Key Takeaways:
- When it comes to exiting a business, a significant misunderstanding is that the value of a company is equal to the price that a buyer will pay.
- The truth is companies regularly sell for much more (or much less) than their perceived fair market value – real-world markets are not fair.
- When it comes to exiting a business, knowing the difference between price and value is critical to understanding the game’s rules and driving to a successful exit.
What is Fair Market Value (“FMV”)?
In a fair market, there is a willing buyer and a willing seller. While these individuals are eager to exchange property for a price, neither is required to buy or sell. In addition, both individuals are assumed to have equal knowledge of the transaction. Additionally, in a fair market, it is considered there is a buyer.
For example, imagine our good friend, Bob, is looking to sell his car and a teenager, Nick, is looking to buy his first car. Bob and Nick are not required to do business with one another. Instead, they willingly choose to make a transaction. The car is ten years old, needs new tires and maybe a little detailing. Since they are operating in a fair market, both individuals are aware of the car’s condition and all the facts surrounding it and are willing to do a deal based on a price that constitutes a fair value to both parties.
But, the Real World is Far Different From FMV
In the real world, often, there is a willing seller but not a willing buyer or vice versa. Or, there is a willing seller and buyer, but both parties may not have equal knowledge of facts.
For example, Bob may have tried to sell his car a year ago, but there was no demand or willing buyer for the car at that time. Or, perhaps Bob’s car was in an accident years ago and required extensive repairs, but he’s chosen not to disclose that to Nick.
Now, he is attempting to sell his car a year later, and there is an interested buyer, Nick. Nick is excited to have found what could be his first car. However, the car is priced high, given its history and condition. But, Nick does not have much knowledge about cars at his age and does not realize the price is not as reasonable as it should be considering the car’s current condition. Nor does he know to seek out additional facts about the car’s history through systems like Carfax. There is information asymmetry (both parties don’t have equal knowledge of the facts). Ultimately, Nick buys the car, but he pays more than the car’s fair market value for some of the reasons already stated.
Related: Involve your executive team in value creation.Â
Price and FMV Often Don’t Align
Price is the amount of money needed to acquire a product, service, or even a company. While many things are considered in calculating the price of a product, the seller’s goal is to set the price high enough for the desired profit but low enough for targeted buyers to be interested in the product. In other words, prices are determined by what a buyer is willing to pay for the product. It is basic supply and demand.
For example, imagine a start-up company making toy trucks has found a way to make them very inexpensively, $2. While deciding on a set price to go to market, they observe a couple of competitors’ prices who make their toy trucks for an estimated $2.50. Competitor 1 sells their toy trucks for $3.50 at a $1 mark-up, and Competitor 2 sells their toy trucks for $4 at a $1.50 mark-up. Both competitors’ trucks vary in style but are not vastly different, and the start-up’s trucks are similar to its competitors. The start-up company decides to price their toy trucks at $4.50 because they believe they have a better product and want to make more money. However, parents are currently price-sensitive, and all of the trucks look the same to them, so they choose a toy truck for a lower price. The start-up company struggles to make sales and has no choice but to lower its costs to $2.75. They are not receiving much profit per sale but begin to make more sales than both competitors after lowering their prices.
In the beginning, the start-up company could not make money or sell because consumers were not willing to pay a higher price for their product. However, when the start-up company lowered its prices, consumers were ready to buy the toy trucks.
Situations like these occur all the time in the buying and selling of businesses.
How are Price and Value Used in Business Transactions?
Value is typically determined through a business valuation. While receiving a valuation before entering a business transaction is not always required, it is usually a smart thing to do. Knowing what a company is worth provides an understanding of what a strategic buyer, or a buyer who knows exactly what they are looking for, might pay for the company and provides a theoretical idea of value for negotiations.
Price is the result of the transaction and is ultimately determined by what a buyer is willing to pay and the amount of money the current business owner is willing to accept. Price may coincide with fair market value. Then again, it may not.
The seller can use the valuation to help determine their desired price or to help calibrate their original desired price. Ultimately, price is determined through negotiations and can be affected by competition or other outside factors.
The goal during a transaction is to find several interested strategic buyers, if possible. Some strategic buyers are entrepreneurs with high knowledge of the industry. Some are individuals who have developed experience and expertise in the industry looking to become a business owner, or maybe another business that could benefit by acquiring the company that is being sold. After these buyers are found, the competition within the market is used to reach a desired price for the seller or reach a price close to the desired price. Of course, this plan is based on the assumption that the timing of the transaction is correct and the market outlook is positive. However, this is not always the case.
If the timing is not correct or the markets look to be taking a turn for the worse, buyers will most likely be reluctant to pay for what the company is worth. If certain events occur or timing causes a buyer to become price sensitive, a seller could have a challenging time finding a buyer willing to pay the fee they are looking for.
Additionally, industry and economic outlooks can impact what a buyer would be willing to pay. When the lookout for industry and the economy is positive, a buyer will likely pay more. Likewise, if the outlook is negative, a buyer will be more likely to spend less.
A few other factors that affect price are the number of interested buyers, the sense of urgency for the transaction, and the resulting power both provide the seller within the negotiation.
The number of interested buyers affects the sense of competition in the transaction and the overall need or desire for the company. If a seller is looking to exit quickly, they could be more willing to sell at a lower price than they might otherwise. Negotiations include requirements from both parties that are not always agreed upon. In cases where this is true, tensions can become remarkably high due to the risk of one side of the transaction pulling out of the deal.
Before Transacting, Understand Both Value AND Price
Both the value and price of a company fluctuate during the life span of a business. The fluctuate due to conditions within the business, within its industry, and within the economy. This is all especially true at the time of a sales negotiation. The belief and trust of the investors in a company’s profitability and its future ability to grow to provide confidence in its value. Therefore, providing the seller with confidence in their desired exit price. Achieving a successful transition requires having a clear understanding of both value and price.
