Friday, 18 March 2016

Business Price vs. Value... what's the difference??

“Price is what you pay for, value is what you get.”  - Warren Buffet

There are many business valuation-related terms used that may lead to some confusion. This blog post will focus on clarifying some common misunderstandings. Specifically, this blog post will focus on clarifying some of the differences between business price vs. value.

What is business value? Is it the book value from a company's financial statements?

Most likely... not. A company's book value refers to the balance sheet value of a company. It is the company's balance sheet assets less its liabilities. On the balance sheet, asset values are normally listed at historic cost amounts and possibly some level of depreciation charged against them. They usually do not reflect the actual values that they can fetch on the marketplace.

If you were looking to sell a company you would most likely NOT sell it for its book value. The big reason for this is that book value does not include the economic goodwill of the business.

For instance, imagine a dental practice. The practice has all kinds of equipment, supplies, tools, computers, furniture and other items. However, if the business was bustling with an established patient roster and lots of revenue and profit then the dentist would not want to sell you the practice for merely the book value of the company. He or she would want some consideration for the patients that keep coming back to him and the reputation of the clinic. This is the economic goodwill.

So... book value is an accounting term. It is not true economic value.

So what is the “value” of a business then? Is it the price that it sells for in the marketplace?

Not necessarily. There is an irritating, often-used phrase that “....a business is worth only what someone is willing to pay for it.” However, this isn't the whole story. A price is simply that amount that a business transacts at in the marketplace, but is it truly value???

Let's step back for a minute. Imagine a situation where a suddenly widowed man (Dave) takes over a business that his wife (Deb) was president of until her sudden and untimely death. Imagine that Dave is suddenly thrust into the job of running the business that he knows little about. Perhaps the business is starting to suffer due to the death of Deb. Dave just wants out and is willing to accept any offer that comes along. Imagine that a competitor of Dave's hears of the situation and offers him a very lowball offer with very little cash down on closing and with all sorts of contingencies baked into the deal. If Dave accepts this lowball offer from them competitor then this is the actual price that the business sold for. But is it truly value? Could Dave have gotten more money for the business if he were personally able to hold out and shop the business around to other buyers? Perhaps Dave is an inexperienced negotiator and the buyer was slick and took advantage of his inexperience. Perhaps if Dave weren't still grieving the loss of Deb then he would have been more inclined to hold out for more money. The point is the price something sells for does NOT necessarily equal its value.

So what is business value then?

According to the Canadian Institute of Chartered Business Valuators (CICBV), the definition of fair market value is:

"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 arms-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."

So let's examine this definition using Dave's example from above, to see if the price he received was at fair market value.

Highest price
Did Dave receive the highest price? Probably not. He was happy to accept the first offer that came along. He didn't talk to other buyers, didn't market the business for sale and didn't negotiate too hard.  He just wanted out and wasn't overly concerned about price.

Expressed in cash
The deal that Dave received was not an all cash. It had very little cash on closing and had all sorts of contingent payments (earnout) negotiated. In order to look at things from an apples to apples perspective, these terms would need to be discounted to see their cash equivalents.

Open and unrestricted market
Did Dave really expose his business to an open and unrestricted market? No, he did not. He didn't shop it, didn't talk to an M&A intermediary, he didn't advertise it was for sale and expose it to the market for any reasonable amount of time. He took the first offer that came along.

No compulsion to act
Dave way very compelled to act. He lost his wife and was emotionally in a tough place and he had no background in running the business.

Both must have reasonable knowledge of the facts
Did Dave really have the full facts? He was new to the business and perhaps did not appreciate the market potential or growth opportunities. The competitor probably knew what he was getting better than Dave did.

The point to the above is that just because a transaction is at an arm's length and between third parties does not necessarily mean that it is done at fair market value.

In the 1990s there were many startup web companies with little to no profit or revenue, trading at billions of dollar on the stock market.  Were they trading at fair market value?   Or were the share prices simply bid up in a speculative frenzy?  Again, the point to remember is that price did not (necessarily) equal value.

There are many other business valuation definitions that are used, depending on the circumstances (such as litigation purposes, CRA/tax related reasons, and so forth). Other value definitions include intrinsic value, fair value, value in use, value to owner, liquidation value, replacement value, reproduction value, and so on..  They key is to know that price does not always equal value and that depending on the circumstances, the precise definition of value may vary.

If you or your client require an independent business valuation or would like to discuss a business valuation issue please contact Steve Skrlac, MBA, CFA, CBV.

Keystone Business Valuations
located in Burlington, Ontario and serving clients accross souther Ontario.
905-592-1525 •

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