What’s “Fair” about Fair Market Value?

Fair Market Value (FMV) is a universal concept in the business, financial, and legal world. Most professionals in these spaces know the basic tenants of FMV: “willing buyer, willing seller, no duress.”

With an extremely liquid asset (such as stock in a large corporation), this definition is good enough. If you don’t want to sell, you don’t have to. If you want to buy but don’t like the price, you can wait. The price is “fair” – it has been set by the open and continuously-correcting stock market.

But with less-liquid assets (such as a small business, real property, inventory, or machinery), the “fair” market is harder to identify. There is not an open, continuous market of publicly observed transactions. Most sales are private, with pricing subject to custom negotiated terms for each buyer and seller.

Appraisers work with small to mid-size businesses (SMB’s) to determine what Fair Market Value represents in for each situation.

Risk and Reward

For machinery and equipment (M&E), FMV means an arm’s length transaction between willing parties, with no compulsion to transact right now, and with the buyer having knowledge of all facts.

There is a presumption that the seller is mitigating the buyer’s risk – they are allowing the buyer to inspect the machine, negotiate terms, take their time to decide, and so on. In return, the seller has the luxury of setting a desirable price and waiting for good buyers to show up.

This is different from a liquidation scenario, where the buyer takes a greater risk. The item is being sold as-is, where-is, with no assurances. There is usually a limited opportunity to inspect the item. Also, the buyer has a limited timeframe to make a decision – in an auction scenario, the decisions are immediate; an orderly liquidation may allow a few weeks or months. In return, the buyer is usually rewarded by a lower purchase price to account for this increased risk. Further, the seller must transact quickly, at whatever price the market will bear. In return for passing off risk to the buyer and forcing a timely sale, the seller will usually receive less money at a liquidation than in a FMV transaction.

Arm’s Length vs. Handshakes

FMV is a “fair” price determined by open market activity, not determined by related parties. FMV buyers and sellers are said to be “at arm’s length,” each acting in their own best interests.

A demonstrative example of (literally) related party transactions would be machinery sold from a parent to a child as a business transitions to the next generation.

Mom may have sold Bill a tractor for $100,000 – but that doesn’t mean the tractor’s Fair Market Value is $100,000. Mom and Bill have other interests together – a familial relationship, a shared business enterprise, a cash rent contract, perhaps a desire to keep Bill solvent or avoid taxes for Mom.

Other examples of (not literally) related parties are less obvious: a large manufacturer forcing a transaction between suppliers; a partner with intimate knowledge of a facility acquiring another partner’s shares; a competitor acquiring a business unit with the intent of reducing competition.

The negotiated prices in these situations are rarely “fair.” That is, the business assets were not offered in an open marketplace of buyers and sellers in order to determine optimal pricing. Rather, price was determined by the negotiated terms, internal relationships, and auxiliary interests of each buyer and seller.

Why Does FMV Matter?

You have a business or business assets being transferred for a price and terms that satisfy both parties…who cares what Fair Market Value should have been?

As it turns out, a lot of people!

To name a few:

-        The IRS and local assessor, who get paid based on market value (not purchase price).

 -        By extension, your CPA, who is trying to improve your tax position for your entire ecosystem of assets and liabilities.

 -        Your shareholders and investors, who want to ensure you’re making smart transactions and not giving sweetheart deals to friends.

 -        The bank and other lienholders, who want to make sure they are properly secured.

 -        Your spouse (current or ex), who stakes a claim to half of your claims.

 -        The insurance company, who needs to make sure your policy can afford to replace your assets.

 -        Your management team, who may be planning to re-package and re-transact a portion of the same assets in the future.

 -        Your children or managers, who are deciding whether to buy your business in 7-10 years.

 -        Your attorney, who may be trying to file, fend off, or settle claims with everybody else on this list.

Fair Market Value may seem like an abstract concept, but it shapes the financial outcomes and strategic future of your business, whether you recognize it or not. Establishing FMV at the time of a major transaction protects you and builds trust with everyone who has a stake in your enterprise.

Don’t leave these critical decisions to guesswork or generic formulas. At Capitale Analytics, we have the experts to complete diligence on your past current, and future transactions. Your business was built on years of effort and dedication – give valuation the attention it deserves.