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 Tags: Valuation

Explaining Intrinsic Value, Fair Value, and Deal Structure Value

When performing a valuation, we believe it’s best to focus on the inherent value of the firm apart from deal structure. While the two are certainly connected when it comes to determining the final purchase price in a transaction, we subscribe to the belief that a valuation “is what it is”. The value of a firm doesn’t go up or down because of the deal structure – the purchase price does. 

After all, what if you’re not selling? What if you need a valuation for life insurance, or an equity compensation plan, or to determine an amount for your estate planning purposes? Surely deal structure doesn’t factor into that valuation equation, so why should it be any different if you’re considering a transaction?

Your valuation should be considered a health metric for your business. Just as you would get your blood pressure and heart rate checked by your physician, so should your valuation be a baseline indicator for your firm. It’s merely a starting point that represents intrinsic value. Remember, when valuing a firm we’re attempting to assign an amount that represents the stability, sustainability, and predictability of a business. 

To look at it in a more technical manner, intrinsic value (or true value) is defined as the perceived or calculated value of a company including tangible and intangible factors. It represents an estimate of value based on available risk and return data. Coincidentally, the intrinsic value may or may not be the same as fair value, which is the price at which a firm would sell depending on the parties involved.

[It should be mentioned that we also don’t believe in using market comp data to determine intrinsic value (or fair market value) because the vast majority of deals are never announced and the data that is available can rarely be validated. See more.

Fair value represents the price that is fair between two specific parties (what a willing buyer and a willing seller are willing to agree upon) taking into account the advantages and disadvantages that each will gain from the transaction. It’s used when performing due diligence in transactions (where synergies may mean that the price is higher than it would be in a wider market).

In other words, the fair value represents the starting offer price – which is unique to a specific buyer and seller. A sophisticated buyer is looking for a return on their investment (typically 12-15%). They’ll determine the price they’re willing to pay based upon that and how risky they think a business’s future cash flow is. Some buyers are looking for certain attributes that they might be willing to pay a premium; others will see deficiencies and apply a discount. 

Once you have determined the fair value, you then consider deal structure to refine that offer. For example, if a seller wants more cash upfront (down payment), you’ll typically see a lower purchase price – in exchange for risk.  When a seller takes the majority of the purchase price in cash, they don’t have skin in the game (and may not make as much of an effort to help retain business); therefore, they’ll often be offered a lower price, because the buyer is hoping to balance risk.

Conversely, if a seller desires to stay with the business for a period of time post-transaction and potentially be rewarded for the future performance of the business (via an earn-out component in the transaction), the final purchase price may end up being higher as an incentive to the seller for retaining some risk. 

Keys to remember:

  • A valuation is not necessarily what a firm would sell for; it represents the intrinsic value and provides a starting point
  • Based on the analysis of a firm by a specific buyer (via due diligence), the fair value reflects any premium or discount to the intrinsic value
  • Seller preference on deal structure may further adjust the fair value (to arrive at final purchase price)
  • The purchase amount ultimately realized by a seller may be higher or lower than the final purchase price depending on deal structure (i.e., earn-out, etc.)

To summarize, a valuation determines the worth of a business using objective measures and evaluates all aspects of the business in a notional context (meaning that it’s time specific, there is no negotiation, and there is no exposure to the open market).

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Disclaimer

The above article is meant for information purposes only and is not intended in any way to provide legal or other advice for any specific situation.  Readers always should consult their own tax, accounting and legal advisors before taking any action related to the above article or subject matter.

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