What’s a “Fair Market” Value for a Private Business?
Whether you are a business owner looking to sell a percentage (or all) of your business or an investor wishing to purchase a company, the first step is to arrive at a fair market value for the business. For every scenario, buyers and sellers need to quantify the worth of all, or part, of a business before the transaction can take place.
What is Fair Market Value?
Fair Market Value (FMV) is often simply thought of as what another person is willing to pay, when neither is acting under compulsion and both have reasonable knowledge of the relevant facts.
An obvious example of market value is the stock market, with the buying and selling of equity securities of publicly traded companies. Both the buyers and sellers have access to information that has followed established business standards and meets strict reporting requirements.
For private businesses, which don’t need to adhere to the same standards as a public company, it is often advantageous to get an independent and objective view.
What Factors Affect Fair Market Value?
Estimating a company’s worth is more complex than a simple review of the financial statements and book value of a business. In fact, the book value, which is an accounting value of a business, fails to recognize the true value of the business. Instead, it represents the current depreciated value of what was paid for an asset.
Arriving at a fair-market valuation needs to include other factors beyond those found on a balance sheet. Factors that can positively benefit the company like the income and earnings potential, the value of the brand and intellectual property need to be included. It’s also important to take into consideration risk factors like damage quantification and potential litigation. Quantifying the value of these factors requires specialized knowledge.
How is Fair Market Value Measured?
There are two basic approaches for value determination.
The first is the empirical approach, which relies on transactions involving similar businesses. It is useful when open market transactions are clearly identifiable and are, in fact, comparable to the business valuation being determined. However, it may be given more credibility than it deserves.
The second approach is the investment approach, which determines a business’s value through a detailed investment analysis. The techniques used are financial statement analysis and risk measurement theory. This approach is often used by sophisticated buyers and sellers in the open market, and therefore, the same technique can be used in the private market.
There are pitfalls and assumptions with both methods, which is why it’s advisable to employ a Chartered Business Valuator (CBV). CBVs are experts with specialized knowledge of businesses and their value, so they’re better able to quantify the worth of all, or part, of a business.