Difference of Fair Market Valuation in Theory Vs. PracticeThe official fair market value definition is "the highest price available in an open and unrestricted market between informed and prudent parties, acting at arm’s length and under no compulsion to act, expressed in terms of money or money’s worth". So this definition represents the perfect world where both the buyer and the seller have all available information, are prudent, etc, etc.
In the real world, this is never the case and this where you can arbitrage to drive a better deal. For example, price can be influenced by:
- Your negotiating skills or your size and leverage - if you know more about the marketplace, have a stronger balance sheet giving you financing flexibility, or simply out negotiate the other party it is possible to realize a better price up or down than what the business is really worth.
- How emotionally involved the other party is - buying or selling a business is never an emotionless process. A business owner may be selling the business to regain some balance in their life, or provide a career for family members, etc. so knowing the motivations is critical to achieving a more optimal price.
- The price may not be all cash. Often times, you can negotiate a better price if you are buying by incorporating earnouts, vendor financing, or retained equity components. If you are selling, don’t be tempted to take the highest number without considering what the consideration entails. Often taking a lower but cleaner number; that is, a number where the cash consideration is maximized may be a better option.
- The price may be driven by who the buyer is in case you are selling the business. There are different kinds of buyers including special interest buyers, financial buyers, and even management by way of management buyouts and all of them have different objectives, interests, and ways of valuing a business so you must know who you are dealing with and perhaps more importantly understand who else is out there who may be interested in your business.
So as you can see, there is any number of ways where price and fair market value will differ. However, before you even consider entering a negotiation; always select the right business valuation method first before you commence any negotiation. Knowing your estimate of fair market value will better prepare you bid the price lower or higher depending on whether you are buying or selling.