When are transactions at fair market value?

Fair Market Value IllustrationWhen determining the fair market value of a business, an appraiser may consider using the private company transaction method. Pricing multiples can be derived from this method, which is based on actual consummated transactions in privately-held stock.

Do these transactions represent fair market value?

Fair market value (“FMV”) is defined in The International Glossary of Business Valuation Terms issued by the American Institute of Certified Public Accountants (AICPA) as:

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.

From this definition, we can see that not all transactions are at fair market value. Although stock in a company may have changed hands, the transfer may not be at FMV. The databases that provide transaction data often lack sufficient detail to assess the nature and details of the transaction. The details provided within the databases often disclose little about the entity sold, the entity or person who bought the company and the reason or catalyst for the sale. Without this information, how can one conclude the the transaction was at FMV?

Consider these Examples

  • A company has been gaining market share on a larger competitor, and this larger competitor decides to purchase the smaller company. Is the price paid truly fair market value? Or might the larger company have paid a premium to eliminate a competitor and expand its own market presence?
  • Would someone looking to enter the industry pay the same premium as the existing competitor? The newcomer’s reason for the purchase may be completely different.
  • Some owners don’t get along. Disharmony among owners may force an expedited sale. If the reason for sale were made public, would the price offered be discounted by a buyer seeking to take advantage of the sellers’ misfortune?
  • Family transactions may cloud the true nature of a transaction. The seller (mom and dad) may not want to unduly burden the buyer (children) with substantial debt. Tax and estate planning may also be influencing the transaction. Is this discounted price 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?” And if so, would that price be more indicative of fair market value?

Evaluating Transactions Must be Done with Care

While the private company transaction method can be a useful tool, it should be used with care. Appraisers need to be careful to make sure the identified transactions are really at FMV. Although using multiple transactions from a database can help identify and isolate outliers, it is the unknown motivating factors that may cause an appraiser to conclude a wrong value opinion.

For more information on valuation services, please contact the experts at Baum Blaugrund.