Business Fair Market Value
A business fair market value (FMV), or market value, is commonly used in business valuations and is defined by several public institutions or valuation associations as: “the price that would be negotiated in an open and unrestricted market between a knowledgeable, willing but not anxious buyer and a knowledgeable, willing but not anxious seller acting at arm’s length.” If you’ve ever asked yourself, “What’s the value of my business? And according to what? The market? My competitor? Why do we define fair market value, and what’s it used for?” Read this article for the answers to all of those questions.
In context of the term “fair market value”, here are some definitions:
- Fair: the buyer has all the important information to make an informed decision when negotiating the price
- Market: a hypothetical buyer across the entire market (in other words, NOT a specific party that has a specific reason to pay extra for it, as in the example of a car collector paying double the price for a vehicle because it completes their collection)
So why do we need this concept of standard of value, which in this case we call “fair market value”?
Knowing the fair market value of your business can be used for several different purposes. You might find yourself in a position in which you wish to sell your business because you’re retiring, but you want to make an informed decision about what the current market (hypothetical buyer) value of your business is.
This could apply as well to certain share schemes, in which employees are offered shares, so what is the fair market value of those? The answer would have tax implications, and the tax department needs to know what the fair market value is.
On the other hand, there may be one 50% shareholder buying out the other, or you’re planning to hand the company to one of your family members (in which there could be capital gains or gift tax implications), so how much capital did they actually gain?
You might say that your business is worth $1 million, but in the eyes of the tax department, it could be worth $2 million because this is what a buyer in the market would pay without a family member discount. Furthermore, you may have sold it to someone with strategic interests, and the price has inflated past FMV. Consequently, valuing your business under or over fair market value means potentially paying incorrect taxes, which can have obvious consequences.
Alternatively, you could be planning your exit from business and would like to know the current value if you “went to market”, so to speak. A valuation would help to set your objectives and let you know how to increase your business’ value in order to achieve your price goals at sale.
You can then start looking for a specific buyer with synergistic interests, and achieve a sale over FMV (for example, a retail seller buying the wholesaler business).
How you arrive at the fair market value for your business is a complex and detailed process that is beyond the scope of this article. As there are a myriad of datapoints, variables, and assumptions that go into the process, it’s important to consult a professional valuer.
Oftentimes with small- to medium-sized businesses, the business is the largest or one of the largest assets within the owners’ portfolio. For this reason, not having a professional valuation can leave your company grossly under or overvalued, which can potentially cause implications with the ATO or your business to remain advertised for sale for years without an offer. Also, you might end up buying your business partners’ shares for a significant amount over the value you should have paid.