This article was written by Harry Haigley, Business Value Center, and is reprinted here with permission.
As an experienced professional valuation analyst, I am often asked about how Strategic Value and Fair Market Value are different. The dollar amount can be very significant for the business owner.
Recently, I provided a valuation report showing the Fair Market Value of a company of $2.5 million. The company is in an industry that is being consolidated by a private equity firm. It is highly desirable. My opinion of the strategic value is in the range of $5 million to $6 million.
Strategic Value is the amount a buyer will pay for a business that is above its Fair Market Value. The added value is due to the expected benefits that come from combining a small company with a big one. The added benefits include increased profits, reduced costs, a new geographic area, or other enhanced capabilities.
Strategic buyers penetrate an industry by buying a “platform company” that has a strong income stream and advantages in its industry. The buyers then buy smaller companies that they “bolt-on” to the platform company. The combined platform and bolt-on companies may move the business from, say, sixth in its industry to second or third.
Large companies that make strategic purchases include Procter & Gamble, Microsoft, McDonald’s, SAP Ariba, JAGGAER, Coupa Software, Oracle and IBM. Broadly, industries that use strategic purchasing include manufacturing, healthcare, retail, and construction.
Why Fair Market Value is Useful
Most privately owned businesses are not candidates for strategic buyers. There is nothing wrong with these companies. They may be in an industry that is so stable that there is no reason to consolidate. Or they may be limited to small geographic areas. Or they be dependent upon one or two large customers (called customer concentration) who could easily shift their buying to a competitor.
Fair Market Value is defined by IRS Ruling 59-60 as “The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
Strategic Value considers the synergies of a specific buyer. Fair Market Value is the value for a hypothetical and not-yet-known buyer.
Fair Market Value appraisals can be used for determining the value of a company to a financial buyer who is interested in the cash flow. This includes:
- Calculating Seller’s Discretionary Earnings which includes corporate net income and then adding back deprecation (which is a tax deduction but not a cash cost) and other corporate expenses made by the owner that a buyer would not have, with charitable contributions as a good example.
- Estimating the future cash flow, discounting it to current value, and setting a dollar amount on expected income.
- Examining data on the sale of comparable companies. The metric is a multiple of Seller’s Discretionary Earnings, as say, 4.5 times earnings. In other terms, this means it will take 4.5 years of earnings for the buyer to recoup his investment.
Fair Market Value is required in IRS filings for estate purposes. Courts also require Fair Market Value reports to help resolve litigation. An example is determining the Fair Market Value of a company owned by a couple that are married but divorcing. These reports are forensic. A value is determined on the date of marriage and another value (showing the increase or decrease in value) on the date of the divorce filing.
The valuation profession calls these methods a “standard of value.” If you are getting a valuation, start by asking for the standard of value that the analyst will use.
Harry Haigley is the owner of the Business Value Center, Inc. He is a Certified Valuation Analyst. He holds an MBA from the University of Chicago. The firm is an independent valuation firm. It does not engage in mergers and acquisitions, business brokerage or real estate appraisals. The sole focus of the company is business valuation.
Author: Harry Haigley, Business Value Center, Evergreen Advisors LLC, firstname.lastname@example.org, 727 510-1144
If you know of a business owner who’s thinking of selling or buying a business and who might benefit from a complimentary, confidential, consultation with us, have them contact me directly at: email@example.com, or one of the other Managing Directors at Transworld M&A Advisors.
Mike Ertel, CBI, M&AMI, CM&AA
Transworld M&A Advisors
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