Author: Alex Hodgkin
Date: April 24, 2018

In many of the valuation exercises we undertake, particularly the ones related to tax compliance, we are beholden to using a standard of value known as “fair market value”. Many of you reading this note may not know what a standard of value is, so here is the definition for this type as put forth by the American Society of Appraisers:

The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and 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.

There is no doubt it’s a strong basis for establishing the value of an interest in a privately held business, for instance, but I do take some issue with a nuanced provision in italics that clarifies the price, namely that it is expressed in terms of cash and cash equivalents.

From what we have seen in the market place, when there are transactions in minority or controlling interests in these businesses, it is rare the form of consideration is entirely comprised of cash. An exception may exist with transactions involving growth capital for nascent startups and/or those financed by institutional, mostly venture, capital investment firms. More often these transactions involve consideration with some form of note, contingent consideration, or rollover investment from sellers to entice third party buyers and mitigate risk.

This creates some deviation in value from the presumption of all cash. To put the issue at hand in context, an owner selling his or her business may accept some form of seller financing as part of the purchase price. This is more the norm than the exception. Clearly, the seller would prefer an all cash purchase price, but the chosen buyer, who is presumed to offer the optimal terms, does not agree to that. Hence a portion of the price is deferred, and with that comes incremental risk, which could in essence reduce the implied value of the equity in question.

While we’re not certain of the correct answer at all times, there have been some resources that have materialized as of late that could assist in these refining assessments, particularly as it relates to the Guideline Acquisition Method. More specifically, there is an annual study produced by the Pepperdine Private Capital Markets Project called the “Private Capital Markets Report”, that provides empirical data on the composition of the various forms of consideration by transaction size. It might make sense to juxtapose this on the implied price, with downward adjustments made to forms of consideration not firmly defined as “cash equivalents”, to come up with a more realistic view of the actual price received. The methods for valuing seller notes for example can be borrowed from valuing debt securities in other contexts.

This may be commentary on the fringes of the general discourse amongst business valuation professionals. However, we are believers that our community benefits from the input of its constituency. After all, the exercises we undertake is most often in the realm of the theoretical, and as such should, as any academic endeavor, be exposed to ideas that can move the accuracy and precision of our assessments forward.