An appraiser seeking to determine a company’s fair market value may choose to use a market approach called the private company transaction method. This method is based on actual transactions in privately-held stock. It is from these transactions any number of pricing multiples can be derived. Buyers, sellers and investors may ask, however, if the pricing mechanisms determined using these transactions accurately indicates the fair market value of the company?
What is Fair Market Value, or “FMV”?
Here is how fair market value is defined in The International Glossary of Business Valuation Terms:
The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
While stock in a company may have changed hands, does the transfer price meet the definition of FMV? The databases which provide transaction data rarely offer insight about the nature and details of the transaction. The details provided within the databases disclose little about the entity sold, the entity or person who bought the company or the catalyst for the sale. Without this information, can we be assured that the resulting conclusion of value is actually fair market value?
How circumstances influence a sale
Let’s look at an example. If you have a company that has been gaining market share on a larger competitor and this larger competitor decides to buy the smaller company, is the price paid truly fair market value? Perhaps the larger company paid a premium to eliminate a competitor from the marketplace and expand their own market presence. Would someone looking to enter the industry pay the same premium as the existing larger company/competitor? Most likely not, as the newcomer’s reason for the purchase may be completely different.
Another example would be a company whose owners can’t get along. The relationship among them is so toxic, they finally see no alternative but to sell the entire company even though they may not want to sell. If the reason for sale is made public, it’s likely a buyer would offer a discounted price for the company. Is it truly fair market value as it may not meet the “willing seller” and “neither is under compulsion to…sell” standards of the FMV definition?
Then there is the situation where a parent begins and grows a business over 2 – 3 decades and grooms the children to buy the company and run it as they see fit. However, mom and dad have made more than enough money to retire and don’t want to burden their children with debt service obligations. Instead, they sell their stock at a discounted price to their children. Is this discounted price truly fair market value? Could the parents have gotten more money if they had attempted to consummate an arm’s length transaction in an open and unrestricted market? Would not that price be more indicative of fair market value?
While the private company transaction method can be a useful tool in a business appraiser’s toolbox, these examples show why it should be used carefully. As we have seen, circumstances unknown to us may cause the sale price to be a poor reflection of a company’s fair market value.