Sellers frequently think their business is worth a lot more than the result of a fair market value (FMV) appraisal.
As a side note, when it comes to divorce cases, the business owner wants to make believe the business has no value. When the owner wants to sell the business, all of sudden, he/she claims the business is worth a fortune.
Why do sellers frequently think their business is worth more than the appraised value? This stems from the seller’s confusion between Fair Market Value and Investment Value.
Fair Market Value
The Fair Market Value of a business is defined by the International Glossary of Business Valuation Terms 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.
According to the International Glossary of Business Valuation terms, Investment Value is the value to a particular investor (buyer) based on individual investment requirements and expectations.
The important difference between Fair Market Value and Investment Value is the identification of a particular buyer as compared to a willing buyer or hypothetical willing and able buyer used in the previous Fair Market Valuation definition.
The business might be worth a lot more to a particular buyer (such as a strategic buyer) than to a hypothetical buyer (a financial buyer).
Let’s say we value a 21% interest in a company. The 21% interest is a minority interest. However, the 21% interest is worth a lot more to somebody who already owns 30% in the company as together he/she would have 51%, thus, control in the company. In other words, for a particular buyer the 21% could have swing vote potential and therefore he/she would be willing to pay a premium over FMV.
Another example is synergies. Very large companies are diversified. They can achieve economies of scale. Thus, a strategic buyer is willing to pay a premium over FMV due to synergies. When we include the synergies, the value is not FMV but Investment Value.
What is synergy? As an analogy, we can explain synergy with the formula: $1 + $1 = $3. Assume the seller’s company has an appraised Fair Market Value of $1, and the buyer’s company has a presumed Fair Market Value of $1, then the combined companies may realize a Fair Market Value of $3; i.e., more than the sum of the parts. The additional $1 in the total value is the synergy created from many potential opportunities in combining the two businesses:
- Reduction in costs from lowering overhead, combining benefit programs, increasing purchasing power and a host of other possible cost reductions
- Increase in revenues from combining or widening distribution channels, broadening the product or service offering to the customers, improving pricing power, etc.
- Reduction in total investment from eliminating duplicate facilities and equipment, reducing inventories, combining technology and other intangible assets, etc.
Relating to a Business Appraisal
No portion of the additional synergistic $1 enters into a Fair Market Value appraisal. Fair Market Value is the value of the willing seller’s business as the stand-alone entity that could be purchased by a willing buyer who may or may not have opportunities to create any synergy.
The question becomes, “Should the seller or the buyer receive the extra $1 of synergy created in the combination?” The seller’s gut feeling is that his or her business is worth more than the appraised Fair Market Value. When synergy is considered, the seller’s gut feeling has some validity. The seller’s position is that he brings the opportunities to the buyer to improve both companies. The buyer’s argument is that without the buyer purchasing the company, those opportunities will never be realized.
Separately both arguments make sense. In reality, both buyer and seller will likely share in the $1. However, when the two arguments are laid next to each other, the buyer usually comes out with a greater share of the $1. The buyer is laying out the money and has the burden of turning the potential synergistic opportunities into reality to achieve the combined $3, while the seller may be off fishing or golfing with the buyer’s cash.
Risk of Attaining Synergies
There are also many risks of attaining synergies:
- 61% fail to earn back equity capital invested within three years (McKinsey)
- 50% of mergers erode shareholder value; 33% produce marginal returns (Mercer/Business Week)
- 66% are financially unsuccessful (Coopers & Lybrand)
- More than nine out of ten mergers fail to achieve their objectives (Hay)
- Fewer than 50% of mergers and acquisitions achieved their hoped for cost savings and barely half deliver their expected revenue (Accenture)
It is no wonder that buyers are hesitant to offer the share of the synergy that the seller thinks he or she deserves.
This article was partially excerpted from an article authored by C. Peter Smith, MBA, published in Business Appraisal Practice, Fourth Quarter 2012, p. 13.