Friday, August 14, 2009

The value of private businesses in the United States

The vast majority of businesses in the United States are privately held, and approximately 99 percent meet a common government definition of "small." However, we know surprisingly little about the market values of these organizations. In this paper, we estimate the market value of privately held firms in the United States from sources on earnings, assets, and reported market value of multiple forms of business entities, including corporations, partnerships, LLCs, and sole proprietorships. We discuss various theoretical and practical methods of valuing assets, including those arising from economics, neoclassical finance, portfolio theory, and tradition. Concluding that most of them are not appropriate for valuing private firms, we use insights from dynamic programming and ratio analyses from traditional technique to produce a new estimate based on reported taxable earnings, net worth, and tax filing status. Using this approach, we estimate that privately held U.S. firms had earnings that exceeded those of publicly held firms in two recent years by a significant margin. Moreover, the market value of these firms exceeded that of publicly traded firms. We also conclude that policymakers, perhaps grossly, underestimate the true scale of "small" and privately held firms in the economy.

Keywords: valuation, small business, private business

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The market values of publicly traded companies are tracked on a daily basis by millions of investors, and "the stock market" is the subject of intense and nearly continuous media exposure. However, privately held companies employ the majority of workers in the United States, and produce the majority of the output. We know surprisingly little about the market values of these organizations, especially when compared with their publicly held counterparts. Such ignorance places policymakers, investors, and workers at risk when they make vital decisions about the economy in general and their individual roles within it. In particular, this lack of knowledge compromises the ability to make informed decisions in all the following matters: entrepreneurial management decisions; lending decisions where private firms (or firms that may become private) are involved; investment decisions by portfolio managers; pension decisions by both pensioners and pension fund managers; actuarial projections that involve private firm investments; public policy debates over "social security" and other assets available over the long term to fund retirement income; economic development policies for states and regions; and national tax and economic policy.

Ignorance of the market value of privately held companies also undermines many of the practices of modern finance, in which the stock market is used as a proxy for the total value of investment assets. In particular, the Capital Asset Pricing Model (CAPM) and other descendents of the mean-variance framework rely heavily on a simplifying assumption about investments: that the stock market serves as a valid proxy for the universe of equity investments available, and therefore the risks and returns of publicly traded stocks are the relevant focus of portfolio decisions by these investors. This will be discussed further below.

In this paper, we assemble data from a variety of sources on the assets, revenue, and earnings of privately held firms. Using these data, and employing a mixture of techniques, we estimate the market value of privately held firms in the United States, which may be the most important economic statistics for which there are no direct empirical data. We also demonstrate a methodology to revise this estimate in the future, and offer some suggestions for improving it.

In Section 1 of this paper, we assemble data on the number of business entities operating in the United States, define "privately held" companies, and distinguish them from other "business" entities. We also review stylized facts about "small" businesses. In Section 2. we survey the numerous classes of entities that file business tax returns, and categorize them into publicly held firms, privately held firms, and nonfirm business entities. In Section 3, we review the few available indicators of the value of businesses in the United States, including the Flow of Funds, stock market indices, and the Survey of Consumer Finances. Finally, in Section 4. we use all the foregoing material to estimate the market value of private firms, using several methods. We also compare our estimate with available direct and indirect estimates of the value of public and private firms. Section 5 closes with conclusions, some possible extensions, empirical tests of the findings, and limitations. We also include an appendix that surveys the valuation methods.

1. Information on Privately Held and Publicly Traded Firms

Most news media provide daily news about the major stock markets in the United States. However, the "stock market" includes only a small fraction of the firms in the United States. These are generally, though not always, larger and longer-established firms that have chosen the corporate form of organization for the advantages it offers to professionally managed firms that need capital investments on a large scale. As we will demonstrate below, far more firms, with larger earnings, are outside this well-publicized subset of American businesses. We start our analysis of privately held firms by looking at the available data on firms and their value.

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