cost of obtaining access to an established trading market is substantial. Flotation costs, or cost of selling stock in a public offering, often are used as a benchmark for quantifying the discount for lack of marketability for controlling interests. Flotation costs can amount to more than 10% of the offering, when all of the underwriting expenses are considered. A public corporation, even with no assets, has a high value attributable to its ability to raise equity capital without significant additional flotation costs.

Public companies also get more attention when they are for sale, primarily due to auction pricing. Majority interests in public companies transfer at substantial premiums over their normal trading ranges. Studies by Mergerstat Review, a publication that measures control premiums, show the average control premium paid in the past ten years has been in the 35% to 45% range.14

Since there is no active market for shares of private companies, pricing is set by buyers aware of the situation. This lack of marketability depresses a private company's stock in two ways.

Efficient market theory does not apply to private companies in the same way it applies to public companies because the markets are structurally different. Chapter contains a discussion of these structural differences.

Portfolio Theory

Applications of portfolio theory are apparent in other areas of the private capital markets. Generally, in the value worlds, it is possible to view the firm as a portfolio of risky assets and liabilities, each with an expected level of return that can be calculated. Treating the firm to be valued as a portfolio of assets, liabilities, risks, rewards, and related income streams is a far more sophisticated approach than treating it as a single isolated asset. For example, in the world of economic value, it is possible to measure the contribution to margin of a product line, where the strategic array of products is treated as a portfolio of investments.

Private capital is allocated based on segmentation of risk and the development of specialized instruments, methods, and personnel to achieve the optimum return at a given a level of risk. Segmenting risk and pricing it accordingly allows financial institutions to create a portfolio with optimum returns. Most banks and other lenders today utilize sophisticated portfolio management techniques to manage returns and insure that those returns exceed their hurdle rates. With these portfolio tools, lending institutions are able to ration credit more selectively. Banks, for example, may be driven by yield rather than a strict reliance on balance sheet decision making.

Option Theory

Option pricing theory as applied to the public markets cannot be ported to the private markets. Many of the variables associated with the Black-Scholes option model simply do not exist since private companies do not trade on an exchange. Once again, however, options are used every day in the private markets. Many equipment leases have options associated with end-of-lease decisions. Stock options are used throughout the private markets. Chapter suggests private owners have transfer options that have value. Much more work needs to be done in this area. But it is clear that option theory is implied and applied in many ways to the private markets.

Obviously, most middle-market private firms have little use for options pricing theory because they do not issue stock to the public and do not utilize these sophisticated capitalization techniques in assembling their capital structure. However, if Black-Scholes is understood in its broadest sense as a method of covariant analysis, a number of applications are possible in the middle market.

In the value worlds, a central argument of the current work is that value is a range concept. Not only are there a number of mutually exclusive worlds with divergent value ranges, values can range within each world. Therefore, covariance is an integral concept beginning with the discussion of the application of Monte Carlo simulation as a method for calculating the probability distribution of possible values of a firm. As indicated earlier, the Black-Scholes model can be used as a valuation model for a firm's equity and debt.

In private capital, a manager has some ability to choose among capital access points, and that choice is amenable to a covariant analysis. Within a number of worlds, Black-Scholes analysis or something similar to it is used regularly. In equipment leasing, leasing companies have used Black-Scholes analysis for years. That lessees do not use it only indicates that they approach the question using less sophisticated analysis. Asset-based lenders have the prerogative of using a form of Black-Scholes analysis in assembling their portfolio of investments. Business owners seeking financing often have the prerogative of determining the level of equity versus asset-based loans and mezzanine financing. Clearly layered financing requires an analysis of multiple variables.

In business transfer, business owners have their widest latitude to choose the channel they wish to accomplish the transfer in. Understanding this choice involves analyzing multiple variables of risk and return within and between the value worlds. Initially the project is too complex for an analysis like Black-Scholes, but as the number of choices is narrowed, there is no reason why a sophisticated analysis in not appropriate. Some transfer techniques directly involve option pricing theory. Buy/sell agreements frequently involve puts and calls that are, of course, directly amenable to Black-Scholes analysis. Employee stock ownership plans use calls by employees on the stock of the firm also rendering such analysis appropriate.

There is no question that option pricing theory was developed for, and is applicable to, the corporate finance needs of large public companies and investors in those companies. It is also clear that there are areas in the private capital markets where it applies. Moreover, it is likely that as middle-market finance theory matures, there will be more opportunities to apply option analysis in this market.

Agency Theory

In the middle market, most firms are owner-managed; therefore, approaches through agency theory require some modification. Owners often are confronted with the question of how to appropriately reward or compensate key employees and consider granting stock as a possibility. Management teams clearly add value to a company; balancing the cost of that value increment against the cost is an appropriate question for agency theory.

Private firms incur agency costs. In 2001, Schulze, Lubatkin, Dino, and Buchholtz published a research article concluding that family-managed firms incur agency costs as they invest in internal controls.15 The authors found midmarket firms are exposed to agency risks that are increased by the necessity for self-control rather than controls imposed by the market for corporate control.

In the value worlds, a fundamental rift is found between the world of owner value and other worlds involving investor value. Owners experience less agency cost and typically view less risk than investors. In a sense, the business actually may be worth more absent agency costs. However, management teams do add value, particularly in the world of market value where investors are more likely to pay a premium for a business whose management team helps ameliorate risk in the eyes of the investors.

Questions central to agency theory and common to owners of businesses of all sizes are: What form of equity should a firm issue? and Under what parameters and constraints should it be issued? As financing moves along the capital access pricing line, away from asset-based financing and toward financing involving intangible assets, the greater is the role of the management team. Mezzanine financing is based on two things that actually reduce to one thing: business plans and the management teams who conceive and implement them. Equity and mezzanine investors base their funding decisions on the efficacy of the agents they are funding. In short, they bet on management teams.

Agency theory also plays a considerable role in transfer. A strong management team allows an owner a broader choice as to which transfer world is available. Not only is it possible for management teams to add value, as discussed, but they can render a buyer's transition and ongoing operations more stable and less risky; thus, a broader range of buyers, and a broader range of transaction types, may be available.

Summary

Corporate finance theory was developed in the 1960s to explain the behavior of large companies in the public capital markets. Economists who originally developed these tools never intended for them to be used to predict the behavior of other markets. Certain corporate finance theories, such as net present value, the capital asset pricing theory, and efficient market theory, either are not used by owners of private companies or do not apply to private markets. Applying these theories in private markets is like utilizing the wrong tools in a tool box. Corporate finance tools were designed specifically to work on public market mechanisms.

Market theories are designed to organize and predict behavior in an underlying self-contained market. Each structure rests on a foundation of the purposes for which the activity is undertaken. Employing powerful theories in the wrong context leads to frustration and a loss of utility. For example, assessing risk using a theoretical structure applicable to one market while expecting a return in another market is serious disconnect. Middle-market finance theory is designed to reflect the reality of the private capital markets. It is also the beneficiary of a rich intellectual tradition conditioned by powerful meta-financial theories.

NOTES

1Robert T. Slee, Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interests, (Hoboken, NJ: John Wiley & Sons, 2004), foreword.

2Charles P. Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises (New York: John Wiley & Sons, 2000).

3Joe Walker, Rick Burns, and Charles Denson, “Why Small Manufacturing Firms Shun DCF,” Journal of Small Business Finance (1993), pp. 233–249.

4Thomas Copeland and J. Fred Weston, Financial Theory and Corporate Policy (Boston: Addison-Wesley, 1998), p. 211.

5Shannon P. Pratt, Robert F. Reilly, and Robert R. Schweihs, Valuing a Business, The Analysis and Appraisal of Closely Held Companies, 4th ed. (New York: McGraw-Hill, 2000), p. 180.

6A good source of information on this topic is: Christopher Z. Mercer, Quantifying Marketability Discounts (Brockton: Peabody Publishing, 1997.)

7“Discounts Involved in Purchases of Common Stock (1966–1969),” Institutional Investor Study Report of the Securities and Exchange Commission. H.R. No. 64, Part 5, 92d Cong., 1st Sess. 1971, pp. 2444–2456.

8Milton Gelman, “An Economist-Financial Analyst's Approach to Valuing Stock of a Closely Held Company,” Journal of Taxation (June 1972): 353.

9Robert E. Moroney, “Most Courts Overvalue Closely Held Stock,” Taxes (March 1973): 144–154.

10J. Michael Maher, “Discounts for Lack of Marketability for Closely-Held Business Interests,” Taxes (September 1976), pp. 562–571.

11John D. Emory, “Expanded Study of the Value of Marketability as Illustrated in Initial Public Offerings of Common Stock,” Business Valuation News (December 2001).

12Pratt, Reily, and Schweihs, pp. 344–348.

13Ibid, 348.

14Mergerstat Review 2000, Los Angeles, p. 24.

15William S. Schulze, Michael H. Lubatkin, Richard N. Dino, and Ann K Buchholtz, “Agency Relationships in Family Firms: Theory and Evidence,” Organizational Science, 12 (2), (March-April 2001).