'Fair market value' useless as a tool in business sales

A prospective business buyer recently told to me that he had been advised "not to pay more than fair market value for a business." That may sound like good advice but in fact it was fairly useless.

First of all, the term "fair market value" is a theoretical construct used by business appraisers to state an opinion of the price at which a specifically identified business would change hands between the hypothetical "typical buyer" and hypothetical "typical seller" assuming the entire price is paid in cash at close of escrow. No business ever sells for "fair market value." The price a specifically identified real person actually pays for a business will be that person's unique "investment value" which will almost certainly be more or less than an appraiser's opinion of the fair market value of the business. Moreover, if any portion of the price paid is partially financed by the seller, then that price is automatically disqualified as an indication of the businesses' fair market value. However, it is a wise buyer who first obtains a professionally developed opinion of a business' fair market value as a baseline from which to develop a reasonable offering price so as to avoid paying too much, which does happen often.

Let's assume a buyer has obtained a professionally developed opinion of the fair market value for a business he is considering buying, which is $300,000. More than likely that FMV opinion will be for the owner's equity information that is absolutely useless from the buyer's perspective. The estimated fair market value of the owner's equity is equal to the business' estimated fair market enterprise value minus all current liabilities and long-term debt. Thus, the point of departure in developing a reasonable offering price for a business is to obtain an opinion of the company's enterprise value which is the value of its current assets, fixed assets and the value of the goodwill. Thus the enterprise value will be the appraised FMV of owner's equity plus total liabilities.

Taken as a given that the professionally estimated fair market value of the owner's equity is $300,000, let's next assume that the company has $75,000 in current liabilities and another $75,000 in long-term debt. This means that this company's enterprise value is $450,000. This is the number that should be the baseline for purchase price negotiations. The wild card in this transaction scenario is the value of the company's goodwill. This is a very subjective component of a company's value, which will be different for every prospective buyer and need not be the same or even close to an appraiser's opinion.

For the purpose of this discussion, let's assume that our buyer agrees with the appraiser's opinion for the value of the goodwill which is $100,000. This means that the value of the current assets and fixed operating equipment is $350,000. Let's assume the agreed value of the fixed operating equipment is $180,000. This means that the book value of the current assets is $170,000 which is comprised of $15,000 cash in the bank, $1,000 in change and small bills for making change, $65,000 in inventory, $25,000 in accounts receivable, $12,000 in pre-paid insurance premiums, $5,000 for a loan to an employee, a $17,000 lease deposit and $30,000 in marketable securities.

The thing that should be immediately apparent in this example is that our buyer will have no interest in acquiring the company's cash in the bank, the $5,000 note receivable from the employee or the $30,000 in marketable securities. Moreover, it's doubtful that our buyer would be willing to pay the book value for the accounts receivable but more than likely would not want to purchase them at all, and the same goes for the cash-in value of the pre-paid insurance and the lease deposit. He may or may not include the cash register change bank in his offering price. The point being that, assuming an asset sale which is by far the most common transaction scenario for small businesses, the buyer will not buy all of the company's current assets and in many cases neither will he buy all of the company's fixed operating equipment for example the seller's personal automobile which in this case is included in the $180,000 fixed asset value estimate. Thus the price the buyer will (or should) offer for this business is its enterprise value minus the assets that he doesn't want to buy. In this example transaction there are eight separately identified current assets and three categories for fixed assets the operating equipment, the seller's car and the goodwill which totals eleven itemized assets altogether. This means that there are 2,048 possible combinations of which assets the seller will keep and which ones the buyer will buy which means that there are 2,048 possible offering prices that will all net the seller exactly $300,000 in cash and retained asserts after paying off the total debt (i.e., 2 to the 11th power).

The amount of cash the buyer needs to deposit into escrow in order to close will be the agreed purchase price minus any assumed seller liabilities such as outstanding gift certificates or other customer pre-payments. In other words, the different possible amounts of cash the buyer must deposit into escrow will be 2 raised to the power of the number of itemized assets and liabilities on the seller's balance sheet. The amount of cash the buyer must have to start his newly acquired business will be the cash he gives the seller at closing plus an amount equal to the value of the current assets the seller keeps. This means that a buyer will almost always need much more cash to get started than the price paid for the business and that price will never be the businesses' fair market value.

Toby Tatum is a certified business appraiser, owner of Alliance Business Transfer Services in Reno and author of "Pricing A Small Business For Sale: A Practical Guide for Business Owners, Business Brokers, Buyers and Their Advisors." Contact him at 775-847-7481.