Maine business owners are often surprised when they receive their valuation report from a hired appraiser. Often times the expert is hired to determine the fair market value of a business interest for, say, divorce or gift and estate tax purposes, and the client wonders, “Is this all I would receive if I were to sell the business?”
Because the owner’s business is likely his or her most valuable personal asset, this valuation can be quite concerning. However, these two standards of value are not synonymous and it’s important to understand the differences between fair market value and investment value in order to alleviate some of the panic and frustration.
Fair Market Value vs. Investment Value
Fair market value is the hypothetical price, expressed in terms of cash equivalents, at which a property would change hands between willing and able buyers and sellers acting at arm’s length in an open and unrestricted market. Neither would be compelled to act and both would have reasonable knowledge of the relevant facts. It’s essentially the price the universe of hypothetical buyers and sellers would agree on for the business. This standard of value is relevant for various tax purposes and for many litigation scenarios. It’s also a useful starting point when selling a business, but it may be less than you’d receive in a well thought-out sale of your business.
In the real world, value is in the eye of the beholder. Some investors have different perceptions of risk or may operate complementary businesses that provide cost-saving or revenue-enhancing synergies. When selling your business, you want to find a strategic investor who’s willing to pay a premium above fair market value, such as a competitor or joint venture partner. In other words, the appropriate standard of value in a merger or acquisition is investment (or strategic) value. This is the value to a particular investor. It can be more or less than fair market value — but when it comes to selling the business, most owners will hold out for a buyer willing to pay a premium price.
Nontransferable, Owner-Specific Elements of Value
A business may have more value in the hands of certain types of owners. This is especially true of professional practices that require the owner-operator to obtain specialized training or licensing. These businesses possess what is known as “personal (or professional) goodwill,” as opposed to “enterprise (or business) goodwill.” The Indiana Supreme Court succinctly defines personal goodwill as the value “associated with the individual practitioner. This type of goodwill is based on revenues being generated because of the practitioner’s skills, knowledge, and reputation” (Yoon v. Yoon, 1997).
It extends beyond professional practices and can exist in any commercial enterprise. In that context, personal goodwill includes not only skills, knowledge, and reputation, but contacts and relationships among other things. Business owners will often look at these relationships and specials skills without realizing that they may not be able to transfer some of them to a new owner.
Fair market value would not include these nontransferable personal goodwill items, and the business is worth less to the extent that these nontransferable skills generate income that’s also nontransferable to a buyer.
In addition, many Maine business owners do not realize that as the owner they are entitled to a job, and that translates to a value proposition for them. While there are individuals in the universe of hypothetical buyers who also might be buying a job, they are not all of the buyers out there, and often have fewer resources with which to buy a business. As such, the asset of having a job, which provides income as well as elements of control, is not likely to be as valuable an asset in the market place as to the owner of the business.
Valuators Bring Objectivity
Value, in the eyes of an entrepreneur who’s nurtured the business for years, may be skewed by pride, joy and other emotions. Valuators can provide objective market evidence that can serve as a sanity check for unrealistic owners.
Using Both Standards to Improve Decision-Making
Both fair market value and investment value are important metrics when selling (or buying) a business. It’s often cost-effective to measure both standards of value simultaneously if you’re currently having the business appraised for estate tax planning, litigation or other purposes,. Every Maine business owner is curious about the value of his or her investment, regardless of whether or not a sale is imminent.