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What is a fair market business valuation?

We argue in this article that “fair market value” in the realm of business valuation cannot exist in practice. It is subject to a very nice definition. But it falls on every condition in the definition.


The USA IRS

The USA Internal Revenue Service defines fair market value as the price, expressed in cash equivalents, at which property 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.

The fair market business valuation does not exist

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.

1

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."

2

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 haves been out of work for three months now, and personal cash flow is 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 has received yet another call from the procurement department of the mine. Head office is getting impatient for those BBBEE points. It has been two years now. “Let's offer some vendor finance.”


Buyers or sellers are almost always under some degree of compulsion - one or the other. That is no basis for a fair market value, as defined.

3

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 enough supply and demand.


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.


After a weekend of strategising, each may have suggestions. The buyer may offer more to get vendor financing. The seller may offer a discount to entice the buyer.


Business brokers often have legacy relationships with buyers on their books. They have often missed out in previous acquisitions, and so now they are keen. When a new business appears on the books of the broker, they rush it to their list of “hot buyers”. Sometimes they will never list it on a web site. The seller’s business never gets anywhere near an open and unrestricted market.

4

Acting at arms length

It may appear that a buyer and seller reach agreement at arms length. In reality, the intermediaries may enter the arena for their own gain. The "political interference" here is always a concern. It matters less to them that they receive 80% of the commission earlier anticipated.


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 can 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 dilligently and honestly.


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

5

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.


This part of the definition succeeds, albeit flaccidly.


Hint: Get your business valuation done professionally every 3 years or so.

6

The price expressed in cash equivalents

Achieving aspirational deal prices because of favourable terms to the buyer:

  • 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.

The seller expresses confidence in the warranties in their pitch. The purchaser agrees on a higher price. But the higher price may not represent value. 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”.


But what about the deal 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 won't be difficult.

  • Willing and able buyer with willing and able seller
  • Acting at arms length in an open and unrestricted market
  • Neither under any compulsion to buy or sell
  • Both have reasonable knowledge of the relevant facts

OK< that last one kinda spoils the story. But apart from that...


Well, this very situation played out with a client of mine, just into the new century.


He 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 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, I looked after my own interests too.

So what is fair market business valuation then?

"Fair market value” is necessary as a concept. It avoids a situation where one must actually sell a business to determine a value of the asset. Too darn 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.

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