Word to the Wise: Why Fair Market Value Does Not Equal Selling Price
It’s not unusual for a valuation analyst to be called upon to “come up with a quick price” for a company, as if a few mathematical calculations would do the trick.
Often this is because a business owner has a number in mind that he or she is aiming to confirm for a sale. Or sometimes, an owner really has no idea what the company might sell for. The owner is hoping that a quick look at the books will yield a dollar amount that can then be shopped around.
What many of these owners say they’re after is “fair market value.” The reality, though, is that valuations take time and effort. Even then, the valuation analyst’s arrival at a fair market value doesn’t mean that’s what the company will sell for.
The American Institute of Certified Public Accountants (AICPA) defines fair market value as “… the price, expressed in cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
In real life, however, a company will likely sell above or below fair market value depending on a number of factors, including the particular buyer involved. Once that buyer is identified, the price becomes based on “investment value.” This is defined by the AICPA as “…the value to a particular investor based on individual investment requirements and expectations.”
Investment value differs from one buyer to another based on such variables as perception of risk, required rate of return, estimates of future earnings, financing costs, tax status, and synergies with existing companies.
For sellers interested in aggressively marketing their companies, it’s wise to create compelling stories to “sell” the company to potential buyers based on these variables.
Most buyers are interested in acquiring other companies to facilitate expansion into new markets, increase market share, obtain new or better technology or processes, or decrease competition. With these motivations in mind, the seller should present his or her company in a way that highlights the opportunities and synergies the newly combined company would provide.
For example, the buyer could illuminate the bottom line benefits of better technology, or demonstrate the results of an expanded footprint. The buyer could also communicate the increased revenues or decreased expenses gained from eliminating duplicate administrative jobs, sales staff or line employees; obtaining a larger customer base; or taking advantage of economies of scale in purchasing.
Showing a potential buyer what he or she could do with the newly combined company is inspiring and creates a more realistic earnings stream on which to base negotiations. The idea is that a buyer with these synergistic opportunities would be more likely to pay above fair market value for the company.
Of course, there are always ways to improve the value of a company to any seller. Identifying the key value drivers in the company provides a path toward enhancing efficiency, capacity and profitability, to name just a few outcomes.
These actions include steps that tend to increase the fair market value by reducing risk and increasing cash flow. For example, owners can diversify the customer base, fine-tune supplier contracts and pricing, improve accounts receivable turnover ratios, and streamline inventory.
Being “sales ready” is a good state for a seller to be in. This only improves the daily operations of the company — and increases the likelihood of an optimized sales price.