Fair Market Value vs. Strategic Value

Buyers and sellers often have a different perspective relating to the value of a business.  While both hope to achieve their desired results, reconciling these value differences is often one of the most challenging aspects of effecting a successful transaction and can be a stumbling block for SBA loans.  Business owners with too high expectations may find themselves unable to sell the company because a prospective buyer may not be able to get financing.  In transactions, greed is not necessarily good;

Strategic buyers of a company seek to maximize the return on the transaction through the long-term creation of value by capitalizing on synergies—financial benefits that may be the result of economies of scale, integrated marketing, horizontal or vertical integration, etc.  If the acquirer pays too much for the business and the synergies never materialize, value may well be destroyed.  Overpaying for a business could have adverse long-term consequences for the value of the company and its shareholders.

Individual buyers of businesses are significantly different than strategic acquirers.  Individual buyers are usually looking to “buy a job” for themselves or their family members.  While they may be assessing the acquisition in terms of the ability to provide a lifestyle for their family or simply receiving a return on their investment, other non-financial factors often influence individual buyers.

Thus, it is important for both the buyer and the seller to be familiar with the differences in fair market value and strategic value and how these value estimates affect the ability to consummate a transaction, particularly with respect to obtaining SBA guaranteed loans.

For those individuals seeking to buy a business via a SBA guaranteed loan, the SBA may require an independent, third party appraisal from a business appraiser with one of several professional credentials.  The appraiser is typically engaged to provide an estimate of the fair market value of the business being acquired.  The SBA will not usually accept a valuation based on strategic value.  Thus, the relevant standard of value for SBA loan financing is Fair Market Value.  IRS Revenue Ruling 59-60 of Internal Revenue Code Section 2031 defines Fair Market Value:

[T]he price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

For valuation purposes, fair market value includes several assumptions inherent in the definition.

First, property changes hands in an arm’s length transaction between the willing buyer and willing seller.

Second, the hypothetical buyer and seller are rational investors.  As rational investors, they assess economic and financial factors in relation to the subject interest in order to determine a price at which the transaction will be conducted.

Third, the willing buyer is a financial buyer rather than a strategic buyer.  A willing buyer does not have synergistic opportunities in the transaction.  The willing buyer, then, assesses the transaction only upon the potential for return on invested capital by utilizing a comparable management team.

Given that the willing buyer does not possess any special value-adding factors or synergies that will enhance the value of the business, the fair market value may be lower than the highest price that could be obtained in the market.  The fair market value provides the value of the business on a stand-alone basis.  To a buyer seeking a financial return only, the fair market value represents the maximum amount that the buyer should paid to acquire control of the future cash flows associated with the business based upon the risk characteristics of the company and the buyers’ required rate of return that reflects the relative level of risk of the cash flows.

Fair market value is also the minimum amount that a seller should accept in a transaction.  It is easy to see that the actual price at which a transaction is consummated may vary greatly from the fair market value based on the particular situations surrounding the seller and the particular motivations of the buyer.  Both buyers and sellers should remember that price is the monetary consideration negotiated between the parties whereas fair market value is a “theoretical” price or standard of value developed by a professional business appraiser that utilizes a number of methodologies and assumptions regarding risk and return for the universe of willing buyers and sellers—not that of particular parties to a transaction.

Unlike stand alone value, which measures the value to the universe of willing buyers, strategic value measures the value to a particular buyer that seeks to capture synergies by combining like operations or complementary operations.  The overriding goal of undertaking an acquisition that produces synergies is to create shareholder value of the combined entity that exceeds the value of the individual, stand alone companies.

In nearly all cases, strategic value produces a higher total transaction value than fair market value.  The following illustration depicts the relationship between fair market value, strategic value, and synergies.

sba

Buyers and sellers should be cognizant of the difference between fair market value and strategic value and how these differing standards of value impact a transaction using SBA guaranteed loans.  The fair market value standard excludes using the buyers’ expectations regarding growth in sales, new marketing initiatives that will increase sales, cost cutting initiatives that will increase profitability, budgets and forecasts, changes in cost structure due to decisions made by the buyer or as a result of the buyer’s relationship with suppliers, etc.  If the buyer of the business is paying the seller more than fair market value, the buyer is paying the seller for the synergies that he or she will be brining to the table by completing the transaction and will likely be unable to obtain financing for any difference between the fair market value of the business and the purchase price.  This may require the buyer to put in additional cash in the deal structure or the seller finance the difference.

Buyers who do not understand this may engage in transactions that significantly reduce their ability to capitalize on the synergies or unique qualities they bring to the business and may not be able to successfully finance the deal using SBA guaranteed loans.  Sellers who want more than the fair market value of the company risk turning away potential buyers who are relying on SBA guaranteed financing.  As a result, the transaction itself may be doomed to fail on various levels.