The commonly accepted definition of fair market value used by Chartered Business Valuators is “the highest price available in an open and unrestricted market between informed and prudent parties, under no compulsion to act and acting at arm’s length, expressed in terms of money or money’s worth”. While this may seem like an overly wordy definition, each of the terms in the definition are important in their own right when determining fair market value. Let us examine each of these terms individually:
- The highest price available – while perhaps somewhat obvious, the importance of this term is that some buyers may be willing to pay more for a business than other buyers. Fair market value is not merely any price, but the highest price.
- An open and unrestricted market – this means that all possible purchasers are included in the notional market and that there are no restrictions on the sale of the business. While such restrictions (e.g. as contained in a shareholders’ agreement) may be considered in determining fair market value, the approval of a notional sale is assumed to be granted;
- Between informed and prudent parties – it is assumed by the valuator that all material information that could be expected to influence the price to be paid for a particular business is available to the buyer and that both the buyer and seller are acting in a rationale manner;
- Under no compulsion to act – this term assumes that neither party is being forced into the act of buying or selling the business. There will be no ‘fire sale’ price and either the buyer or seller is assumed to have the ability to walk away from the transaction if they are unable to reach a price;
- Acting at arms-length – a valuator assumes that the notional sale of the business is taking place between unrelated parties and that negotiations between the parties would be undertaken with each party attempting to achieve the best price regardless of non-business factors; and,
- Expressed in terms of money or money’s worth – fair market value, as defined by a valuator, is the cash equivalent price. Although in live transactions the full purchase price is rarely paid in cash at closing, valuators conclude at a cash equivalent price.
While this definition of fair market value allows a valuator to determine the notional value of a business, often one or more of these value terms does not hold true in the marketplace. When this happens, differences between the notional fair market value as determined by the valuator and the actual price paid for a business on the open market can be significant.