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Why Fair Market Value and Price Aren’t Always the Same

November 5, 2015

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When we perform a valuation of a business, in essence we are determining the fair market value (“FMV). Under valuation terms, FMV is defined as:

“The highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”

Fair Market Value

FMV is based on a notional market (i.e., one that is determined without exposing a company for sale in the open market). The price paid for a company in the open market may differ from FMV determined in a valuation due to factors such as the negotiating strengths, differing levels of motivation to complete the transaction and non-cash considerations.

  • Negotiating strengths: As a buyer and seller may have different skills and abilities in negotiations, the price actually paid for a business is dependent on which side is able to push harder to reach the price they want. In most cases, the buyer is inclined to pay a lower price for the business while the seller wants to sell for a higher price. Buyers and sellers have different knowledge and financial strengths and the final price will be influenced by this imbalance.
  • Differing levels of motivation to complete the transaction: As buyers and sellers respectively have different reasons to buy and sell a business, it is expected that their differing motivations and/or emotional considerations will influence how much a business will ultimately sell for. For example, a seller’s main motivation may be for retirement. As such, the seller may be willing to sell the business at lower price in order to save them the trouble of negotiating back and forth and have more time to enjoy retirement.
  • Non-cash considerations: Although a valuation determines the highest price of a business expressed in cash or cash equivalents, open market transactions may include non-cash components as part of the deal. These may include promissory notes, debt or shares of a buyer’s company.

As a result of these factors, the actual selling price of the business or entity may be higher or lower than the notional FMV determined in a valuation.

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