In a business valuation context, the term value can have many different meanings. Terms such as fair market value, fair value and price are often used synonymously to describe "value"; however, each of these terms has a different meaning and interpretation. The purpose of this article is to define fair market value.
FAIR MARKET VALUE
In the absence of an open market transaction, where an informed buyer and an informed seller negotiate a transaction price, business value must be determined in a notional market context. Notional market valuations are required for a variety of reasons including family law proceedings, commercial litigation, shareholder oppression proceedings and income tax and estate planning.
In a notional business valuation, the most common definition of value that is adopted is fair market value. The definition of fair market value generally accepted by Canadian courts is:
"The highest price available in an open and unrestricted market between informed and prudent parties, acting at arm's length and under no compulsion to act, expressed in terms of cash."
In determining fair market value, the valuator must consider each of the components of the fair market value definition.
Components of Fair Market Value
Highest Price Available
In a notional market context, the highest price available must be determined without exposing the business interest to the open market. Determining the highest price available on a notional basis is difficult and requires professional judgment and experience. It is important to identify that price, as determined in an open market transaction and fair market value, as determined in a notional context may not be equal (we identify some of the reasons for this at the end of this article).
Consider that conceptually, a buyer and a vendor will only transact at a price and upon terms to which they both agree based on their own motivations and self interest. This transaction price is the price at which the vendor's interest, being to maximize the selling price and the buyer's interest, being to minimize the purchase price, are in equilibrium. In general, when provided two different purchase offers, a vendor will transact at the higher price.
The purchase price arrived at through open market negotiation often includes the consideration of "special interest purchasers". A special interest purchaser is a purchaser that is willing to pay a premium over intrinsic value because they will receive additional value from the combination of the acquired business with their own ("synergies"). Special interest purchasers may receive additional benefit from economies of scale, from cross selling opportunities or from the elimination of a competitor.
For example, Google may purchase a start up technology company for a premium in order to acquire access to technology that can be implemented with existing Google capabilities thereby expanding on existing products or services. On a standalone basis the start up technology company's product may have a limited application, but when combined with other Google products the range of applications and customers expands.
It is difficult to quantify the premium that a special interest purchaser may be willing to pay for the perceived synergies they expect to receive. From a practical standpoint, the special interest purchaser will only pay a premium up to the level that they require to secure the acquisition. Given the difficulty in ascribing value to post-acquisition synergies, valuations in a notional context are typically based on a stand-alone or intrinsic value, without the consideration of post-acquisition synergies. In specific cases where post-acquisition synergies can be evaluated and special interest purchasers are readily identifiable, the value of post-acquisition synergies may be quantified.
Open and Unrestricted Market
An open market implies that no potential purchasers are excluded from the notional market valuation. It is a fundamental assumption that all potential buyers with the will and resources to transact are included in the valuators considerations.
An unrestricted market refers to the assumption that any statutory, contractual, or other restrictions that may influence the marketability of a business are temporarily lifted for the purpose of determining value in a notional context. For example, a shareholders' agreement may restrict the transfer of shares; such limitations are assumed to be lifted for the purpose of determining fair market value.
However, prevailing case law indicates that the assumption of an unrestricted market does not completely disregard restrictions on a hypothetical sale of a business. For example, in practice, any restrictions are generally reflected by discounting the value that has otherwise been determined by applying a marketability discount.
Informed and Prudent Parties
The fair market value definition assumes that both the vendor and the purchaser are informed with respect to all material facts important to the value determination. In an open market transaction, the vendor often has greater knowledge of the business and its operations, while the buyer has greater knowledge of the potential post-acquisition synergies and future plans for the business.
Canadian case law supports the assumption of full and open disclosure of all relevant information that was known or ought to have been known at the valuation date. All information that would or should have been available at the valuation date is assumed to have been available in the notional market value determination. It is generally accepted that hindsight information is not considered in the fair market value determination. This is consistent with an open market transaction whereby the price negotiated between a buyer and a seller is based on the information available at that time without the benefit of knowledge of future events.
In addition, it is assumed that both the purchaser and seller perform a reasonable level of due diligence and exercise a reasonable level of care and judgment when consummating a transaction.
Acting at Arm's Length
Acting at arm's length relates to the assumption that the buyer and seller are opposing parties in the negotiation of the terms of purchase and sale. It is assumed that arm's length parties will act in their own best interest, whereby the seller will work to negotiate the highest selling price and the buyer will work to negotiate the lowest purchase price.
Under No Compulsion to Act
The fair market value definition assumes that neither party is forced or compelled to transact. In reality this may not always be the case as a business owner may be compelled to sell their ownership interest for a variety of reasons including personal health or financial difficulty. A buyer who is aware of a seller's compulsion to sell may be able to take advantage and transact at a lower price. The fair market value definition assumes that each of the buyer and the seller are willing to transact at a price that is deemed to be fair.
Expressed in Terms of Cash
A notional market valuation is expressed on a cash equivalent basis and assumes the transfer of the rights and risks associated with the business at the valuation date. This is often in contrast to open market transactions which are frequently consummated based on non-cash consideration such as the transfer of shares. Similarly, open market transactions often involve a conditional price or earn-outs that are based on the future performance of the acquired company. By adopting a cash equivalent value and immediate transfer of the risks and opportunities of the business, the notional market context avoids the interpretation of value based on non-cash terms and conditions that would otherwise complicate the valuation process.
Open Market Price versus Fair Market Value
Having consideration for the foregoing, differences may exist between fair market value determined in a notional market context and price as determined in an open market transaction. These differences may arise as a result of:
- the presence of special interest purchasers. As discussed above, special interest purchasers may drive a price as determined in an open market transaction higher than the fair market value as determined in a notional context;
- differences in the information available to each of the parties to an open market transaction. Generally open market transactions are negotiated between parties with varying degrees of knowledge and as such the consummated price may be higher or lower than the 'highest price available' determined in a notional market context. For example, the vendor generally has more detailed knowledge of the historical results of the business and the buyer has more information with regard to the potential perceived synergies;
- imprudent decisions by either the purchaser or vendor that are contrary to the fair market value assumption that a transaction occurs between prudent parties. Human emotion can impact the price consummated in an open market transaction or vendors may not want to deal with certain parties;
- non-cash or other consideration. Open market transactions often involve non-cash consideration or other forms of compensation including earn-outs, management contracts etc that impact the price paid. This contrasts with the cash equivalent basis assumed in a notional market context; and
- forced transactions in an open market context whereby a purchaser or vendor is compelled to act perhaps as a result of personal health or financial reasons.
Understanding which definition of value is adopted is critical to interpreting a value conclusion. The definition of value utilized should be clearly defined and understood. In practice, the definition of value generally adopted is fair market value. As outlined above, fair market value has a generally accepted meaning and interpretation. Comprehending this meaning is critical to appropriately interpreting the value conclusion.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.