Business Valuation Standards of Value & Fair Market Value

Executive Summary

One of the most common ways to value your business is to calculate its fair market value (FMV).

FMV is defined by the American Society of Appraisers as follows:

“The amount 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 these understandings:

• Amount/Price: The prevailing standard in business transactions is the highest price, whereas in real estate transactions, the standard is the “most probable price.”
• Willing: The definition implies that both parties are willing and able, have sufficient motivation, and are acting in their best interests.
• Compulsion: FMV assumes the parties are dealing with one another at arms-length and are not influenced by special motivations.
• Knowledge: FMV also assumes the parties are well-informed and possess knowledge of the industry, marketplace, and the opportunities and weaknesses of the business.

FMV is a standard of value. The standard of value reflects who the parties will be in the hypothetical transaction.

For example, synergistic value is the value if sold to strategic buyers, investment value is the value to corporate purchasers, and intrinsic value is the value to financial buyers (e.g., private equity groups).

The standard of value is a critical premise in any valuation and determines the specific methods used to appraise the business. If you retained an appraiser to value your business and the appraiser used FMV as the standard of value, you would know that potential synergies were not taken into account.

What standard of value is most applicable when valuing your business? If your business was appraised at $5 million, is it possible to receive $7 million or even $8 million for your business? Why do some businesses defy conventional wisdom and sell for significantly more than fair market value? This article explains.

Hang in there — the first part of this article is mainly theoretical, which sets the stage for the real-world implications on the value of your business that are outlined in the second half.

Business Valuation Standards of Value

Before we delve into the answers to these questions, let’s lay the foundation by defining “standards of value” and explain why FMV has the potential to undervalue your business.

Fair market value is the most common standard of value used when valuing or appraising a business. A standard of value is the definition of value that is being measured.

Standards of value can be:

• Legally mandated in appraisals for legal or tax purposes
• Mandated by way of contract (e.g., a buy-sell agreement that requires “fair value” as the standard of value)
• Chosen by an appraiser for marketplace appraisals (e.g., selling a business)

Fair market value has an almost universally understood and agreed-on definition, but there are hundreds of regulations, statutes, administrative rulings, and supporting case laws containing nuanced opinions regarding the precise definition, most of which are meaningless in the real world. This article will generally be restricted to the universal opinion of FMV in the real world and ignore the complexities that exist in the theoretical world. But be aware that specific interpretations of the definition of FMV are nuanced depending on a number of factors.

Other standards of value, besides FMV, include:

• Fair value
• Market value
• True value
• Investment value
• Intrinsic value
• Synergistic value
• Fundamental value
• Insurance value
• Book value
• Use value
• Collateral value

The standard of value reflects who the parties will be to the hypothetical transaction. For example:

• 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 (usually dissenting stockholders or for valuing stock options)

As you can see, the standard of value is a critical premise in any valuation. The standard of value determines the specific methods of valuing used to appraise the business. For example, selecting FMV as the standard of value precludes an appraiser from using any valuation methods that assign weight to potential synergies. This limitation has the potential to undervalue your business. In other words, you may undervalue your business if you are using FMV as the standard of value to price your business.

In reality, the exact standard of value is a theoretical term exclusively used by appraisers. You will rarely hear a buyer mention fair market value or strategic value, but an understanding of the premise upon which the standards of value are based is critical. For example, if you retained an appraiser to value your business and the appraiser used FMV as the standard of value, you would know that potential synergies had not been taken into account and your business could be undervalued.

Alternatively, a direct competitor with whom you are negotiating might argue that your business is only worth a 4.0 multiple because prevailing multiples in your industry are 3.5 to 4.5. You point out that the majority of buyers in your industry who purchase a business are private individuals who bring no synergies to the table. The buyer you are negotiating with will be able to decrease costs and generate a 30% increase in EBITDA as a result of the acquisition and will be able to afford a higher price as a result of the increased cash flow and the synergistic value of the purchase, as in this example:

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
Result: The value of the business increases by $2,400,000 as a result of the increased cash flow (30% increase in EBITDA = $600,000 increase in EBITDA). In reality, the value of synergies that the seller receives is negotiated. The seller will not always receive 100% of the value of synergies.

The Fair Market Value (FMV) Standard

The real-world understanding of fair market value is:

“The highest price a business might reasonably be expected to bring if sold by using the normal methods and in the ordinary course of business in a market not exposed to any undue stresses and composed of willing buyers and sellers dealing at arm’s length and under no compulsion to buy or sell, and both having reasonable knowledge of relevant facts.” – American Society of Appraisers

EXPLICIT in the definition of fair market value is the following:

• Amount (Price): The prevailing standard in business transactions is the highest price, whereas in real estate transactions, the standard is the “most probable price.”
• Willing: The definition implies that the parties are willing and able, have sufficient motivation, and are acting in their best interests.
• Compulsion: FMV assumes the parties are dealing with one another at arms-length and are not influenced by special motivations.
• Knowledge: Fair market value also assumes the parties are well-informed and possess knowledge of the industry, marketplace, and the opportunities and weaknesses of the subject business.

IMPLICIT, and nearly universally agreed, in the definition of fair market value is the following:

• Current economic and market conditions: The valuation is based on the current state of the economy and industry.
• Sufficient time: A reasonable period of time is given to properly and competitively market the business using channels customarily used to market related businesses.
• Negotiated: The parties will hammer out the price based on supply and demand.
• All cash, or equivalent: Payment is made in cash or its nearest equivalent (e.g., the buyer obtains bank financing and pays the seller in cash at closing). If creative financing is involved, an adjustment is made to the price.

Why do values sometimes exceed FMV? Here are examples of why a business may sell for more or less than fair market value:

• Unwilling: An unwilling minority partner refuses to sell and drives up the price of the business at the last minute, which the buyer ultimately pays, to recover their sunk costs (in the form of time, energy, and lost opportunities) in the transaction.
• Compulsion: The seller is being forced to sell due to outside circumstances, such as health reasons, and does not have time to adequately prepare, market, and negotiate the sale, thereby leaving money on the table.
• Insufficient Knowledge: There may be times when the buyer is not fully informed. For example, the seller may fail to disclose material facts, or the buyer may fail to research the industry and not predict intense competition from a venture-backed competitor. In these cases, the buyer will ultimately pay a higher price than if they had reasonable knowledge of relevant facts.
• Insufficient Time: The seller is forced to sell for personal reasons puts the business on the market in haste, and receives far less than what they could have if the sale had been conducted in an orderly fashion.
• Creative Financing: The seller offered creative financing for the business, increasing the risk and the resulting purchase price.
• Synergies: The buyer brings significant synergies to the table, such as an expanded distribution network, which increases the purchase price by 20%.

Strategies for Maximizing the Value of Your Business

Now that we have defined fair market value and its limitations, here are some suggested recommendations for maximizing the value of your business.

Maximize Positioning

Positioning is more important than negotiating in M&A. Positioning is the foundation of negotiating. It is nearly impossible to negotiate from a position of weakness. You know you have maximized positioning when you do not have to sell, but the buyer is desperate to buy.

Give Yourself Ample Time

Give yourself sufficient time to prepare for sale to maximize positioning and to develop as many alternatives and contingency plans as possible so you don’t have to sell. If you give yourself adequate time, you are less likely to be subjected to compulsion. The more alternatives you have, the less likely you are to fall prey to the sunk cost fallacy.

Arm Yourself with Knowledge

Arm yourself with as much knowledge and data as possible to combat the buyer’s concerns, especially if you approach financial buyers. Most direct competitors will understand your business well enough that knowledge of the industry won’t give you a competitive advantage, but a strong knowledge of the industry will give you a big leg up when dealing with financial buyers, such as private equity groups. Most entrepreneurs are ignorant of their competition, and any buyer will view this ignorance as a risk factor. Arm yourself with as much research and data as possible to ease the buyer’s concerns.

Prepare a Short Growth Plan

Prepare a short plan that outlines the potential growth opportunities in your business. Combine your growth plan with positioning and communicate to the buyer that you don’t have to sell. Most buyers will ask why you are selling when you are at a supposed inflection point in your business. Your answer will either maximize or destroy your positioning. You should be in the process of executing your growth plan, and the assumptions in your growth plan should be based on current data as you execute your short growth plan.

Offer Financing

There are two simple ways of maximizing the price in relation to financing. One is to run your business so a buyer can obtain financing — you do this by maximizing the business’s taxable income. This is necessary because banks measure the available cash flow on the business’s federal income tax returns to cover the debt service when underwriting your transaction. Second, you can offer generous seller financing terms, though we only recommend doing this with a buyer who is strong both operationally and financially.

Appeal to Strategic Buyers

Restructure your business to appeal to strategic buyers. Develop aspects of your business that cannot be replicated by buyers, such as strong relationships with customers, trade secrets, proprietary processes, long-term contracts with customers, patents, and so on. The more easily a buyer can replicate what they are buying, the lower the price they will be willing to pay. If you can create something that the buyer cannot easily copy, you are almost guaranteed to receive more than FMV.

Sell at the Peak

The ideal time to sell is when your industry is at its peak. While timing the sale to occur precisely at the height of your industry may be impossible, it is far easier to sell your business while the industry is on an uptick.

When valuing your business, you do not have to limit yourself to fair market value as the standard of value. FMV is a useful tool that serves as a baseline value from which to start your planning process. While fair market value is the most common standard of value used to appraise small to mid-sized businesses, you do not have to limit yourself to FMV. Ideally, you should begin the planning process as early as possible. The earlier you begin planning your exit, the more value you can create.

If you would like to know what your business is worth, we recommend retaining us to perform an assessment of your business. Our assessment includes an unbiased valuation of your business, along with a detailed exit strategy to help you maximize the value of your business. Such a plan is the starting point from which to begin the process of strategically planning your exit.