why fair market value can’t always be used.
by ed mendlowitz
77 ways to wow!
there are many ways and purposes for valuing a privately owned business. there is no one “right” way. an appropriate method should be determined depending upon the reason and use for the valuation. here are explanations of some of the most used methods.
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fair market value
many people refer to a business’ value as its “fair market value” but this is generally a misused term. its derivation is from a 1959 irs revenue ruling that specifically addresses valuations for gift and estate tax purposes and does not necessarily provide a reasonable valuation for other uses.
fair market is defined as “the price at which property would change hands between a willing and able buyer and willing and able seller with neither being under any compulsion to buy or sell and both parties having reasonable knowledge of relevant facts, with both seeking their maximum economic self-interests.” implicit with this definition is that
- there is a “hypothetical” buyer and seller who are assumed to be well-informed about the property and the market for such property and
- are willing and able to complete the transaction using cash or cash equivalents and
- that the property would have been exposed on the open market of a period long enough to allow market forces to establish a value.
part of the determination of a fair market valuation are upward adjustments for a partial interest with control or swing vote ability and downward adjustments for minority interest or lack of control shares and to recognize special difficulty in marketing those shares.
limitations in this method exist when a current value is needed in a divorce or business dispute, when an actual sale is being negotiated, or where special attributes exist that are not reflected in the earnings history such as a patent or new procedure that is just taking shape.
be aware that in determining values, consideration needs to be given to the reasons for the valuation, the actual buyers and sellers and pressures they have, family members, employees and other parties of interest, hidden agendas, negotiation skills of the participants, payment terms and periods, income taxes and tax-based allocations, transaction costs and legal precedents and rulings that guide and establish values. in the presence of any one of these, a fair market valuation might not be appropriate.
standards in a divorce
there are varying methods for matrimonial issues that extend from what a business might be worth in an immediate sale to what it costs to create or to recreate to what it is worth to the present owner – concepts not used in the fair market value method. matrimonial valuations arise in state courts with each state setting their own rules and methodology and judges many times deciding the value in part by using their experience, knowledge and judgment.
selling the business
valuing a business that the owner wants to sell can be done in several ways, but at the end of the day, few buyers will base their purchase price on a valuation prepared by the seller. additionally, valuations prepared by advocates of the seller lack credibility because they are not considered to be independent.
it is advisable for the owner to consult with an appraiser to get a range of the value and guidance on how to address the negotiation process, and perhaps help determine an opening price and a price for which they should try to settle, or a walk away value.
considerations should also be given to the ultimate use of the net proceeds and cash flow that can be expected from the proceeds. occasionally, the appraiser will suggest methods of structuring the transaction so the greatest cash flow can result from the sale proceeds.
buying the business as an investment
this refers to the value of the business’ cash flow and future profits considering the owner’s expectation of risk, return, potential and type of involvement they will need to provide. on some basis most businesses are acquired with this in mind, but not all.
job value to the buyer
this method values the business in terms of the job wanted in the business with the expected salary and benefits, in comparison to what the buyer could make if they had a comparable job, or any job they are reasonably suited for.
strategic value
included in this value are synergies and special features of the business that will add incrementally to a buyer’s current business, and for which the buyer is willing or should be willing to pay substantially more than its current value based on traditional valuations.
this could be in situations where a company wants to enter a market and it is less costly to acquire a business already in that market; where a company has a patent or secret process that the buyer can better exploit; where a company wants to eliminate the threat of a competitor or to acquire “critical mass” quickly, irrespective of cost, or expand their product line; or get access to a certain type of customer or the location of the business, where a business wants to maintain a supplier, or a supplier’s competitor; where the combination of two or more companies creates a major niche player, specialty business or one-stop shopping source; or where someone is desirous of getting a “job,” i.e., they want to work in the business, or they want to protect their job or own the company they helped create or build.
many of these situations do not fall within the fair market value definition because there is no hypothetical willing and able buyer and willing and able seller with both having reasonable knowledge of relevant facts.
partners, members or shareholders agreements
different considerations go into valuing a business for a buy-sell agreement. and one agreement can have different valuations depending upon the reason for a partner leaving. voluntary or forced withdrawal, retirement, disability and death, personal bankruptcy or losing a professional license can call for different methods of valuation. further, when there is a death or transfer to family members, the valuation must pass irs scrutiny. and today’s valuation issues might not be applicable many years down the road when the agreement is acted upon if there is no means of keeping the valuations current.
valuation in a personal financial plan
many business owners value their business when they are doing financial planning for their future, retirement or asset allocation. how the business is valued will depend on many factors, the least of which is the fair market value. valuation for estate or gift tax purposes would be at the fair market value, but that might have no basis in reality, what the owner could expect to receive from a sale, net of taxes, nor the ultimate cash flow from the proceeds.
conclusion
valuing a business is an art – not a science – even though careful calculations are made to arrive at an appraisal of the business. the above indicates just some of the uses of a valuation and the considerations involved in the process.
