Business Valuation Standards of Value & Fair Market Value
Valuing your business often involves determining its fair market value (FMV).
FMV, according to the American Society of Appraisers, is:
The price at which a property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.
This definition of FMV includes the following aspects:
- Price: In business transactions, the standard is the highest price; in real estate, it’s the “most probable price.”
- Willingness: Implies both parties are willing, able, and motivated to act in their best interests.
- Compulsion: Assumes an arms-length transaction without special motivations.
- Knowledge: Assumes well-informed parties with industry and market knowledge.
FMV serves as a value standard, reflecting the hypothetical transaction’s nature.
For instance, synergistic value applies to strategic buyers, investment value to corporate purchasers, and intrinsic value to financial buyers like private equity groups.
The chosen value standard significantly impacts the valuation methods used. If FMV is chosen, potential synergies are excluded.
Which value standard suits your business best? Can your $5 million appraised business fetch $7 million or $8 million? Why do some businesses sell above FMV? This article delves into the answers, with theoretical foundations in the first part and real-world implications in the second.
Business Valuation Standards of Value
Let’s establish the groundwork by defining “standards of value” before we explore the answers to these questions. This will also help us understand why FMV might not fully capture your business’s worth.
Fair market value (FMV) stands as the prevalent standard when valuing or appraising a business. A standard of value defines the measured value.
Standards of value can be:
- Legally mandated for legal or tax appraisals.
- Required by contract (like a buy-sell agreement specifying “fair value”).
- Chosen by appraisers for marketplace evaluations (such as selling a business).
While FMV is generally well-understood and accepted, numerous regulations, statutes, rulings, and case law opinions contribute nuanced perspectives on its exact definition, many of which lack real-world relevance.
There are various standards of value apart from FMV, including:
- Fair value
- Market value
- True value
- Investment value
- Intrinsic value
- Synergistic value
- Fundamental value
- Insurance value
- Book value
- Use value
- Collateral value
The chosen standard of value identifies the hypothetical parties involved in the transaction:
- Synergistic value = Strategic buyers
- Investment value = Corporate purchasers
- Intrinsic value = Financial buyers (e.g., private equity groups)
- Collateral value = Banks
- Insurance value = Insurers
- Book value = Tax authorities
- Fair value = Minority partners (often dissenting stockholders or for valuing stock options)
Clearly, the standard of value is pivotal in any valuation, dictating the specific valuation methods employed. For instance, opting for FMV as the standard precludes methods accounting for potential synergies. This limitation can lead to undervaluation. In essence, using FMV as your standard of value might undervalue your business when pricing it.
In practical terms, the precise standard of value is a concept primarily utilized by appraisers. While buyers may not explicitly mention fair market value or strategic value, comprehending the underlying principles of these standards is paramount. For instance, if an appraiser assesses your business using FMV as the standard, you’d be aware that potential synergies haven’t factored in, potentially leading to an undervaluation of your business.
On the flip side, during negotiations, a direct competitor could contend that your business merits only a 4.0 multiple based on prevailing industry multiples ranging from 3.5 to 4.5. In response, you could point out that most buyers in your sector lack synergies. However, the buyer you’re negotiating with anticipates a 30% EBITDA increase post-acquisition due to cost savings and synergy benefits:
- With Synergies: $2,000,000 EBITDA x 4.0 Multiple = $8,000,000 Value
- Without Synergies: $2,600,000 EBITDA (Post-Integrated) x 4.0 Multiple = $10,600,000 Value
- Outcome: Business value increases by $2,400,000 due to heightened cash flow (30% EBITDA rise = $600,000 increase). The actual value of synergies negotiated might not always be the full 100%.
The Fair Market Value (FMV) Standard
In the real world, fair market value can be succinctly grasped as follows:
“The highest price a business could reasonably be expected to command when sold through customary methods in the regular course of business, within a market unaffected by undue pressures. This market is composed of willing buyers and sellers engaging at arm’s length, without any compulsion to transact. Both parties possess reasonable knowledge of pertinent facts.” – American Society of Appraisers
EXPLICIT within the fair market value definition are these points:
- Amount (Price): In business transactions, the paramount benchmark is the highest price, while real estate transactions adopt the “most probable price” standard.
- Willing: This definition implies that involved parties are willing, capable, and motivated, acting in their best interests.
- Compulsion: FMV presupposes interactions devoid of undue influence or special motivations, ensuring transactions are conducted impartially.
- Knowledge: Fair market value also assumes parties are well-informed, equipped with industry, market, and business insights.
IMPLICIT, and widely accepted, within the fair market value definition are these elements:
- Current economic and market conditions: Valuation hinges on the prevailing economic and industry conditions.
- Sufficient time: Adequate duration allows proper and competitive marketing through customary channels.
- Negotiated: Price negotiation mirrors supply and demand dynamics.
- All cash, or equivalent: Payment is completed in cash or its nearest counterpart (e.g., cash payment through bank financing). If innovative financing arises, pricing adjustments are made.
Why do values sometimes surpass FMV? Consider these instances where a business might sell for more or less than fair market value:
- Voluntary Influence: An unwilling minority partner holds out until the final moments, compelling the buyer to pay a higher price to recover their investments in time, effort, and missed opportunities.
- Compelled Circumstances: A seller faces external pressures like health issues, leading to rushed preparation, marketing, and negotiation, resulting in leaving money unrealized.
- Information Gaps: Instances arise when the buyer lacks comprehensive insight. For instance, undisclosed vital facts by the seller or the buyer’s failure to anticipate fierce competition from a well-funded rival can lead to overpayment due to insufficient knowledge.
- Time Constraints: Forced by personal circumstances, the seller hastily lists the business, obtaining less than its potential value if a systematic sale process had been executed.
- Innovative Financing: The seller offers inventive financing options, heightening risk and consequently elevating the purchase price.
- Synergistic Gains: The buyer introduces substantial synergies, like an expanded distribution network, contributing to a 20% increase in the purchase price.
Strategies for Maximizing the Value of Your Business
With a clear understanding of fair market value and its limitations, here are practical recommendations to enhance the value of your business:
In the realm of M&A, positioning holds more significance than negotiation. It forms the bedrock of effective negotiation, as negotiating from a position of strength is paramount. The pinnacle of positioning is when you’re not compelled to sell, yet the buyer is eager to acquire.
Allocate Adequate Time
Allow yourself ample time for thorough preparation before entering the sale process. This not only maximizes your positioning but also empowers you to cultivate multiple alternatives and contingency strategies, reducing vulnerability to external pressures. A well-prepared approach mitigates the risk of compulsion, and the array of alternatives safeguards you against the pitfalls of the sunk cost fallacy.
Equip Yourself with Knowledge
Bolster your arsenal with extensive knowledge and data to address any concerns raised by potential buyers, particularly when dealing with financial buyers like private equity groups. While direct competitors may possess a deep understanding of your industry, strong industry knowledge serves as a distinct advantage when engaging with financial buyers. Demonstrating comprehensive research and data not only alleviates buyer apprehensions but also strengthens your negotiation position.
Develop a Concise Growth Strategy
Craft a succinct growth plan outlining the prospective expansion avenues within your business. Integrate this plan with your positioning strategy and communicate to buyers that your intent to sell is not a necessity. Buyers often inquire about selling motives, especially during potential growth phases. Your response will either bolster or erode your positioning. Ideally, you should be executing your growth plan while formulating assumptions based on real-time data during this process.
Enhance the Value through Financing Options
Maximizing the price concerning financing can be achieved through two straightforward methods. First, optimize your business operations to enable potential buyers to secure financing. This involves maximizing the business’s taxable income, as banks evaluate available cash flow based on federal income tax returns for debt service coverage during the transaction’s underwriting. Second, consider offering favorable seller financing terms. However, exercise caution and extend such terms only to operationally and financially robust buyers.
Cater to Strategic Buyers
Reconfigure your business to align with strategic buyers’ interests. Foster aspects of your business that are uniquely irreplaceable, such as strong customer relationships, proprietary processes, trade secrets, long-term customer contracts, patents, and more. The more distinct and challenging to replicate your offerings are, the higher the value potential buyers will place on your business. Crafting elements that resist easy replication positions you to exceed fair market value.
Time the Sale Strategically
Optimal timing for selling coincides with your industry’s peak performance. While pinpointing the exact industry peak might prove challenging, capitalizing on an industry upswing greatly favors your business sale prospects.
Diverse Standards of Value
While fair market value (FMV) serves as a foundational valuation tool, it doesn’t necessitate confinement to this sole standard of value. FMV, commonly applied to appraise small to mid-sized businesses, serves as a starting point for strategic planning. Commence the exit planning process as early as feasible, as early planning yields greater value creation.
Professional Assessment and Strategy
For an accurate understanding of your business’s worth, we recommend engaging us for a comprehensive business assessment. Our assessment encompasses an impartial valuation of your business coupled with an intricate exit strategy. This strategic blueprint is your initial step toward tactically planning your business exit to optimize value.