HOW OFTEN HAVE you called a business appraiser for a fair market value assessment of a client’s business, only to find out that was not what the client needed? Unless your client needs a valuation for federal tax purposes, divorce — in New Hampshire, the standard of value — for divorce is always fair market value or some other legally required valuation purpose, "fair market value" is often not what your client really wants or needs.

In most cases, a business owner has no idea that "value" is anything other than plain old "value." After all, does the price of a house change with each potential buyer who walks through the door? Do car prices change on the spot, based on the wherewithal of the buyer to pay? (Okay, maybe that was a bad example, depending on the scruples and negotiating skills of the car dealer!)

The Eye of the Beholder

Value truly is in the eye of the beholder for a business. If a client tells a business appraiser that he is interested in selling his company to his management team, that buyer may only be able to pay an amount that can be supported by the cash flow. If he tells the appraiser that he hopes to sell it to a key competitor, and the acquisition will allow that competitor to sell new products in new markets, that buyer may be willing to pay a substantial premium.

Each of these analyses would be very different. In the case of a sale to the management team, the seller may be most interested in how he can structure the sale as a step acquisition to make it more affordable to the team, how it can be financed, and how a consulting agreement can be structured over a period of years to ensure a smooth transition. If that is the assignment, the appraiser must be sure that the client understands that what the management team can afford may in no way represent the market value of the company were the owner to try to sell it. In the case of a strategic acquirer, the seller may only be interested in a search for transactional data, to determine who is doing the deals, and at what acquisition multiples and deal structures.

In either case, if the appraiser were to have simply launched into a fair market value appraisal of the company, at best, she would be providing a document of very limited utility to your client, at worst, of no utility at all. What good is fair market value if the management team cannot see how they can pay for it? And, what good is fair market value to the seller when what he is looking for is someone to pay a strategic premium?

Most sellers ultimately want to know the highest price they can get for their busi ness. Business appraisers know that they simply cannot tell the clients that figure because: the appraisers do not know if the seller’s business will be lucky enough to be acquired by a strategic acquirer; and, even if the appraiser did know that, he does not know how much of a premium that buyer would pay. That being said, appraisers could identify what buyers are active in the marketplace and what sorts of premiums are being paid within particular industries.

This is not to say that a fair market value analysis is never appropriate for a seller. It often is, in the sense that it can set the minimum financial value that the seller would be willing to accept.

What Is It Worth?

On the other side of the coin is a client who wants to buy a business and you suggest that an appraiser value it for him. However, in this case, too, a fair market value analysis may not be what the client really wants or needs.

Instead, the buyer may really want to know what purchase price the cash flow will enable him to afford to support any necessary purchase financing. The buyer might want to see pro-forma cash flows using anticipated company financial data as it will likely look once ownership changes hands. Is the buyer going to pay himself the same salary as the prior owner? Is the prior owner going to stay in place? Is the buyer going to eliminate a division of the company?

Consideration of these issues presents the appraiser with a different analysis, an "investment value" analysis. This identifies what the business is worth to a specific buyer, rather than to the hypothetical buyer. What the business can support as a purchase price for the buyer may be totally different from what the business may generally be worth in the market to the universe of buyers as a whole.

In the real world, a company might have very little in the way of earnings or cash flow, yet buyers may be willing to pay a great deal for it based on expected future results, market forces, or other factors. Therefore, an affordability or reasonableness test of value based on a company’s cash flow may deviate very materially from its actual market value.

To adequately define the engagement of an appraiser, it is critical for the business appraiser to ask your client numerous pointed questions and listen to what he wants. It is surprising how often the answer is not a fair market value analysis.

What Is Being Valued Anyway?

Taking the standard of value one step further, the need for the appraiser to understand what she is valuing seems like such a simple notion, and yet it is surprising how easily it can be miscommunicated or misunderstood. Does your client need a minority interest valued or a controlling interest? Should she value the whole company or only a division?

The subject of the appraisal can easily get mixed up. Assume you hire an appraiser to value a 15 percent interest for purposes of a minority shareholder buyout. In valuing the 15 percent interest, the appraiser capitalizes the cash flow available to the minority shareholder, a lack of marketability discount is taken, and the value of the 15 percent owner’s share is determined.

Upon issuing the report, your client asks a seemingly very simple question: he wants to know what 100 percent of the company is worth. Since the appraiser thought the purpose of the engagement was to value only a 15 percent interest, he had valued that interest directly rather than determining a value for 100 percent of the company, taking discounts for minority and lack of marketability. Thus, he cannot answer the client’s seemingly simple question. Had the appraiser been aware that the client wanted to know what the 100 percent control-based cash flow and value would have been, she would have approached the project completely differently.

Perhaps there are no cases where "clarity up front" is needed more than cases in which the appraiser is jointly retained.

For example, in the case of a minority shareholder buyout, the departing shareholder may not want the appraiser to determine the fair market value of his interest, which is a minority interest and would reflect its lack of control and marketability. Instead, he may want the appraiser to value the interest based on its pro-rata share of a 100 percent controlling interest value, which reflects the minority shareholder’s share of what the entire business is worth to one buyer having total control. This is a very different and potentially much higher value. Alternatively, he may even want the appraiser to value the interest based on multiples derived from strategic deals happening at the time. Meanwhile, the acquiring shareholder may want the appraiser to value a minority interest based on the amount that the cash flow can support, taking into consideration appropriate discounts.

Therefore, the appraiser must be very careful in the valuation report to explain just what is really being done, lest the reader be misled. If the appraiser is taking steps to estimate value using assumptions that do not result in a true fair market value estimate, the report is not a value estimate at all, but instead must be labeled a "hypothetical valuation." In these situations, appraisers often look to attorneys to instruct them on how the subject interest is to be valued.

In a shareholder buy-out situation, the terms of the shareholder agreement, if there is one, may be ambiguous or may not adequately capture the value of what is subject to the agreement, potentially causing the shareholders to hold the value that such an agreement sets with little regard. Also, the shareholders may have very different perceptions of value. A classic example of this is seen in professional practices.

The retiring professional wants to sell his interest and capture the goodwill from the long list of clients he has generated over the years. As such, he may believe there to be substantial value in his interest that deviates from the value set forth in a shareholder agreement. On the flip side, the professional acquiring the business does not see as much value in the retiring professional’s interest and is therefore only willing to pay a lesser amount for the stock because he believes the professional has already taken out any value along the way in the form of salary.

When possible, having the discussion with the buyer and seller up front, and getting them to agree to a conceptual framework of what value means will facilitate the process and minimize significant surprises in the end results. Once numbers begin to be talked about, it becomes very difficult to go back to the theoretical "intentions" of the parties involved. Appraisers have learned that separate discussions with all parties at the front end can provide an opportunity to determine where different perceptions of value exist. Those differences can then be narrowed and dealt with specifically, winnowing down to the "most common view" before proceeding with the valuation process.

Obtaining Sensible Results

Fair market value is not always the appropriate analysis for an appraiser to undertake. However, communicating the facts and circumstances up front and early on with an appraiser can assist in arriving at a more sensible result for your client.

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