So far in these sessions, we've talked about valuing primarily public companies, whether it's discounted cash flow valuation or relative valuation, but what if your task is to value a private business, a small private business or even a large private business? What's different about valuing private business? There are two aspects to a private business that I think make valuation a little more difficult. The first is there is no market value for the company right now. You're saying so what?
Take a look at the discounted cash flow valuations to public companies and think of how much used market values along the way use market values of equity and debt to get the cost of capital used market values of debt and equity to get a level beta. And when you were done with the valuation, you actually compare the value that you got to the market value to see if you're within shouting distance away. You should be. I'm going to take that market value away from you in a private business.
The second difference is that accounting statements might be difficult with public companies. There might be small differences across companies, but at least they follow a common standard with private businesses, especially small private businesses. The differences in accounting standards tend to be much larger. What does that mean when you're buying a private business? It's buyer beware. You cannot take the financial statements as is. And there are two issues at least that you will have to deal with. One is the owner might not charge himself or herself a salary.
The line between salary and dividends is a fine one. The second private businesses as an intermingling of personal and business expenses that might make the numbers a little deceptive. Here's the other thing to remember. Private businesses. If you're ever asked to value private business, the first question you need to ask is why motive matters? Because the value attached to a private business can depend very much on who the potential buyers. But I'm going to divide this discussion into four types of transactions.
You can have a private private transaction where one individual sells his business to another individual, can be a private to public transaction. Where you sell your business to a publicly traded company can be a private to IPO, where you're taking a private business public, not an option for most private businesses, but if you have one, you might take it. And the final scenario I'd like to talk about is a private company that sells a stake in itself to a venture capitalist.
Let's start with what I think is the most difficult of these scenarios are private, the private transaction in a private, private transaction. There are three big issues you've got to deal with along the way. The first is your potential buyer in this case, because it's another individual is unlikely to be diversified. You're saying so what? Almost everything we did in coming up with cost of equity in cost of capital for publicly traded companies was based on the assumption that the marginal investor was diversified, an assumption you can get away with, with most publicly traded companies, but with a small private business being bought by another individual, that's an assumption that's not going to stand up to scrutiny.
Second, in private businesses, you have to worry about what I call the key person. The founder or the owner of the private business might account for a big chunk of the value that you see in the business. If you're buying the business from that person, you've got to ask yourself the question if that person leaves, what will happen to this business? In most cases, that's going to lead to a discount in the value. And third final issue you have to deal with.
And it's an issue we dealt with and in part when we talked about public companies, is the liquidity that comes about when you buy an entire business and like buying a thousand shares in a public company, we can change your mind and sell the shares back. If you buy a private business, it's much more difficult to get rid of the business if you don't want it anymore. That leads to a liquidity discount. So let's start with the first issue.
How do you deal with the fact that investors and private businesses, especially if they're individuals buying the business, aren't likely to be diversified? Let's use a very simple example to bring home this process. Let's assume you have a business with a hundred units of risk. Let's assume that 20 of those units are market risk, macroeconomic risk risk. You cannot diversify away when you use a conventional beta. You're measuring the risk in those twenty units. If you're buying this business and you're not going to be diversified, you're going to be exposed not just to those twenty units of risk.
You're going to be exposed to all hundred units of risk algebraically. You're going to be exposed to five times as much risk as a diversified investor investing in this company. I'm going to use that insight to estimate what I call a total beta. And here's my measure of a total beta. A market beta measures your exposure to market risk. That's what we get when we run that regression. We use the slope or all the approach we use for public companies.
We would talk about market basis, a total beta measure, the exposure to total risk. You might wonder how am I going to go from market weighted toward total beta? Let me take a very simple example. Let's assume. You're valuing a privately owned retailer, a high end retailer to get Abeyta for the company. Here's what I did. I went and looked at publicly traded high end retailers debated that I got for those companies. On what basis was one point one eight?
That would be the better. I would have used to value a publicly traded high end retailer. But you're a buyer of a private business where you cannot diversify away the risk. So here's the other statistic I looked at. When you ran a regression to get the beta, you'll also get a sense of how much of the risk in a company comes in the market. It's the R squared, the regression. In fact, if you take the square root of the R squared, you get the correlation of this company with the market.
On average, the correlation of high end retailers with the market is about 50 percent. I keep track of that number. If I divide the unleveled beta one point one eight by point five, I come up with a total unleveled baity. What are you doing? I'm essentially assuming that you're exposed not just to the 50 percent, which is market risk, but to the remaining 50 percent that is firm specific in estimating the cost of equity for your company as a private business in a private transaction.
I'm going to use the total data and here is a final adjustment I need to make with public companies the debt to equity ratio and debt to capital ratios. I used to come up with the cost of equity in cost of capital debt to be market values. The private business. I don't have those numbers. Here's a simple way around it. I use the industry average debt to equity ratio for publicly traded high end retailers. I am in a sense, assuming that this private business has to operate by that same ratio.
That ratio is fourteen point three three percent. Plugging that in, I get a total batur for the company and a total cost of equity. That total cost of equity. Fourteen and a half percent is significantly higher than the cost of equity I would have estimated for a public company. I use that same measure as my debt ratio to come up with the cost of capital for a private business. So in a private to private transaction, assuming that the buyer is completely undiversified, one solution to the lack of diversification promise to adjust to better use a total better use of cost of equity and cost of capital that emerges from the total data that will give you a value for the private business.
Now, let's ask a question about what to do about the fact that the owner might be a key person that put differently if you bought this business from the owner and the owner left, that you might lose some revenue, some customers might leave. You use a common use your common sense to make the best judgment. You can ask yourself this question. If I bought this business and the owners were no longer there, how much of my revenues drop, how much of my operating income drop value, the business using that lower operating income, then use it as a bargaining chip, in what sense?
Go to the owner founder and offer that amount as a value. He or she is probably going to be disappointed that the number is so low. Tell her why you're paying a low value. Maybe you can negotiate away with the owner of founder stays on for a few years and arrange the transition where you don't have as big a drop in operating income that's done in many businesses. So that's a key person issue. You have to deal with it in the operating income.
Which brings us to the third and final issue is, which is the issue of liquidity. As we mentioned in an earlier session, a liquidity is a continuum. All investments are illiquid. The question is by how much private businesses are particularly illiquid. So what do you often have to do as a potential buyer of a private business? Is factoring that a liquidity into your valuation write off from the start? And as again, with public companies, there are two ways you can adjust for liquidity.
One is you can value the company as you would regularly value the company, and then you can use the total data and you can use the higher cost of capital to make that adjustment. But after you come up with the value, you can discount that value for illiquidity. That's what most appraisers do. They knock off fifteen, twenty, twenty five percent of value for the liquidity discount. While that might or might not be justifiable, I'd like you to think about an alternative rather than drop the value of every private business by twenty or twenty five percent.
Would it be more reasonable that discount were a function of the private business being valued small versus large, healthy versus unhealthy cash flow producing versus non cash flow producing? We can come up with this concept very across businesses and I think we should go. The other way to adjust for illiquidity is to change your discount rate at a premium on for liquidity. And this is different. This is on top of the premium you added for the lack of diversification. Here again, you can use some of the techniques we talked about earlier for adjusting the.