“Special Purchasers” and Their Impact on Fair Market Value
There are many instances when a formal business valuation is required regarding the fair market value of a business without exposing it for sale to the open market. For example, business valuations are often required when a business is not changing hands but the fair market value is still needed, such as for income tax and estate planning, family law matters, and for commercial litigation. When a business is valued without being placed for sale on the open market, the fair market value of the business is considered to be determined on a ‘notional’ basis. Since the business is not placed on the open market, Valuators must rely on theoretical principles, past experience, and their professional judgment in order to determine the fair market value a notional basis.
When assessing the fair market value of a business in a notional context, there are two components to value that are considered; the first is the “intrinsic” value of the business, which is the value that buyers will place on the stand-alone business assuming it will continue to operate as-is, and the second is any additional value above the intrinsic value that hypothetical buyers in the market would expect to receive as a result of integrating the acquired business into their existing operations and any other benefits they expect to receive as a result of the acquisition.
Buyers that are expected to realize additional value from an acquisition above the intrinsic value of an acquired business are referred to as “special purchasers”. A special purchaser is defined in Canadian business valuation theory as a purchaser “who can, or believes they can, enjoy post-acquisition synergies or strategic advantages by combining the acquired business interest with its own”. These special purchasers are willing to pay a premium for the business above its intrinsic value because they expect to benefit from these post-acquisition synergies, economies of scale, or strategic advantages that are a result of combining the acquired business with their own.
Special purchasers are often interested in acquiring a business in order to realize synergies. Synergies occur when the value of two combined entities is greater than the intrinsic value of each on their own, and typically arise as a result of new cost savings or increased revenues post-combination. Some examples of common synergies are increased purchasing power, reduced costs, lower debt interest rates, and increased diversification. It is generally difficult to determine the value of synergies when assessing the fair market value of a business. This is because each potential acquirer of a business typically has different types and amounts of synergies they expect to realize from an acquisition.
Economies of Scale
Economies of scale are cost advantages that a business receives as its operations grow and become more efficient. This can occur because when the volume of output of a business increases, the costs can be spread out over a larger amount of goods/services. When economies of scale exist, the value of the combined businesses to the purchaser is greater than the value of each business separately. In such cases, these buyers would be considered special purchasers since they would potentially be willing to pay more for the business than a buyer who is not able to take advantage of these economies of scale.
Special purchases may also be motivated to purchase a business in order to receive greater strategic advantages. These buyers typically already own operating businesses in the same/similar industry, and are motivated to purchase other businesses in order to advance their strategic goals, such as eliminating a competitor, acquiring new technologies, or growing into a new geographic area. Often these special purchasers are competitors, suppliers, or clients of the subject business.
When Are Special Purchasers Considered?
In Canadian business valuation theory, the ”highest price” component of the fair market value definition mentioned earlier in this article is assumed to include the consideration of potential special purchasers, as these buyers are expected to offer a higher price for a business than non-special purchasers.
However, Canadian legal precedents generally dictate that when the notional fair market value of a business is required, consideration should only be given to special purchasers when such buyers are readily identifiable in the market and the price premiums they would be willing to pay can be reasonably estimated.
Even if it is believed that hypothetical buyers in a notional context may be able to realize synergies, economies of scale, or strategic advantages, it is often still difficult to determine to what level (if at all) these buyers would be willing to pay the seller for the additional value. For instance, in cases where only one special purchaser is thought to exist in the market, this special purchaser is not expected to pay a premium above the intrinsic value of a business for such benefits if they are the only buyer that could realize them. However, when multiple special purchasers exist, increased competition between these buyers to purchase the business and access these additional benefits is expected to result in the buyers offering more than the intrinsic value to acquire the business.
In such cases, valuators will examine the probability and number of special purchasers for a business that exist in the market, their ability and willingness to transact, and the estimated size of any premiums these special purchasers might pay. However, often the information available to valuators is not sufficient to determine with certainty the existence of special purchasers for a business and the size of any special purchaser premiums. It is also possible that the “special purchaser” premium warranted is already reflected in the calculated value if the calculations are based on multiples derived from actual market transactions which may already reflect industry-wide premiums. If this is the case, then no additional special purchaser premium should be considered.
A special purchaser premium is usually only considered in the notional fair market value of a business when these special purchasers in the market can be identified, and the additional value to each prospective buyer can be meaningfully quantified. When this is the case, it may be reasonable for valuators to attempt to determine the value of the business including the synergies, economies of scale, and strategic advantages that these market participants could reasonably be assumed to benefit from. However, this additional value is usually discounted to reflect the uncertainty of how much a special purchaser would pay for these additional benefits, and the risks associated with achieving them.
Acquiring a Business as a Special Purchaser
In addition to scenarios where the notional fair market value of a business is required, valuators may also be asked by potential special purchasers in a business acquisition to assist in quantifying the additional value that should be paid for the target business above its intrinsic value. In this case, valuators may attempt to determine the value of the synergies, economies of scale, and/or strategic advantages that will arise from the acquisition being considered. However, even if the additional value above the intrinsic value of the business can be reasonably determined it is often still difficult to determine to what extent the purchaser should pay for this additional value. Generally, when a business is purchased with the intent of realizing synergies, economies of scale, and/ or strategic advantages, the additional value paid for the business above its intrinsic value is determined as a result of negotiations between the buyer and seller.
If you are considering a sale transaction where a “Special Purchaser” may be involved, we can help guide you in the right direction.