Generally, there are two broad circumstances in which the value of a business is determined: a) in contemplation of an open market transaction, where the price of a business is negotiated between a vendor and purchaser; and b) where it is necessary to determine the value of a business in the absence of open market negotiations.
In the first instance, the value of a business is ultimately determined when the vendor and purchaser agree on a price and the relevant terms in an open market. In the second instance, in the absence of open market negotiations, a "notional" market valuation is undertaken. Notional market valuations are usually required for:
- transaction between various "non-arm's length" parties as that term is defined in the Canadian Income Tax Act. Provisions in the Canadian Income Tax Act state that transactions between non-arm's length parties must be consummated at fair market value;
- transaction pursuant to income tax reorganization;
- transactions pursuant to the Provincial Family Law Acts, the Federal Divorce Act, and the Federal and various Provincial Expropriation Acts;
- "fairness opinions" required pursuant to Provincial Securities Acts;
- appraisal remedies and oppression remedies pursuant to Federal and Provincial Corporation Acts;
- commercial litigation and business interruption claims; and
- negotiation of financing with banks and lenders.
When determining a notional market value for a business, the term "value" needs to be defined. The most common definition of value is "Fair Market Value".
Fair Market Value
In a notional market context, the definition of fair market value generally accepted by Canadian Courts is:
"the highest price available in an open and unrestricted market between informed and prudent parties, acting at arm's length and under no compulsion to act, expressed in terms of cash."
Fair Market Value is quantified on a "best effort" basis and includes a degree of professional judgment, as the valuation in a notional market context is based on assumptions and conditions that may or may not necessarily exist in an open market context.
Highest Price Available
Determination of the highest price available considers that both vendor and purchaser would transact at a price deemed fair by each. Conceptually this price is the equilibrium price between the vendor's interest (to maximize price) and the purchaser's interest (to minimize price). The vendor will transact with the purchaser willing to pay the highest price. Without exposing the business for sale, the highest price can never be ascertained in any notional market valuation with certainty due to the possible existence of "special interest purchasers" and the price they may be willing to pay for expected post-acquisition net economic value added (or "synergies"). In this regard, without open market negotiations, it is seldom possible to accurately quantify the post-acquisition net economic value added that a purchaser would be willing to pay for. As a result, valuations in a notional business context are often based on a stand-alone or intrinsic value, without consideration of post-acquisition synergies. However, in situations where special interest purchasers are readily identifiable, the post-acquisition synergistic value added can, on occasion, be quantified.
An open market refers to the assumption that no potential purchasers are excluded from participation in the notional market for the business being valued. It is assumed that the business is exposed to all potential purchasers with the will and resources to transact, notwithstanding the fact that this rarely occurs during the course of an actual business sale.
An unrestricted market refers to the assumption that statutory, contractual, or other restrictions influencing the marketability of a business are lifted in order to facilitate a sale in a notional market. An example is a restriction on ownership transfer specified in a shareholder's agreement in privately held companies.
However, prevailing jurisprudence suggest that in a notional market context, the assumption of an unrestricted market does not extend to the complete disregard of restrictions on a hypothetical sale of a business. Rather, these restrictions are reflected as a discount from the fair market value determined without consideration of the restrictions.
Between Informed Parties
This relates to the assumption that both the vendor and purchaser are informed with respect to all facts important to value determination. In an open market transaction, a purchaser may not be fully informed with respect to the vendor's financial position, competitive issues and near term prospects, while the vendor may not be able to meaningfully quantify the purchaser's perceived post-acquisition synergies.
Canadian jurisprudence supports the proposition that full and open disclosure of information relevant to a purchase and sale that was available at the date of value (the valuation date) is assumed in a notional market value determination. It is generally accepted that hindsight evidence is not considered in the determination of fair market value. This is consistent with the notion that the price negotiated between a vendor and purchaser in an open market transaction is done so without the benefit of knowledge of future events that will take place. While Canadian Courts generally have found that hindsight evidence is inadmissible when determining value in a notional market context, it has accepted that it may be utilized to determine whether actual events subsequent to the valuation date are generally consistent with assumptions made and conclusions reached in the determination of fair market value.
Between Prudent Parties
Assumes a marketplace where both vendor and purchaser exercise reasonable and appropriate diligence and care when consummating a transaction.
Acting at Arm's Length
This relates to the contemplation of negotiation between parties with opposing interests, each of whom has only an economic interest in the outcome.
Under no Compulsion to Transact
This relates to the contemplation of negotiations between parties where neither party is unduly compelled to transact nor constrained in any way from acting with full choice. This is not always the case in open market transactions, where a business is compelled to sell. An example would be a business in financial difficulty that requires the assistance of a purchaser to continue
as a going concern. In these instances, a purchaser will attempt to take advantage of the vendor's weakened negotiating position.
Expressed in Terms of Cash
Notional market valuations are expressed on a cash equivalent basis and assume a transfer of the risks and rights associated with the business. Open market transactions are frequently consummated in circumstances where a portion or the entire price is not in the form of cash or cash equivalent. The non-cash component can include shares of the acquiring corporation and or an earn-out component.
Open Market Price vs Fair Market Value
The difference between fair market value under a notional market and price as determined in an open market can be significant. The differences arise from factors that are contrary to the assumptions and conditions in the determination of Fair Market Value in the notional market context. For example:
- open market price may include consideration for post-acquisition synergies, while fair market value in the notional market context is often determined on a stand-alone or intrinsic basis, which does not consider these synergies;
- legal and contractual restrictions that impact the sale of a business and results in a downward impact on value, contrary to the fair market value assumption of an unrestricted market;
- prices are negotiated between parties with differing knowledge, contrary to the fair market value assumption that vendor and purchaser are fully informed of all facts relevant to value determination;
- open market price may be based on imprudent decisions by the vendor, purchaser or both, contrary to the fair market value assumption that a transaction occurs between prudent parties;
- both vendor and purchaser may not be dealing at arm's length, contrary to the fair market value assumption that negotiations between parties are at arm's length;
- the open market price can be from a forced or compulsive act by the vendor, purchaser or both. Fair market value assumes that the transacting parties are under no compulsion to transact; and
- the open market price paid may be a combination of cash and non-cash consideration. Fair market value is based on the assumption that cash or cash equivalent is paid for the acquisition of a business.
In the absence of exposing a business for sale into the open market, value is often determined in a notional context. A notionally determined value may vary from the price that would be obtained if the business was offered for sale in an open market.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.