What's Your Business Worth, and Is Fair Market Value Really Fair?

How can you get the most for your business when you’re ready to sell?  When a business is valued with a formal appraisal, the objective is usually to determine fair market value.  But what is fair market value, and how does that differ from a final selling price?

What Fair Market Value Really is…and isn’t

Fair market value is loosely defined as “the price at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms-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.”  For purposes of formal business valuations, fair market value is typically based upon hypothetical circumstances and usually does not take into account a specific transaction structure or specific buyer to arrive at a value.

In reality, “fair market value”, can be very different from the actual price a buyer is willing to pay.  As beauty is in the eye of the beholder, value is in the eye of the buyer. The true value of a business may be different to one buyer than it is to another.  The bottom line is the buyer who will benefit more may be willing to pay more to purchase the company, regardless of what a fair market value appraisal shows. 

Different Buyers, Different Valuations

Let’s assume there are two buyers interested in your company.  One is a competitor of yours looking to expand.  The other is a mid-level executive looking to use his retirement money to purchase a business as an investment so he can leave the rat race of the corporate world. If the executive purchases your company, he will essentially step into your shoes as the new owner.  He will incur all the same operating expenses and all the same issues you currently face.  He may bring a fresh perspective and new energy into the business and may be able to grow the company through his own hard work and vision, but the operating costs will likely stay much the same.  The best way for him to grow the company will come from attracting new customers and increasing sales.  This type of buyer will only look at the company’s current cash flow to decide if it is worth his investment, and this is the type of buyer that most closely relates to the “hypothetical buyer” used in most formal business valuations. 

Now take the competitor.  If he buys the company, there will be many additional benefits to him.  He is acquiring all of your customers and revenue while potentially decreasing the operating costs.  Any costs he is already incurring in the operation of his own business may be costs that can be reduced or eliminated from your company after he buys it, thereby increasing his cash flow and bottom line. 

If he is going to consolidate operations under one roof, he can use his existing building and eliminate rent, utilities, and other real estate related costs.  If he already has employees who can handle the customer accounts from your company, he may be able to reduce employment expenses.  His existing advertising budget may be sufficient to cover advertising and marketing for both entities after the sale, so he could eliminate any advertising expenses from your company.  This buyer won’t just look at current cash flow to determine whether he can justify the purchase price; he will also take into account any additional benefits that will add to cash flow after the purchase.  In some cases, it’s very easy to show potential cash flow to a buyer.  In other cases, it may take a little extra work to illustrate the added value to each buyer.  As the saying goes, you can lead a horse to water, but you can’t make him drink.  Though you can’t make a buyer pay what he’s not willing to pay, you can certainly lead him to the true potential value and let him decide.

Should You Pay for a Formal Business Valuation?

So, when you are selling your business and you are the “hypothetical seller,” make sure you fully understand the value in the eyes of the buyer and not just the fair market value.  While the potential synergies, economies of scale, and other similar items fall outside the realm of a standard business appraisal or valuation report, the more you know about your potential purchasers, the more negotiating power you will have.  This does not mean you should never have a formal appraisal or valuation on your business.  A formal fair market valuation or appraisal used in conjunction with financial projections and recast financial statements can serve to illustrate potential value to each buyer. 

Getting The Highest Price

What is the true value of your company to a competitor?  How about to another closely related business like a supplier or customer?  How about to an investor or financial buyer?  How will each potential buyer value your company?  One thing is certain; a standard business valuation will treat them all equally.  If you treat them all equally, you probably won’t sell your company for any more than a simple appraised value.  

Once you have done your homework to understand the value to each potential buyer over and above the “fair market value” from an appraisal, you will be in a better position to sell your company for the highest possible price and not just fair market value.

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