What is a fair market business valuation?

In an attempt to make the allocation and justification for what they call "fair market value", governments around the world follow the USA Internal Revenue Services in a complicated and unlikely definition which leaves gaps on all sides large enough to make the uninitiated poorer. So what is fair market valuation, and how does it relate to a fair market business valuation?

Why is "a fair market business valuation" resorted to so eagerly?

We argue in this article the concept of “a fair market business valuation” cannot exist in practice because the romantic, but trite definition falls on every condition in the description. This does not mean the definition should be discarded, but nor should business owners fall for the use of it to persuade them to accept lower prices.

A legislated definition of "fair market value"

The USA Internal Revenue Service, I believe in an attempt to give everybody something to hang their coats on, defines fair market value using a number of check-boxes. They must all be ticked. The definition is conflated from the outset with PRICE. Here it is, just to remind you:

A Fair Market Business Valuation is the price, expressed in cash equivalents, at which property (a business) would change hands between:

  •   a hypothetical willing buyer and a hypothetical willing seller,
  •   who are both able to do the transaction
  •   acting at arm's length
  •   in an open unrestricted market,
  •   when neither is under compulsion to buy or sell, and
  •   when both have reasonable knowledge of the relevant facts.

A fair market business valuation does not exist

If one can get beyond the conflation of "price" and "value", the premise of the definition has its nexus in the word “would”. It is the price which “would”, not the price which “did”, “has”, or “is”. “Would” in this context is full of ideals. Let’s unpack the definition from the bottom to the top.


Both parties have reasonable knowledge of the relevant facts

In the world of M&A this is seldom possible. I can’t believe this is ever possible in the small, medium, and closely held business environment. There, the seller has usually toiled in their business for some years. Those guys live their businesses. So they know everything about them.

The buyer, on the other hand, has to learn quickly. They do so by asking the seller questions. Then they conduct a due diligence exercise to confirm the answers. But how much knowledge discovery can happen in a few interviews and a short due diligence?

There is abundant evidence of the knowledge disparity between buyer and seller elsewhere. In most sale agreements there is a clause: “the seller will remain in the business for {a period}.” This may be to train the buyer in the ways of the business. Or it may be to introduce them to suppliers and customers.

The inference is that the buyer feels lacking in knowledge. They need a knowledge transfer and guidance.

When they agree the price they do not “have reasonable knowledge of the facts”. In these circumstances there can be no "fair market value."


When neither party is under compulsion to buy or sell

Very often business sales happen at the time of the most compulsion to sell because of

  • Divorce settlements
  • Shareholder disputes
  • Death or serious injury of a shareholder
  • BBBEE imperatives
  • Approaching retirement
  • When the knowledge under the first heading becomes the compulsion for one or other party.

The truth is that both buyer and seller negotiate to their own private agendas. If either understands a compulsion or duress of the other, they will act on it.

Approaching deadlines affect both buyer and seller. The buyer needs an income. They may have been out of work for several months, with personal cash flow running low. The imperative is not helped by another potential buyer poking around the business. So maybe they will agree on a higher price after all.

The seller, on the other hand, may have received yet another call from the procurement department of the mine. They hear that "head office" is getting impatient for those BBBEE points. It has been two years now. The seller's board may hasten the deal closing by resolving: “Let's offer some vendor finance.”

Buyers and sellers are almost always under some degree of compulsion - one or both, one way or another. That is no basis for a "fair market value", as defined.


In an open and unrestricted market

If “open and unrestricted” means anybody can buy or sell whatever, whenever, then fine, we can work with that.

Unfortunately the Competition Commission may hold a different opinion. Of course, the Commission won’t have any bearing on small business. So let’s put some other things in perspective.

Open and unrestricted must also mean "supply of" and "demand for".

When a buyer cannot get funding, but they are the only buyer in sight, there is an effective lack of demand. That may result in a price shift to accommodate the buyer's budget. The respective values to both buyer and seller remains the same, but the buyer gets a better deal. Perversely, the seller may also be getting a better deal because they are able to "move on."

Conversely, the buyer may blink first and offer more to persuade the seller to provide vendor financing. Depending on how that deal is structured and secured, value may be reduced for the buyer, while the price has inflated. 

Business brokers skew the fair market valuation

Business brokers often have legacy relationships with buyers on their books. It is a fact of the industry that they can only sell a business to one of the potential buyers responding to their marketing. Their buyers lists quickly swell, and so when a new seller comes to them they rush it to their list of “hot buyers”. Sometimes they will never list it on the open market. The seller’s business never gets anywhere near an open and unrestricted market. This is a well-developed scandal which goes unreported in this little game.


Acting at arms length

It may appear that a buyer and seller reach agreement at arms length. In reality, the intermediaries may have entered the arena for their own gain. The "political interference" here is always a concern. Business brokers and bankers, in particular, wade in to affect price, to speed up deals, to reduce their own risk, or blatantly favour both buyers and sellers, without the knowledge of the other.

Business brokers may offer the advice to a buyer: “the asking price is 'X' but I know he will accept 'Y' if you act now.” A smaller commission earned sooner and certainly is always prized. The brokers cut the sellers’ arms short

Many brokers says they act in the interests of both buyer and seller. But a business broker should never act in the best interests of both sides. They can only act in the interests of their principal - usually the seller. They have some duties of care to both sides of the equation. But that is about doing their professional thing diligently and honestly.

Nor should they be taking secret profits from banks, private equity, or buyers. But they do. And so the “arms length” leg of the definition fails.


Willing and able buyer and seller

Nobody is willing to sell their business to satisfy a divorce settlement. But sometimes they have to do so. Nor are they likely to willingly sell to fund a medical imperative. And while dead business owners are not able, their heirs are very willing.

Ageing business owners become more and more willing. But they become less and less able to do so if they have not kept up with its valuation development.

Too many business sellers are horrified at the prices on offer. But they accept the inevitable, based on their lack of preparation and foresight. They become willing, reluctantly so.

Fair market value at work

Just into the new century, I was introduced to Len Birger and his wife. 

Len told me he had done exceptionally well out of his business, and he wanted to retire and emigrate. He wanted a quick sale, without any fuss, and was prepared to accept only net asset value.

We worked quite a bit together to create a nice pitch with supporting documents. Then he went to Australia to visit children and grandchildren.

"Bugger that," thought I. And while I could meet with prospective buyers on my own... Well, let's just say I pushed the price. When he returned I had several buyers short-listed.

Business broker appreciation

Did I push the price beyond the actual value? Definitely not. But I stretched the "willing and able seller" envelope significantly.

Did I risk losing the buyer? Nope. There were two others at and about the same price. And I knew I was working at value.

In looking out for the seller without his interference while he was away in Australia, I looked after my own interests too.


The price expressed in cash equivalents

Often sellers achieve aspirational deal prices by extending favourable terms to the buyer. There are dozens of variations, permutations and combinations of:

  • Vendor loans, where seller defers a portion of the agreed price for later payment.
  • Part payment in stock of the buyer, vesting in the seller against guarantees.
  • Profit share agreements and earn-outs.
  • Deposit and balloon payments.

The seller expresses confidence in the warranties in their pitch. The purchaser agrees on a higher price even though the higher price may not represent value to them. The seller takes risk to comfort the buyer. The buyer pays a premium for the risk mitigation.

In these examples confidence in the business of the seller will transfer to the buyer for a future value. These deals go a long way to dispel the risk of the unknown for the buyer. But the payment structures fall outside of the reasonable definition of “cash equivalents”.

What about where the seller is willing and able to sell at a low price? Of course it requires that they find a willing and able buyer. But at a low price, that will be less difficult.

So what is fair market business valuation then?

"A fair market business valuation” is necessary as a concept. It avoids a situation where one must actually sell a business to determine a value of the asset. Obviously that would be inconvenient.

“Fair market value” sounds so... well fair. Banks, attorneys, auditors, magistrates and judges need something upon which to hang decisions.

When we prepare business valuations for clients we justify everything with facts. Our report readers can cross reference all the claims.

Everything in the accepted IRS definition points to actual prices, not values. But then again the USA IRS calls significant shots. So I guess they can call their definition "fair market value", if they want.

It just isn't. It is price, and it is, like its protagonists, hypothetical.

We conduct considered, bespoke, reasoned

Business Valuations

specific to South African companies of all sizes in all industries