Why Fair Market Value is Fair
The fair market value of anything is the price a rational buyer would agree to pay a rational seller for it. For instance, the fair market value of a pop-up hot dog toaster is about $20. I know this because I reviewed prices from a number of online re-sellers and I consider myself a rational buyer of pop-up hot dog toasters. I’m not really in the market for one of these things, but I would advise my kids, who are in the lemonade business, that $20 might be a good investment. Hot dogs, in our local grocery market, cost about 50₵ and buns are about 25₵, The kids can provide condiments and buns for less than 20₵.
With total variable costs under $1, selling hot dogs for $2 to complement their lemonade could be a lucrative idea. If they sold eight dogs a day they would recoup their investment in the toaster in fewer than three days and could enjoy a profitable business asset all summer or even longer. If they stuck with the business, they could make hundreds of dollars before school starts.
If the health inspector shuts them down for touching the dogs without washing their hands, they will have to comply with health & safety laws. They can do this by hiring a staff, moving into a commercial kitchen, and paying for wages, taxes, business licenses, insurance and a plethora of other expenses. All of these things will have a price which they will pay if, and only if, they believe the investment will yield a positive return on investment.
The price they pay for everything will be the fair market price. As rational buyers, they will research the market and negotiate with sellers based on their beliefs about their projected ROI. There is no guarantee they will be able to make any money at all. There are lots of risks. It could rain all summer, for instance. Or, perhaps another kid opens a competitive stand. Or, maybe they just get bored.
In some cases, an unscrupulous seller may attempt to take advantage of their age and inexperience. “You’re going to make hundreds of dollars selling hot dogs, kids, so this hot dog toaster will cost $500. Without it, you can’t start your business,” they say. In other words, this seller priced the toaster on what he thinks the kids are going to do with it, not the fair market value. This is sometimes called “value-based” pricing and sometimes it’s a good approach, but not when there is a clear market for a product or service. In situations like this, the seller is essentially extorting future value from the firm by convincing the founders that they are providing access to a key ingredient without which the venture would fail.
If the kids didn’t know any better, this argument sounds logical so they will overpay. But, just because a seller can get away with something like this doesn’t mean it’s fair. As soon as the kids realize they are being ripped off they will find another seller who is happy getting the fair market price.
In other cases, the kids may attempt to take advantage of their clueless father and not pay me anything for my savvy business advice. “You’re our dad, so you should advise us for free because you love us,” they may argue. Sounds logical. But, just because kids can get away with something like this doesn’t mean it’s fair. It’s not uncommon for startup employees to be severely underpaid.
When dad is no longer helpful, perhaps they will engage an experienced hot dog restauranteur to consult with the operation. Like other rational buyers, they will negotiate a fair fee with the rational consultant. If the kids find comparable services elsewhere for a lower price, they will move to the most cost-effective advisor. The more unique and relevant the skillset of an advisor, the more they will pay.
Like most everything, the basic rules of supply & demand apply in the hot dog business.
If the kids make good, rationale investments and good business decisions they have the chance to create a profitable business.
Smart managers in successful businesses always do their best to pay fair market rates to acquire the inputs they need to create assets in hopes that the assets will create long-term value that greatly exceeds the cost of acquisition. In fact, long-term success often depends on a company’s willingness to pay fair market rates.
Occasionally, managers will overpay or underpay for inputs, but these events will ultimately obscure the real cost of doing business at best, and destroys the business at worst. Startups are especially vulnerable to making bad business decisions based on unfair pricing because founders often negotiate artificially low prices or use equity, instead of cash, to acquire the inputs needed to build their business assets. These seemingly harmless or even beneficial “non-cash” transactions can be disastrous.
Founders are nothing if not optimistic, their belief in their ability to realize their vision is an important skill during the early, bootstrapping days of a company and beyond. They wind up making unsustainable commitments to contributors often in the form of equity allocations based on future values which are unknowable. In the hot dog example, the $500 machine may seem to be a logical investment, especially if they can use equity, instead of cash. In fact, the ability to use equity can be a component of the decision-making process. The founders might be so happy to find a seller willing to take equity that they disregard the price altogether. A good example of this is when a startup gives a seemingly small percentage to an advisor who does little to help the business.
Equity allocations based on future events (i.e. “you’re going to sell lots of hot dogs”) are bad ideas because they are based on unknowable events. As the company moves forward and founders become smarter about the market they will realize they overpaid and disagreements will arise. Even when one party gets away with a bad deal it does not make it fair.
Founders are nothing if not resourceful, their ability to acquire the things they need a low or no cost is an important skill during the early, bootstrapping days of a company. They negotiate low rates with landlords or professional advice, hire employees without pay, haggle with suppliers and do whatever it takes to conserve cash. Sellers are often willing to accept underpayment in hopes that the entrepreneur will eventually be in a position to provide fair market rates. However, when founders don’t properly account for fair market rates they develop an unrealistic understanding of their cost structure that may be unsustainable and/or not scalable.
A common trap is using “low overhead” as an excuse to set prices low in an attempt to undercut a competitor. Even if the company can build early traction, the pricing may not allow the company to make a profit or even cover costs in the long term. Raising the pricing may lose customers and new customers may not value the company’s products or services enough to justify the higher price.
Underpaid sellers will eventually get tired of losing money and prefer to provide their goods and services to others at fair market rates. When this inevitably occurs, founders may not be able to pay and, therefore, run out of working capital before breakeven or other financing event.
Additionally, underpaid participants may grow to resent the founders and withdraw their support altogether leaving the fledgling business without the necessary resources.
We live in a world where market rates are knowable. There are very few resources that can’t be replaced with a quick online search. Fair market value provides a basis for making smart financial decisions. This means that a savvy buyer can shop around to make the most efficient us of the company’s money. However, if either party negotiates too aggressively, the final outcome may not be sustainable. Paying a logical fair market value helps foster stability and good decision making.
Slicing Pie relies on fair market value to ensure that participants are being properly recognized for their contribution and company buyers aren’t kidding themselves about their cost structures. If the company has cash, it can pay cash. If not, the company can allocated slices in the Pie to reflect the fact that the unpaid portion is the seller’s wager on the future success of the company. Artificially inflating or deflating costs based on estimates of unknowable, future events may provide an apparent short-term benefit, but the long-term effect can kill a company.