Is Fair Market Value the Price of the Business?

Regardless of the context in which value is determined, it is vital to recognize that there may be differences between “price” in an open market and “value” in a notional market.

(Originally Posted December 18, 2017)

Entering into negotiations, whether you are the buyer or seller, can be daunting. The business valuator has determined a value of the business, but the offer to purchase (or sell) the business is different.  Shouldn’t it be the same?

Today we discuss possible similarities and differences between fair market value (“FMV”) and price and why business valuators conclude only on fair market value. We will use an example of Bob selling Bob’s Pizza Inc. (“BPI”) to Joe.

Bob has engaged us to value BPI.  We (Davis Martindale Advisory Services) have concluded the FMV of BPI is $100,000.   Joe offers Bob $75,000 to purchase BPI.  Bob and Joe settle at $85,000. In this example, the fair market value of BPI is higher than the price paid.

Fair Market Value

Fair market value is a hypothetical market that tries to best reflect the open market.

The International Glossary of Business Valuation Terms defines “fair market value” as:
The highest price, expressed in terms of 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.

Price

Price is determined in an open market through negotiations between a buyer and a seller acting at arm’s length (i.e., the buyer and seller are not related) that satisfies both parties.  This is the only true way to know the price for BPI.

In our example, the true price of BPI was $85,000 after it was made available for sale in the open market.

Differences between Fair Market Value and Price

Fair market value (“FMV”) determined may differ than the actual price received for the business.  This does not necessarily mean the FMV is incorrect; rather, there are other factors dictating price. We list several significant differences between fair market value and price below.

1. Highest Price Available
   FMV assumes that buyers and sellers are equal in negotiating abilities, financial strengths and knowledge to determine the highest price of the business, whereas price may be influenced by uneven negotiating skills, financial strengths and knowledge.In the example above, Joe may have had stronger negotiating skills resulting in a price favourable to him.  
2. Open Market
   FMV considers all potential buyers in an open and unrestricted market.  Price may be influenced lack of interested buyers, regulatory restrictions, access to financing or other reasons.Bob may have accepted a lower price compared to the determined FMV as he may not have had any other interested buyers, or any other qualified buyers.
3. Informed Parties
   FMV assumes the buyer and seller are made aware of all material information and factors relevant to the value determination at the valuation date.  Price can be influenced by the seller or buyer (typically the seller) having better knowledge of operations and/or the buyer having a better understanding of financing availability, synergies in the marketplace and within the business and other factors that may influence the price that it is willing to pay.The price Joe offered Bob may differ because of additional information that became available after the valuation date.
4. No Compulsion to Act
   Force or compulsion to act is not considered under FMV.  Price may be influenced as a result of a forced or compulsive act by the buyer, seller or both.Bob may be forced to sell BPI because of health or family issues.  Joe may be aware of the issues which resulted in a price favourable to Joe.
5. Cash Terms
   FMV assumes the transaction is to be paid with cash at closing.  The price may not all be cash and instead, earn-outs or other structures may be put in place. Bob may have wanted a cash transaction to walk away from BPI.  Joe may have been the only buyer to offer cash for BPI shares.  Other buyers have offered Joe an earn-out or share redemption over time.

If you’re thinking of selling your business or you’re planning a future sale, the experts at Davis Martindale would love to work with you.