Fair Market Value – What does this really mean?
A public company is one whose shares are freely traded on the stock exchange. Because the shares are traded on the stock exchange, the price of shares can be easily ascertained online. This is not the case with private companies. They do issue shares and have shareholders, but these shares are not traded on public exchanges, thus, making it much harder to determine the value of these shares. However, determining the fair market value of these shares on a regular basis is important when it comes to dispute resolution, taxes, obtaining insurance and a variety of other circumstances.
Fair market value
Fair market value is essentially the price an asset would sell for on the open market. However, certain conditions need to be met for the price to be considered fair market value. First, the buyer and seller must be well informed about the asset. Next, they must be acting in their own best interest and this must be free of undue pressure. Finally, the transaction must not be too rushed so that the parties have time to make an informed decision.
Methods of valuation
There are multiple methods to valuate your shares, and each method has its own set of pros and cons.
The easiest method is for the parties to agree upon a price. Failing that, there are several alternatives:
1.Fixed Price Method
The fixed price method requires negotiating a price in advance. This method is simple, but an obvious disadvantage is that it often doesn’t reflect the fair market value of the shares at the time of exit because the value does not evolve.
A formula can also be implemented in the shareholder’s agreement. Although many variables can be inputted into a formula, it is difficult to account for potential future earnings or losses. This formula could take into consideration the annual EBITDA (Earnings Before Interest Taxes Deprecation and Amortization) and a multiplier that would be specific to the industry.
3.Third Party Valuation
Possibly the best method is to appoint an accountant or an independent valuator. A valuator is able to consider current circumstances and also make an estimate of future earnings, ultimately arriving at the fair market value.
4.Process of valuation
Making the valuation process as clear as possible will be beneficial in the long run. That is why it is important to lay out the steps of the valuation process in the shareholder’s agreement. This can include naming a specific valuator or a process for choosing a valuator. You can also include specific qualifications that the valuator must have. Additionally, you can specify when and how often these valuations should take place.
Understanding what fair market value is and how it may have an impact on you and your business is important. A fair market value is needed in situations where a shareholder may exit the company through their own will, incapacity or death. It is recommended that you consult a lawyer to gain a better understanding of shareholder’s agreements and settle on what process of obtaining the FMV for your company would be most appropriate.