Tag Archives | fair market value

Business Valuation Purposes

See Also:
EBITDA Valuation
Valuation Methods
Multiple of Earnings

Business Valuation Definition

Business valuation is the process of determining the economic value of a business or company. It assesses a variety of factors to determine the fair market value in a sale, but there is no one way to verify the worth of a company. Business valuation can depend on the values of the assessor, tangible and intangible assets, and varying economic conditions. Business valuation provides an expected price of sale; however, the real price of sale can very.

Traditional approaches to business valuation employ financial statements, cash flow models, and comparisons to competitive companies within a similar field or industry.

Business Valuation Methods

Income Approach: determines business value based on income. This type of valuation focuses on net cash flow, discretionary cash flow, and capitalization of earnings.

Asset Approach: determines business value based on assets. This type of valuation focuses on both asset accumulation (assets minus liabilities) and capitalized excess earnings.

Market Approach: determines business value in relation to similar companies. This type of valuation focuses on the comparative transaction method and appraises competitive sales of comparable businesses to estimate economic performance looking at revenue or profits primarily.

(Are you in the process of selling your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.)

Business Valuation Purposes

Although the primary purpose of business valuation is preparing a company for sale, there are many purposes. The following are a few examples:

Shareholder Disputes: sometimes a breakup of the company is in the shareholder’s best interests. This could also include transfers of shares from shareholders who are withdrawing.

Estate and Gift: a valuation would need to be done prior to estate planning or a gifting of interests or after the death of an owner. This is also required by the IRS for Charitable donations.

Divorce: when a divorce occurs, a division of assets and business interests is needed.

Mergers, Acquisitions, and Sales: valuation is necessary to negotiate a merger, acquisition, or sale, so the interested parties can obtain the best fair market price.

Buy-Sell Agreements: this typically involves a transfer of equity between partners or shareholders.

Financing: have a business appraisal before obtaining a loan, so the banks can validate their investment.

Purchase price allocation: this involves reporting the company’s assets and liabilities to identify tangible and intangible assets.

business valuation purposes

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Fair Market Value

See Also:
Adjusted EBITDA
Asset Market Value vs Asset Book Value
Valuation Methods
Goodwill Impairment

Fair Market Value Definition

The Fair Market Value definition is the price a specific property, asset, or business would be purchased for in a sale. A company’s fair market value should be an accurate appraisal of its worth.

Calculating Fair Market Value is subject to the following conditions:

  1. Prospective buyers and sellers must be knowledgeable about the asset.
  2. Buyers and sellers must not be coerced or strong-armed into selling or purchasing.
  3. All parties must provide a reasonable time frame to complete the transaction.

In other words, an estimate of the amount of money an industry-educated, interested, unpressured buyer would pay to an industry-educated, interested, unpressured seller is the FMV.

How to Determine the Fair Market Value of Your Company

If you are considering selling your business in the future or are just trying to strategically plan for the long-term, then it is crucial that you determine the fair market value of your company. The difference between the fair market value and the purchase price can often be considerable; consequently, many sellers hire professional appraisers for business valuation. This cost can range from a few thousand dollars to $50,000; however, we highly recommend to hire a third party as most owners inaccurately estimate the value of their business, which can lead to disappointed expectations regarding the company’s value or a low sale that leaves hard-earned money on the table.

(Are you in the process of selling your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.)

What Your Appraiser Will Look For

There are many ways to calculate the Fair Market Value of your business; some of the factors that affect a business’s FMV are the business type, the economic conditions at the desired time of sale, the book value, recent income, dividends, goodwill, and recent prices paid for comparable businesses. During an assessment of your company, an appraiser will look for the following items along with many others:

  1. Future Earnings: An appraiser will forecast future earnings over multiple years, factoring in the discount cash flow and discount residual value by comparing your company to similar ones. The discount rate reflects the diminishing value of money year after year. They will also determine the “capitalization of earnings rate,” which indicates the cost of capital and the company’s risk.
  2. Asset Assessment: They will evaluate the Fair Market Value of all the tangible assets of the company, such as inventory or equipment, as well as the intangible assets, such as brand, reputation, and location.
  3. Comparable Sales Figures: They will analyze recent sales of commensurate companies.
  4. A Partial Purchase Discount: If the buyer is purchasing a minority share of the company, then less than 50%, apply a discount since the other party would still control the business.

Conclusion

Appraisers and valuation experts typically use more than one approach when evaluating the FMV of a company. So start identifying the value of your business today by grabbing your business tax returns and general ledger. Before you start the valuation process, download the Top 10 Destroyers of Value to identify any destroyers of value and maximize the potential value.

Fair Market Value, Fair Market Value Definition, Determine the Fair Market Value

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Fair Market Value, Fair Market Value Definition, Determine the Fair Market Value

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Purchase Option

Purchase Option Definition

Purchase option, defined as the opportunity to purchase a piece of property which is being leased after the lease is completed, is part of the many options available in a lease agreement. A purchase option is often agreed upon by the two parties involved before the contract is made.

Purchase Option Explanation

Purchase option, explained by many business owners as an option to “try it before you buy it”, is available on almost any leased asset. The value of a lease purchase option agreement is evident. A party wants to lease a piece of equipment because they can not afford to buy it. However, to keep their options open they decide on a purchase option lease. This benefits the lessor by allowing her to choose, at the final moment, whether the item has created value and is worth keeping. Additionally, the lessor can account for changes in needs, expectations, or operations by leaving their options open and opting for a purchase option.

For the lessee, it allows them to make the income from leasing the item while also making the income from selling the item. In this way, a purchase option provides a benefit to both parties. It also allows access to and income from the asset almost instantaneously. A purchase option fee may be accrued while choosing to engage in such a contract.

Purchase Option Example

Asal is renting a piece of equipment for her graphic printing firm. Asal, because of her vast equipment needs, has to watch to make sure she has the cash flow necessary to operate her business based on the current needs it has. She currently can not afford to buy this piece of equipment. Still, she sees the value in having it available in her office. Asal balances these two needs by agreeing on a purchase option with the lessor.

Asal is creating a short-term agreement to lease the piece of equipment, a commercial quality printer. She will keep this printer in her office for one year, at which point she will buy the item. Asal and her lessor agree on a fair market value for the printer. So Asal completes the purchase option agreement and begins use of the item.

One year later, Asal is seeing a lot of growth in her business. So much growth, in fact, that she is going to outsource the printing for her customers to a better equipped company. She trusts this vendor and knows the quality of the products they produce, so she trusts the company.

This change of pace negates her need to purchase the printer she was leasing. Asal is nearing the end of her lease agreement, so she informs the lessor that she will not be accepting the purchase option at end of lease. She has more important expenditures to make at this point.

Asal is happy that she made a purchase agreement. She made the right business decision and will soon see the fruits of her labor. She opens the office the next day with the feeling of success.

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Financing Lease

See Also:
The Dilemma of Financing a Start Up Company
Lease Agreements
Operating Lease
Sale-and-Leaseback
Lease Term

Financing Lease Definition

The financing lease definition, also known as a capital lease, is a method of deferred payment. If the lessee is willing to pay the additional cost of interest, then they can use a financing lease to pay off a capital investment over time rather than all at once. Different from an operating lease, a company who uses a financing lease gains ownership of the item when the lease period is over. Generally, they have to pay a final balloon payment which is less than the fair market value of the item if it was new.

Financing Lease Explanation

A financing lease, explained simply as lease-to-own, has many benefits. First, it allows the interested party to use a deferred payment schedule on a necessary tool. This has been explained above.

Other benefits of a financing lease make it a more attractive option. To begin, the lessee may still gain the benefit of depreciation, thus saving money on taxes. This is a benefit which makes a financing lease more appealing than an operating lease. The cost of this is that a financing lease can only write off the expense of interest payments rather than principal. Insurance premiums, repair costs, and taxes are incurred by the lessee rather than the lessor. Additionally, they claim the risk of ownership on the item.

Another benefit is that this type of lease allows the purchasing party to own the item at the end of the agreement, making the lease an effective investment rather than a cost of doing business. Many financing leases allow the purchasor to receive the item whenever they want by paying off the final principal value in one lump sum.

For a financing lease accounting to run smoothly, a few standards must exist. Ownership of the item at the end of the lease term and purchase choice form the first two. Next, the length of the lease must be 3/4 the economic life of the item. Finally, the lease payments must comprise at least 90% of the cost of the item if it was purchased instead of leasing. These traits make a financing lease a unique tool for a customer who wants a tool, wants to receive vendor financing, wants to gain ownership of the item, and wants flexible terms in all of this.

Financing Lease Example

Devin has created a new soda company. Modeled after the tradition of Italian Sodas, Devin believes the US market would love to try his tasty beverage. He appears to be succeeding from his initial efforts of marketing and selling his product.

Now, Devin must expand his business. To do this, he will need a larger bottling machine. Devin wants the equipment but also wants to reserve the cash he has for expansion. He expects growth but currently, from his planning of company finances, only has so much to spend.

Devin decides on a direct financing lease with the equipment provider. Here, he can have and work towards owning the item as soon as possible. He likes the terms his vendor provides on financing, especially that he can pay off the item if he sees more success than he expected. This is known as a financing lease buyout.

In this agreement, Devin negotiates the total price, interest rate, principal and interest payment schedule, and any associated penalties and fees. Devin is able to find a great deal on the item and completes the contract. He knows that by financing the item he will pay a little more, but overall appreciates his decision. It will help create the success he has envisioned.

For more tips on how to improve cash flow, click here to access our 25 Ways to Improve Cash Flow whitepaper.

Financing Lease Definition, Financing Lease Explanation, Financing Lease

Financing Lease Definition, Financing Lease Explanation, Financing Lease

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Asset Market Value vs Asset Book Value

See Also:
Accounting Income vs Economic Income
Economic Value Added
Value Drivers:Building Reliable Systems to Sustain Growth
Basis Definition
Variance Analysis
Goodwill Impairment

Asset Market Value versus Asset Book Value

Book value and market value are two ways to value an asset. An asset’s book value can differ from its market value. Market value is the value of an asset as currently priced in the marketplace. In comparison, book value refers to the value of an asset as reported on the company’s balance sheet; however, some assets are reported at market value on the balance sheet.

Book value is equal to the asset’s historical purchase price minus accumulated depreciation. Since book value is based on the asset’s actual purchase price, consider it more reliable but less relevant than market value.

Market value, also called fair market value, is equal to the asset’s current price or value in the open marketplace. Since market value is based on current market prices, consider it more relevant but less reliable than book value.

Asset Value for Company Valuations

Are you comparing asset valuation methods for the purpose of valuing your company? This can become complex, especially when comparing methods for valuing assets. When a valuation becomes complex, it is standard practice to consult with a valuation firm. Need help finding one? We will connect you with one of our strategic partners for your valuation needs. Fill out the form below to get connected:

Your will receive your information between 9-5 Monday through Friday. You can expect to hear back within 24 hours. We only use your information to contact you for the desired help.

If you don’t want to leave any value on the table, then download the Top 10 Destroyers of Value whitepaper.

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Arm’s Length Transaction

See Also:
Accounting Principles
Accounting Concepts
Point of Sale (POS) Method
Working Capital From Real Estate
Which Bank to Choose?

Arm’s Length Transaction Definition

An arm’s length transaction or the arm’s length principle is a transaction that takes place between two completely unrelated parties. An arm’s length transaction also implies that the final transfer of assets or services will be valued at the fair market value.

Arm’s Length Transaction Meaning

Arm’s Length Transactions are important in the market because it is implied that these transactions will provide consistent and meaningful information. This differs if the two parties are related or are friends, who might provide a discount for the transfer of assets or services. An arm’s length sale is most often referred to in the real estate market where the fair market value must be determined at arm’s length. This is because the sale of one property affects the price of all the properties surrounding it. If the parties are related there will usually be a benefit for each party in the agreed upon price and drawing the agreed upon price away from the fair market value.

Arm’s Length Transaction Example

Bob is attempting to sell his house in the market and move away. His son Bernie lives in the same city. He would like to keep the house in the family as it has been for years. Bob has the house appraised and it is worth $350,000. However, his son has just entered into a job last year right out of college. Thus, he cannot afford the house at fair market value. Therefore, Bob decides that he will sell the house for $150,000. This is not an arm’s length transaction because the two parties are related. Furthermore, the agreed upon price was discounted well below the fair value. If Bob had sold to a complete stranger for $340,000 this would be arm’s length because they are unrelated. Even though the price is slightly below the appraisal the agreed upon price is the result of negotiations between the two parties.

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