Hypothetical Fair Market Valuation is Price-Range Concept; By Grover Rutter CPA/ABV,CVA,BVAL,CBI.
The art of business valuation has intrigued me for many years because there is always more than one answer, especially regarding the fair market value standard of value. Oh, I know what you're thinking: "Sure, but there is only one right answer!" If that thought crossed your mind, you are not alone.
This article is intended to broaden your perspective on the fair market value standard of valuation. Hopefully, it will allow you to recognize that Fair Market Value can only be derived from a range of perceived values.
The fair market value standard of value actually requires a minimum of two valuation indications, which create a simple range of values. One indication of value must come from the seller's perspective and the other from the buyer's perspective.
Where is my authority for making such a statement? Let's take a look at the classic definition of fair market value in Revenue Ruling 59-60:
The amount at which property would change hands between a willing seller and a willing buyer when neither is under compulsion and when both have reasonable knowledge of the relevant facts.
The ruling implies that the value perceptions of the seller and the buyer must be considered when determining fair market value.
Another definition of fair market value can be found in the Glossary of Terms as jointly developed by representatives of the American Institute of CPAs, the American Society of Appraisers, Canadian Institute of Chartered Business Valuators, the Institute of Business Appraisers and the National Association of Certified Valuation Analysts. According to that Glossary's definition, fair market value is:
The price, expressed in terms of cash equivalents, at which a 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 to sell, and when both have reasonable knowledge of the relevant facts.
Based upon the foregoing definitions, the concept of fair market value is a concept of price range, with actual fair market value falling somewhere within a range of prices. That range is determined by the opposing value perceptions of the seller and the buyer. The seller tries to justify the highest value (yet may sell for a lower price) while the buyer justifies the lowest value (while willing to buy for a higher price), thus creating the valuation range.
Unfortunately, Revenue Ruling 59-60 sews confusion pertaining to the fair market value standard. The ruling says, in part:
Because valuations cannot be made on the basis of a prescribed formula, there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. For this reason, no useful purpose is served by taking an average of several factors (for example, book value, capitalized earnings and capitalized dividends) and basing the valuation on the result. Such a process excludes active consideration of other pertinent factors, and the end result cannot be supported by a realistic application of the significant facts in the case except by mere chance.
A strict reading of this section of the ruling might indicate that a valuator must pick one specific method and stick to it. However, such an exclusive approach (picking just one value) would also exclude active consideration of other pertinent factors associated with both the buyer and the seller. In short, there will always be more than just one opinion of value going into the arm's-length negotiating process. And those varying opinions of value must be considered by the parties to the negotiation in order to arrive at an actual fair market value (the negotiated value).
While discussing my hypothesis for this article with some of my peers, I realized that some valuators do not have a clear grasp of the terms hypothetical buyer and hypothetical seller. For purposes of the fair market value standard, hypothetical buyers and sellers will act and react as would real buyers and real sellers in a real market. The term "hypothetical" only means that there is no real intent to sell the subject, and no buyer has been sought. Otherwise, the dynamics of an actual deal negotiation and structure should still be considered in the hypothetical transaction.
Why is this discussion important? Because it logically suggests that a single method or approach to determine a single opinion of hypothetical fair market value should seldom, if ever, be used.
How did I come to this conclusion? I have observed that the sellers of a business (and their advisors) will generally approach the valuation differently than the buyers (and their advisors) approach the same valuation. Table 1 shows some, but not all, of the considerations.
Table 1: Valuation Methods Considered by Buyers and Sellers
Discounted Valuation Method:
Who Might Use: Buyers
Possible Reasons for Use: I have observed that buyers will more likely use this methodology. Often they will ignore terminal values, use higher risk assumptions, or ignore growth rates in calculation of terminal values. Sometimes buyers should be made aware of such oversights in the use of this method.
Adjusted Asset Method:
Who might Use: Buyers & Sellers
Possible Reasons for Use: Buyers who look at higher-profit businesses (with low asset bases) tend to look at the underlying asset values in their negotiations. Buyers will try to greatly discount the value of goodwill associated with the intangible earning ability of the company, by only looking at the value of tangible assets. Sellers, on the other hand, might look to the adjusted asset method to value their under-performing businesses (where the earnings do not provide a very good return on the assets). In this instance, of course, the buyers become very interested in the lower value associated with the lack of cash flow.
Capitalization of excess earnings method:
Who might use: Buyers & Sellers
Possible Reasons for Use: This method may provide a good view of the business value to both the buyer and the seller. It measures estimated values of underlying tangible assets and attempts to quantify the value of cash flows in excess of a reasonable return on the net assets of the business. Of course, sellers will generally use lower risk assessments (when developing capitalization rates) than the buyers will use.
Direct market Data method, multiple of revenues:
Who Might Use: Sellers
Possible Reason for Use: Sellers generally love to apply some sales multiple to their company's revenues. It is easy, and sellers more often tend to think of company values in terms of sales volumes. This method is generally not given the same consideration by buyers, because buyers are more interested in the earnings or benefit streams than revenues.
Direct market data Method, multiple of earnings:
Who might Use: Buyers
Possible Reason for Use: Buyers may place a greater emphasis on actual earnings of a business than on sales or revenues.
The seller's indication of value (typically the higher value) and the buyer's indication of value (the lower value) establish a simple range of value. The actual negotiated value will fall somewhere within that simple range of values. It is the valuator's job in hypothetical fair market valuations to determine what would be a reasonable and defendable value by both the seller and the buyer. Therefore, the upper and lower valuations must be considered, I believe.
Observations of a Business Broker
In 2003 I expanded my valuation and consulting services to include business brokerage and intermediary services. During the many negotiations and transactions in which I have been involved, I realized that actual transactional valuation is quite different from what business valuators are taught in most valuation course work. In transactional fair market valuation, my proposed definition of fair market value is the following:
Fair market value is that point within a range of prices where the seller (who is striving to sell at the highest price) and the buyer (who is attempting to purchase at the lowest price) converge. The actual value will be the negotiated point at which the seller will enter into the transaction at less than the desired highest price, and the buyer will enter into the transaction at a price greater than the desired lowest price. The transaction must make economic sense to both the seller and the buyer. Also, the terms (or lack of terms) offered by a seller to a buyer will have a significant impact on the resulting value of the business.
True fair market value is negotiated by two opposing parties, each striving to achieve separate and independent economic outcomes. In the negotiation process, sellers, buyers, and the professional advisors of each are likely to use many valuation methods in arriving at the final negotiated value. Generally some weight is afforded to each method, based upon its merit and relevance. In my opinion, when we valuators render opinions of hypothetical fair market value, we can do so only after making some of the same considerations that buyers and sellers would make in an actual transaction.
Allow me to illustrate. I recently sold a business where the business owner had engaged an outside valuator to determine the fair market value of the business before we were engaged to market the company. After we successfully marketed the company, the buyer's valuator arrived at a much lower valuation. Then the buyer's bank did its own valuation analysis and arrived at a price higher than the buyer's valuator's value, yet lower than the seller's value. The seller offered to provide seller financing for 25 percent of the transaction price, which was still lower than the original seller's valuation but higher than the subsequent buyer's valuations. The bank adjusted its valuation upward after considering the seller's financing (which was subordinated to the bank loans). Meanwhile, the seller's and buyer's attorneys each tried their hand at valuation. The seller's attorney determined an outlandishly high value, while, you guessed it, the buyer's attorney figured that the business was almost worthless.
In this case, there were multiple determinations of value. Were any of those valuations "right"? Not really. The final transaction price (fair market value) was the result of negotiation, with each side considering the other party's valuations and logic.
A seller's initial notions of value will tend to lean heavily toward those methods resulting in the highest value indications. An acquirer's initial notions of value will lean heavily toward those methods resulting in the lowest. If a deal is struck, neither party's initial valuation will be "right." The transaction price will actually fall somewhere within the range of values established by the valuations performed by the buyer and seller.
Two Willing Participants
The foregoing discussions point to a fact often neglected by business valuators: Fair market valuation must consider the objectives of both the buyer and the seller. Attorneys, judges, and CPAs, too, often forget that determination of fair market value requires two willing and able participants, each with an opposing view of value. In short, a minimum of two different valuations are required if pertinent consideration is to be given to both the willing seller and the willing buyer.
How many times have we read case histories where some valuator has argued that the results of a certain valuation method or approach are superior to all other methods or approaches? How many studies are performed and articles written about cost of capital theory, in which the authors try to develop a discount rate to some exacting and precise number? Let's not forget: The answers produced by such methodologies may be only part of the final opinion of fair market value.
Two Value Notions
The fair market value standard gets confusing when valuators mix and match it with other standards of value, and try to pawn off the hybrid values as fair market value. Table 2 presents different standards of value, with a few of the prerequisites of each standard:
Table 2: Standards of Value and Some Prerequisites
Fair market value standard:
Prerequisites: The hypothetical parties to the transaction are willing and able, and have opposing economic interests: the seller seeks the highest price while the buyer seeks the lowest price. The parties are not being compelled to buy or sell, and are unrelated and negotiate at arm's length. Market conditions are assumed to include other similar businesses available on the market, providing price competition to the seller. The pool of buyers should include all categories and classes of willing purchasers. Prevalent economic and market conditions exist as of the date of the valuation. The opinion of value must make economic sense to both seller and buyer.
Number of Participants: At least two willing and able participants are required: seller and buyer.
Fair value standard:
Prerequisites: Generally there is a willing buyer and an unwilling seller. The seller may be under some compulsion to sell with no free and open market remedy. Fair value must be taken in the context of state statutes dealing with the right of oppressed or dissenting shareholders. In most cases, one party tries to force a value that is considered inequitable by the other party.
Number of Participants: One willing participant and one unwilling (for the call price) participant are involved.
Investment value standard:
Prerequisites: Investment value represents value to a particular owner or investor. The investment value to one owner or prospective owner may differ from fair market value due to: Relationships with other owners, Synergies with other operations owned or controlled, Different estimates of future earning power, Perceptions of degrees of risk and its effect on ROI
Acquisitions are made only if they fall within the value guidelines set forth. Little consideration may be given to the perspective of the seller.
Number of Participants: Typically only one party determines a particular investment value.
Again, fair market value can be established only when the valuator shows that consideration has been given to the value notions of the seller and the value notions of the buyer. This process will call for differing values that would typically be sought by the seller and by the buyer. Accordingly, a fair market value cannot be determined by using just one method of valuation. Consideration of only a single method of valuation suggests some other standard of value.
Taking a Closer Look:
Hypothetical fair market valuations are different from actual transactional valuations used for negotiating purposes. That's because when transactional valuations are used in negotiating, the type of buyer is already known: The buyer is an institutional investor, a synergistic buyer, an individual investor or an owner-operator. Each type of buyer will have their own objectives, which will affect their valuations and bids:
Table 3 below will assist valuators in the identification of differing classes of buyers.
Institutional investors may look at projected returns and anticipated stability of those returns. The financial returns will generally be compared to returns experienced by the rest of the industry. The target (acquired) business usually has a management team in place. Institutional Investors often value acquisitions lower than might Synergistic Buyers and Owner-Operator buyers.
These will look for operating cost efficiencies, increase in market share, and acquisition of new technologies and/or product lines, development of certain customer or vendor relationships, attainment of location or other specific attributes that will add to the profitability of the buyer's existing operations. These considerations may tend to greatly enhance the value of the acquiring company.
Individual investors often have a goal of some targeted return on their investment. Sometimes investors will purchase a business with the intent of investing additional capital to improve the business for the purpose of "flipping" and/or taking the acquired business public (The buyer's cost of capital and desired returns on the investment may tend to limit the value).
Owner-operators are generally buying a job, and ideally a retirement plan. They will work in the business and experience varying degrees of success. (These buyers may pay more than the investor or institutional buyers, but generally will pay less than paid by a synergistic buyer).
In hypothetical fair market valuations, valuators cannot assume any one particular kind of buyer. Unlike in transactional valuations, the valuator does not know the identity or nature of the buyer. However, valuators should consider the eligible classes of likely buyers. Why is this an important point? Because knowledge of the potential types (or class) of buyers will provide the valuator with insight as to which valuation methods and approaches are appropriate to use in developing the valuation considerations that would most likely be made by the hypothetical buyers.
Business valuators performing hypothetical fair market valuations must recognize the seller's objectives and the buyer's objectives. In addition, the valuator must identify and understand the types of potential buyers who are in the market pool for a specific business. In a situation where only one likely class of buyer exists for the valued business (for example, an owner-operator interested in a local donut shop), the valuator might be able to justify giving equal weight to the valuation indications of each the seller and the buyer. In this manner, an argument could be made that consideration was given to both buyer and seller.
However, where there are three potential buyer classes and only one seller, the valuator might (depending on circumstances) consider applying less weight to the seller's indication of value and more weight to the three likely indications of value from each of the buyer classes. In this manner, the valuator has not unduly influenced the seller's indication of value, has not picked a specific buyer, and has considered value indications from all classes represented in the pool of likely buyers.
While these opposing fair market value considerations produce multiple indications of fair market value for the sale-side valuation and also for the buy-side valuations, there is no set number of valuation methods or approaches that should be used for every valuation. Likewise, there is no weighting formula that can be applied to every situation. Each situation will call for analysis, identification of the market pool, and application of valuation methods and approaches commonly used by each class of buyer.
In short, the valuator must use judgment in considering the merits of each valuation method likely to be used by the seller and the buyer(s) and in reconciling indications of fair market value produced by those methods. In so doing, the valuator can develop a reasonable range of values that represent the buyer and the seller.
Special recognition and "thanks" are given to the following peer reviewers of this article: Les Smeach, CPA, CVA; Douglas Crocker CPA and David Miles, CPA, CVA. Their input and observations were extremely valuable. Also, I'd like to thank David Freedman of NACVA for his support and painstaking reviews and numerous edits of the manuscript.
The Revised Model Business Corporation Act defines fair value as "the value of shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable."
Copyright 2010 Grover Rutter Business Brokerage, Valuations & Consulting LLC
About the Author: Grover Rutter CPA/ABV, CVA, BVAL, CBI is a partner in the firm Grover Rutter Mergers, Acquisitions and Valuations in Findlay, Ohio. Mr. Rutter has over 30 years experience working with owners of privately held companies. He has valued and or sold manufacturers, wholesale distributors, trucking companies, truck dealerships, machine shops, construction companies, veterinary hospitals, propane distribution companies, medical equipment distributors, CPA practices, dental offices, chiropractic offices, civil engineering firms and environmental consulting firms, just to name a few. Mr. Rutter has written numerous articles that have been published in a variety of trade and professional publications. He is also the author of "How to Sell Your Business for the MOST Money" which is sold through several online retailers.
Grover Rutter CPA/ABV, CVA, BVAL, CBI
Mergers, Acquisitions, and Valuations
1212 North Main Street
Findlay, Ohio 45840
419-427-1564 866-825-8283 Fax 419-422-7202
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|Date:||Nov 22, 2011|
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