The Cost of Capital for Middle-Market Companies
Esposito, Edward F., The CPA Journal
Using Middle-Market Finance Theory and the Pepperdine Private Capital Markets Project
Members of the baby boom generation who are approaching retirement age and own businesses should start thinking about exit and succession plans for their companies. Because CPAs must act as trusted advisors during this process, it is important for them to become familiar with the way private businesses are sold and financed in today's nonpublic markets, the availability of financing, and the cost of this financing (i.e., cost of capital).
There is an abundance of information on public companies; most CPAs studied corporate finance in college, learning how public companies raise capital and how the public capital markets operate. But little information has traditionally been available on private companies and on nonpublic, or private capital, markets (defined as the place where middle-market companies obtain capital). Thanks to the pioneering work of John K. Paglia, an associate professor at Pepperdine University, and Robert T. Slee, an investment banker and author of Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interest (Wiley, 2nd ed., 201 1), the veil over the private capital markets has been slightly lifted.
CPAs and valuation analysts now have a clearer picture of how private companies operate and how they raise capital from institutions in the nonpublic markets. This discussion highlights those insights, explains a new finance theory (the "middle-market finance theory"), and examines how capital is raised in today's economic climate. CPAs need this information to advise business owners on exit and succession planning, as well as on investment and finance decisions.
Private Businesses in the United States
Because CPAs act as trusted advisors for privately held companies, they know firsthand that such businesses dominate the U.S. economy. In fact, private businesses account for more than 99.9% of all U.S. businesses, as shown in Exhibit 1. Of the approximately 27 million businesses in 2007, only 6,500 were public companies. In addition, private companies generate nearly 50% of the U.S. economy and employment (Slee 201 1). Despite the dominance of private businesses in the U.S. economy, it is still not always understood how they obtain capital, how they are sold, and how their cost of capital is determined.
Public Companies versus Private Companies
The premise of Slee's aforementioned book is that public and private capital markets differ fundamentally in their structure and behavior. Exhibit 2 provides a concise description of the main differences between public and private companies. Almost all private companies never qualify to become public companies.
In a nutshell, almost all private companies are very illiquid investments. For example, an owner looking to retire from a fancy restaurant in Manhattan is lucky if she can sell her ownership interest in six months to two years; in fact, she might never sell it Due to this illiquidity, potential investors demand higher rates of returns on investments in private companies. In contrast, publicly traded stocks are highly liquid investments. For example, an investor in Apple stock can sell his shares immediately and receive the cash proceeds in three business days.
Middle-Market Finance Theory
When finance professors teach corporate finance theory, they either ignore private companies completely or, more typically, they assume that the financial motives and needs of private owners are the same as those of managers of large public companies (Slee 2011). Finance students are taught that the goal of private companies is to go public (Slee 201 1); however, as Exhibit 1 shows, less than 0.1% of companies are public.
Slee introduced middle-market finance theory; he illustrated this concept as the "middle-market triangle" Exhibit 3). There are three interrelated "sides" to middlemarket finance theory: business valuation, raising capital, and transfers of private companies. …