Choosing a Discount Rate for Private Firms

Introduction

Deciding on the right discount rate when valuing a private company is rarely as straightforward as plugging numbers into a standard CAPM formula. You know how it goes in real life—private businesses usually come with a greater dose of risk: reliance on one superstar founder, narrower customer bases, limited liquidity, and so on. So if you’re thinking, “Hmm, a plain old CAPM approach might not fully capture all that,” you’re spot on.

This section explores those extra layers of risk and shows how analysts typically account for them, particularly within the income approach to valuation. Although we’ll spend much of our time on the all-important Build-Up Method, we’ll also check out how a traditional CAPM approach often needs to be expanded for private firms. By the end, you’ll (hopefully) feel confident about selecting discount rates for private businesses—whether you’re doing a straightforward capitalized cash flow model or a multi-stage DCF.

The Need to Adjust for Private Firm Risks

Private firms directly expose investors to several risks that public companies don’t face as severely:

• Illiquidity Concerns: Because private shares can’t be quickly offloaded on a major stock exchange, there’s a higher required return to compensate for that illiquidity.
• Key-Person Dependency: Often, the business revolves around an owner or a small group of people. If they leave—or get burned out—the business can collapse in a heartbeat.
• Ownership Concentration: A handful of customers might account for most of the revenue. Or a single product line might be the company’s entire bread and butter.
• Smaller Scale: Size definitely matters in risk. Smaller companies often face a tougher time accessing capital or sustaining large downturns.

In short, that discount rate needs to be higher to reflect these hidden (or not-so-hidden) red flags. If you forget to layer in these extra risk premiums, you could dramatically overvalue the company.

CAPM-Based Approaches for Private Firms

Sure, the CAPM approach was originally intended for publicly traded securities (where you can observe betas, etc.). But in private valuations, you can still do the following, with some modifications:

• Start with a Risk-Free Rate (usually a long-term government bond maturity).
• Add the Market Equity Risk Premium (ERP).
• Estimate or proxy a Beta for the private firm using comparables.
• Add a Size Premium if the firm is substantially smaller than typical public peers.
• Layer in a Company-Specific Risk Premium (CSRP) to capture unique exposures like key-person risk, illiquidity, or unusual product concentration.

Sometimes you’ll see Beta replaced by “fundamental betas” or “synthetic betas” derived from industry proxies, but the rest of the approach remains similar. For example, let’s say you’re valuing a niche craft brewery run by a single founder. If the public comparables (large beer companies) have a Beta of around 1.0, you might pin the private brewery’s Beta slightly higher or add a fatter CSRP, because the small, private company partly depends on that single founder for marketing, operations, and growth impetus.

The Build-Up Method

Because private companies often lack observable market betas, a lot of practitioners go with the Build-Up Method. Essentially, you start at a base risk-free rate and then add incremental premiums for each risk factor you identify:

    flowchart LR
	    A["Risk-Free Rate <br/>(e.g., Gov't Bond)"] --> B["Equity Risk Premium <br/>(Market Risk)"]
	    B --> C["Size Premium <br/>(Small Firm Adjustment)"]
	    C --> D["Industry Premium <br/>(Sector-Specific Risk)"]
	    D --> E["Company-Specific Premium <br/>(Key-Person, Illiquidity, etc.)"]

• Risk-Free Rate: Typically a long-term government bond yield.
• Equity Risk Premium (ERP): The average additional return demanded by equity investors over Treasury bonds.
• Size Premium: Sourced from historical data (e.g., Duff & Phelps or Ibbotson SBBI) to reflect the higher risk of small firms.
• Industry Premium: Sometimes pulled from industry-specific data if it exists.
• Company-Specific Premium: This is a catch-all for unique attributes—like reliance on one superstar salesman or concentration in a single geographic region.

Common Magnitudes

• Risk-Free Rate might be around 2–5% historically (though this can jump around with macroeconomic conditions).
• Equity Risk Premium can range 4–6% in many markets.
• Size Premium can range from 1% to 5% or more (some extremely small microcap data suggests even higher).
• Company-Specific could add, say, 2–5% again, depending on that firm’s special vulnerabilities.

Putting it together, a final discount rate can easily fall between 10–20+% for a small, private enterprise. It occasionally creeps even higher—especially if the business is in a volatile niche.

Cross-Checking Discount Rates

Once you compute a final discount rate, it’s helpful to do reality checks:

• Compare to Observed Private Transactions: If you have access to data on recent acquisitions or equity stakes in similar private companies, see if your discount rate lines up.
• Compare to Public Businesses: If your private discount rate is suspiciously close to a large public competitor’s cost of capital, you may be missing a chunk of private risk premium.
• Adjust for Economic Environment: In high-inflation or high-volatility periods, discount rates can shift quickly.

Also, consider that private deals often hinge on relationships, negotiation power, and synergy potential. So the “observed discount rate” might not always be purely an objective reflection of risk.

Capitalized Cash Flow vs. Multi-Stage DCF

No matter which discount rate you pick, it’s going to have a big effect on final valuation, especially if you’re using an income-based approach:

• Capitalized Cash Flow Method: Here, you assume a single measure of normalized cash flow grows at a stable rate forever. So you typically pick a single, constant discount rate.
• Multi-Stage DCF: If the firm is in a development stage or you expect shifting risk profiles, you might vary the discount rate by projection phase. For instance, maybe a 15% rate applies for the first few uncertain years, stepping down to 12% once the firm matures.

I once worked on valuing a small publisher that planned to shift its revenue mix from an older print catalog to fully digital products. During the transition, the company faced multiple expansions, rebranding, and additional marketing outlays—essentially higher risk. To reflect that, we assigned a higher discount rate in the early years. But as the digital strategy stabilized, we tapered it closer to industry averages.

Common Pitfalls

• Underestimating the Size Premium: People sometimes think small shops are less risky if they’ve been around a while or if the owner is “smart.” But from a market perspective, smaller is riskier.
• Forgetting Key-Person Risk: If a huge chunk of sales depends on personal relationships, the discount rate must capture that.
• Relying Too Heavily on Public Betas: Public betas are useful reference points, but the real-world operational risk of a private company can be dramatically higher.
• Failing to Scrutinize Industry Data: “Industry premium” might be inconsistent or dated. Make sure you’re using up-to-date, reputable sources.

Mini Case Example

Let’s take a fictional example—Ben’s Gourmet Baklava, a small pastry business relying heavily on local clientele and famous for its unique Middle Eastern desserts. Owner Ben is the star, and the brand is intimately linked to him being on site daily.

• Risk-Free Rate: 4% (10-year government bond).
• Equity Risk Premium: 5% (for the broad equity market).
• Size Premium: 3% (small local business).
• Industry Premium: 1% (baked goods category sees moderate volatility).
• Company-Specific Premium: 3% (Ben’s brand revolves around him personally, so key-person risk is high).

When we add these up, we get 4% + 5% + 3% + 1% + 3% = 16%. That might feel high, but we have to remind ourselves: this is a small, closely held operation with big reliance on one person. And that’s exactly why we add those premiums.

Best Practices and Critical Thinking

• Document All Assumptions: Regulators, auditors, or clients will want to see why you picked each premium.
• Use Multiple Sources: Ibbotson SBBI, Duff & Phelps Valuation Handbook, or other empirical studies.
• Make It Empirical: If possible, gather private deal multiples or discount rates of similar businesses.
• Update for Market Conditions: If interest rates rise significantly, rework your discount rate accordingly.
• Don’t Overcomplicate: Especially for stable small firms with well-known local markets, keep your approach systematic, but don’t weigh down your analysis with excessive (and perhaps spurious) detail.

References for Further Study

• Duff & Phelps Valuation Handbook: Offers size and industry premium data, widely used in practice.
• Ibbotson SBBI Yearbook: Historical risk premiums for bonds, stocks, and different asset classes.
• CFA Institute Materials: Look for readings in “Equity Valuation” and “Alternative Investments” for advanced coverage on private and illiquid investments.
• “Valuing a Business” by Shannon P. Pratt and Alina V. Niculita: Classic reference for general private valuation approaches.

Practice Questions: Choosing the Right Discount Rate in Private Valuation

Below are some sample exam-style questions to help you test your understanding of discount rate determination for private firms. Practice these, and you’ll be better prepped for the complexities of private valuation scenarios on exam day.

Test Your Knowledge: Discount Rate Essentials for Private Firms