Have you ever heard a business owner brag, “I was offered $X million for my business!”, or have you been lucky enough to receive an offer from another party to purchase your private business stock? It seems that such offers reveal how much an objective third party thinks your business is worth. However, a purchase offer and the fair market value of a business interest may differ significantly, and valuators must tread lightly when relying on purchase offers to value a business.

Value Indicator vs. Sanity Check

There are three main approaches to valuing a business: the cost, market and income approaches. However, appraisers must evaluate less obvious indicators of value, including active or expired offers from third parties to purchase the business. The weight that appraisers ultimately give to written bids and other less formal offers varies depending on the facts and circumstances of the case. However, appraisal reports should address third party indicators of value and explain whether or not they’re relevant, because courts often give them substantial weight, especially when the timing is recent and the bidder is serious.

When deciding how much weight to give a purchase offer, it’s important to assess the bidder’s financial strength and how far along the parties are in the negotiation process. If substantial due diligence has been done and a written offer made, it’s a more serious offer than someone who casually expresses interest over lunch, using calculations made on the back of a napkin.

The latter kind of offer is far from a closed business sale, and the offer would provide only limited insight into the fair market value of the business, especially if the appraiser is valuing a minority interest that lacks the requisite control to consummate a deal. In this case, the offer might simply serve as a sanity check for values indicated by the three valuation approaches.

Deals in Progress

Active written offers to purchase the business present their own issues because the offer price relates only to the willing buyer side of the equation. So even though a written offer can provide some evidence as to what a potential buyer is willing to pay for the business, a fair market value requires both a willing buyer and a willing seller.

When an offer expires without being accepted, it’s important to find out why the deal was never consummated. Ask questions such as, did the seller think the price was too low? Did the prospective buyer’s financing fall through? Did pre-closing due diligence expose problems that caused the prospective buyer to walk away? The answers will help the appraiser evaluate whether the expired offer should be relied on to value the business, or merely to provide a sanity check.

Marketability Issues

The length of the investor’s expected holding period may also impact valuation conclusions. In general, the expected holding period is shorter for businesses that have active offers on the table, and active offers may make the business more marketable or easier to convert into cash. However, reduced marketability discounts can become a major issue when valuing a business for items such as estate tax purposes. It is imperative to consider the probability that the business will eventually sell, and the selling prices that the parties will likely settle on.

Full Disclosure

Appraisers should always inquire about and consider purchase offers when valuing a business because they can provide insight into its value. However, there are many valid reasons that offers should be taken with a grain of salt and a healthy dose of professional skepticism. To ensure that your valuation addresses all relevant facts, always discuss active and expired purchase offers with a valuation expert like Filler & Associates.