Does a Business Valuation Determine the Selling Price?

A business valuation estimates the market value of a business enterprise under a defined set of assumptions. However, a final selling price is determined through negotiations between a business buyer and business seller, with each party’s unique circumstances affecting the transaction. Business value may be different for each combination of buyer and seller.

Therefore a business valuation (also called a business appraisal) may help inform the buyer and seller of fair market value potential, but no, a business valuation typically does not determine the selling price of a business.

A Business Valuation Estimates Fair Market Value, Not Your Unique Position

Business valuations are typically estimated at “fair market value” – this is what an unrelated willing buyer and willing seller would pay with neither compelled to transact. However, many buyers and sellers are not actually transacting under these terms.

For example, consider a small restaurant which has been owned by a local family for twenty years. The business has built community goodwill and employee loyalty. A current long-time manager wishes to buy the restaurant as the current owners plan to retire. In this case, the buyer has a pre-existing relationship with the business.

A business valuation estimates value not for this specific buyer, but for an arm’s-length unrelated buyer who has no relationship with the sellers. This theoretical buyer will likely have a different perspective on the business than the long-time manager.

• For example, an outside buyer may be considering several restaurants in other communities, while the manager is only interested in one restaurant to which they have emotional ties.
  
• An outside buyer may be concerned about the sellers’ after-sale involvement while the manager trusts the sellers to transition effectively.
• An outside buyer may worry about retaining employees after the sale, while the manager already knows the employees personally.
  

In this example, the long-time manager may be willing to pay above fair market value because their employment, intimate knowledge of the business, and positive relationship with employees and the sellers has removed many common business transition risks.

To put it another way, the unique positions of the buyer and seller could, in this case, result in a purchase price higher than market value.

Many Transactions are Not Made at the Fair Market Value Level

The prior section explained how a sale to a long-time employee may not be equal to market value because of the relationship between the buyer and seller. There are many other situations which create non-fair market value transactions:

• A seller may be distressed due to personal or health reasons. The transaction has a willing buyer, but not a willing seller. The seller is compelled to sell, and may therefore concede on price and other terms in order to transact quickly.
• A seller may decide to offer the business at a generously low price or on generous terms. This is common in family transfers, or sales between generations of the same family. The seller would not likely offer the same pricing to an unrelated party; therefore, the sale is made below the fair market value level.
• The buyer may not be able or willing to make a sufficient payment at closing, and the seller may agree to be paid through an earnout or revenue sharing agreement. The eventual transaction price remains uncertain at closing, and may or may not end up at fair market value after the earnout is complete.
• A competitor may desire the seller’s intellectual property, location, or market position to augment their current business operation. The buyer in this case is called a “strategic buyer,” which means they have more to gain from a purchase than simply the assets and earnings of the business being sold. Strategic buyers may be willing to transact above fair market value due to their unique ability to take advantage of the acquisition.

In any of the circumstances listed above, a business valuation made at the fair market value level would likely not be equal to the selling price for the business.

Selling Price is Affected by Transaction Terms

Consider a landscaping business preparing for sale. The seller, who wishes to retire, has two offers in front of them:

• Offer A includes full payment at closing, with the buyer bringing their own working capital, and the seller allowed to fully retire within 90 days. The total offer is $1.8 million.
• Offer B includes 80% payment at closing, with the remaining 20% coming from a multi-year earnout; the seller has to leave $100,000 of working capital in the business; and the seller needs to be available for consulting 10 hours per week for six months. The total offer is $2.2 million.

Prior to listing the business for sale, a business valuator appraised the business enterprise to have a fair market value of $2 million. This valuation assumed a standard set of transaction terms, which doesn’t specifically match either Offer A or Offer B.

In this case, the business valuation report was not incorrect. It was accurate in predicting an approximate sale price of $2 million. However, the specific terms of each offer have resulted in different potential purchase prices:

• Offer A is clean, fast, and lower-risk for the seller. The buyer is taking on more risk and therefore reducing their price accordingly.
• Offer B is more complicated, slower, and higher-risk for the seller. The buyer is not willing to take on as much risk, but is increasing their price accordingly.

Business acquisitions are not completed between theoretical buyers and sellers who meet a business valuator’s assumptions. They are completed between unique individuals or entities, each with their own risk tolerances, investment capacities, and priorities.

A business valuation can serve as a benchmark for a transaction price, but the terms of each unique offer will determine the price achieved.

Not Every Business Valuation Serves the Same Purpose

Business valuators are engaged to answer very specific questions for their clients. For example:

• A business seller might ask, “What would my business be worth if I sold it for 100% cash at closing on January 1 of next year and included the real estate and inventory?”
• A prospective buyer might ask, “How does this business compare in price to similar businesses sold in the past two years within a 50-mile radius?”
• A divorce attorney might ask, “How much should one spouse have to pay for another spouse’s shares of this business as of the valuation date of divorce filing 14 months ago?”
• A civil attorney might ask, “How much would this business have been worth right now if a competitor had not infringed on key patents and used them to steal a key customer three years ago?”

The four questions above may result in four different value opinions from the business appraiser.

One common purpose of engaging a business valuation is due diligence for a Small Business Administration (SBA) loan guarantee. SBA business valuations are typically not used to advise a buyer and seller on specific transaction pricing – in fact, they are not usually ordered until after a purchase offer has been accepted and a draft purchase agreement has been written.

An independent business valuation for SBA loan purposes answers the specific question of, “Does this proposed purchase price appear to be appropriate considering the terms of the transaction?” The valuator is not engaged in this case to comprehensively develop market value. The SBA valuation engagement is scoped to allow for sufficient investigation and analysis as required to determine whether the transaction appears reasonably priced.

When Should You Obtain a Comprehensive Business Valuation?

Certified business valuations are essential decision-making data points for buyers, sellers, and their professional advisors. The most common purposes requiring a business valuation expert include the following:

Qualified business appraisers carry designations such as the ASA or CVA which demonstrate their commitment to the profession and competency to answer your specific valuation questions.

• Business sale or business acquisition
• Shareholder disputes
• Estate planning or gifting
• Divorce or civil litigation
• Financial reporting
• Tax planning or advisory
• ESOP setup or management
• Succession planning

Common Questions

Does a business valuation determine the selling price?

No. A business valuation estimates market value under a defined standard of value and set of assumptions. The final selling price is determined through negotiations between the buyer and seller and reflects the specific terms of the transaction.

Why can a business sell for more or less than its appraised value?

A business may sell above or below its appraised value because every buyer and seller has unique motivations, risks, financing arrangements, and transaction terms. Strategic buyers, distressed sellers, earnouts, seller financing, and family transfers can all result in prices that differ from fair market value.

Is an SBA business valuation the same as a comprehensive business valuation?

Not necessarily. An SBA business valuation is generally performed to determine whether a proposed purchase price appears reasonable for lending purposes. A comprehensive business valuation is typically developed independently to estimate market value for purposes such as transactions, litigation, tax reporting, shareholder disputes, or financial reporting.