Business owners know a lot about their companies, right down to the minute details of their day-to-day operations, customers, marketing, payroll and personnel. However, they often do not know one of the most important details of all — the value of their company if they were to market it for sale.

The concept of fair market value can be difficult to assess because, except in the case of a completed transaction, it is largely theoretical and based on hypothetical scenarios. Buyers and sellers can be expected to act in specific ways when the conditions and outcomes of the sale are predictable. In reality, however, M&A transactions seldom follow such a simple, predetermined path. In other words, buyers and sellers typically do not act according to predictable patterns, and neither do conditions that could potentially impact a sale, i.e., the timing of the transaction, market conditions, political and economic conditions, etc. As discussed in prior posts, absent a completed transaction, a theoretical valuation is based on a variety of factors including the following:

  • Comparison of the company to “comparable” public companies
  • Comparison of the company to “comparable” completed transactions
  • Income valuation methodologies
  • The judgment of a seasoned investment banker or valuation professional

What is fair market value? By its traditional definition, fair market value is the price at which a company would change hands in a transaction between a willing buyer and a willing seller, both being reasonably informed as to all of the relevant facts about the business, and neither party being under any compulsion to buy or sell. Generally, fair market value represents a “floor” value for a seller since by definition it represents a value agreed upon by a hypothetical willing buyer and seller.

Achieving fair market value is dependent on a variety of factors. For example, the value of a company for sale can vary with the type of sale process being run. Was the transaction a negotiated deal with a single buyer candidate, or an auction or limited auction process? Was the transaction marketed to strategic buyers and financial (private equity groups) buyers or only to one segment of buyers? Were there buyers precluded from the sale process for competitive reasons? Were there other conditions that might limit the attractiveness of the company to the widest group of buyers such as the owner’s (or management’s) unwillingness to remain with the company post-closing? All of these factors will create a fair market value that is personal to the subject company. In fact, fair market value may vary widely for the same company based on the sale process and/or the conditions of the sale.

Further to the auction process discussion, was the company marketed to a targeted group of buyers who understand the company and its merits, or was it marketed to every “warm buyer” that was willing to sign a confidentiality agreement and review the marketing materials? In the case of the former, the buyers are well-informed with respect to prevailing market valuations and thus will place, within a range, a market value on the company. The latter could include “deep value” buyers that would be “happy” to purchase the company because the deep value purchase price significantly reduces the risk profile for the buyer. If the company is marketed in a competitive process to the right sized group of knowledgeable buyers who understand the company’s value proposition the result of the process will determine fair market value.

While it may not be easy to estimate fair market value, ultimately, achieving fair market value is about the process and the perceived competition for the company in the marketplace. If the company is marketed to an appropriate number of knowledgeable buyer candidates, the market will tell the owner the value of their business. Of course, if the owner does not agree with the market, then the owner is under no obligation to sell their company. As discussed in prior emails, a failed sale process can create a host of unintended consequences for the owner. While the sale of private companies is not necessarily efficient, the form of the sale process can significantly improve the efficiency and achieve fair market value.

Many business owners may have an idea about the worth of their company based on rules of thumb or broad industry metrics; however, these rules of thumb or broad industry metrics could be wildly low or high. Overestimating fair market value could lead to disappointment and a busted transaction. While in the worst case, not knowing the fair market value of their company could cause the owner to part with their company for less than its true value. As such, it may prove to be valuable for the owner to hire a professional who can help them engineer a sale at a price that is not only fair, but helps them achieve their overall objectives.