Is Fair Market Value Really Fair?

Investment Value vs. Fair Market Value

July 2001

Selling a business for investment value rather than fair market value requires knowing the true value of the business to the buyer.

Consider a scenario in which a large lumber products distribution company is seeking to acquire a mid-market lumber products distribution company that could generate an additional $20 million in revenues and over $2 million in earnings. The acquisition candidate actually earns $1.2 million; however, the purchasing power of the potential buyer with annual revenues over $200 million will result in an eight percent savings on the $16 million in annual purchases or approximately $1,280,000. The candidate generates $20 million in revenues and $1.2 million pretax. From a fair market value perspective, it doesn’t matter who the buyer is—the price would be based entirely on the candidate’s performance. However, from an investment value perspective, it’s a very different story.

For this particular buyer, the candidate controls $20 million in revenues and $2,480,000 in earnings ($1.2 million on its own and $1,280,000 from the purchasing power the buyer brings). The investment value to this specific buyer is substantially more than fair market value because of the synergistic benefits this buyer can derive from the transaction. In this case, the buyer, given the particular strategic objectives, brings as much, or even more, to the valuation equation than the seller.

Of course, buyers never want to pay for value that they bring to the table, but they will because it makes good financial sense. Consider our example above. Let’s say that this particular buyer requires a 20% pretax return on its investment. Based only on the seller’s performance, the maxi-mum price the buyer would pay for our-acquisition candidate is $6 million ($1.2 million in earnings divided by a 20% [.20] return equals a $6 million purchase price).

With an additional $1,280,000 in earnings to be realized from increased purchasing power riding on the acquisition, how-ever, the buyer could pay substantially more for the company and still anticipate an aggregate return of 20% or more. If the buyer paid $8,250,000 for the company, the $2,480,000 in earnings would represent a return of 30% or more. Although the price might be greater than fair market value, it is still an excellent deal for both the buyer and the seller.

Sellers can utilize several basic strategies to maximize the value of their investment and increase the value of their business above fair market value (which is average at best) to premium investment value. Our next letter will discuss these basic strategies.

Is Fair Market Value Really Fair?

Investment Value vs. Fair Market Value

Continued from July 2001

In our previous newsletter we discussed that it is how well the seller’s company meets individual buyers’ strategic objectives that creates investment value premiums. For this reason, a seller’s company should be presented to many strategic buyers. For the lumber products company, these buyers would include horizontal integrators—other lumber products distributors; vertical integrators—manufacturers of plywood, particleboard and others. Presenting to multiple qualified buyers creates competition and maximizes the oppor-tunity to find the best-fit buyer willing to pay the highest premium.

Next, be wary of unsolicited inquiries. When a buyer calls a seller expressing interest in acquiring the company, the seller may be setting the stage for what will be a fair market value transaction at best. Investment value opportunities become limited if the seller begins sharing information exclusively with one buyer. From a negotiating perspective, this puts the seller in a reactionary posture, usually resulting in losing control over the content, timing and flow of information. Obtaining premium value requires the seller to maintain control over the selling process.

Third, sellers must correctly identify areas of value. Emphasis is usually on revenues and earnings which support a fair market valu-e conclusion. Instead, identify and emphasize those intangibles that can create investment value. These include market area, market penetration, name recog-nition, depth of management, synergistic benefits, unique products, patents, and more.

Finally, sellers must understand each potential buyer’s strategic objectives if they are to properly position their company to maximize its value. Sellers should question buyers regarding their interest in acquiring the company. Try to determine the synergistic fit—you’ll learn much more than you realize. Review marketing materials; talk with others in the buyer’s industry and with the buyer’s sales personnel. If the buyer has made other acquisitions, speak with the sellers. If the buyer is a public company, request an investor package (annual report, press releases, and more). Various securities firms may have analyst reports available.

Your objective is to get investment value instead of fair market value for your business. Using these strategies together with good negotiating skills can result in a transaction that is excellent for both the buyer and seller.