Why Fair Market Value Often Falls Short of the Purchase Price in SBA 7(a) Deals: 10 Reasons Every Lender Should Know

~ Certified Business Appraiser

In SBA 7(a) business acquisitions, a common hurdle arises: the fair market value (FMV) in the business valuation report is lower than the agreed-upon purchase price. FMV represents what a hypothetical, willing buyer would pay for a business based on its current, verified financial performance. This gap can delay loan approvals, frustrate borrowers, and complicate underwriting. Understanding why FMV falls short is critical for lenders to navigate these deals effectively. This article outlines 10 clear reasons for the discrepancy, tailored for SBA lenders seeking practical insights.

1. Historical Data Limits Future Optimism

Buyers often pay a premium for a business’s growth potential, brand appeal, or market trends. However, SBA valuations prioritize historical performance over speculative upside. FMV is calculated using consistent, historical free cash flow—cash generated after expenses, taxes, and reinvestments. If future growth isn’t reflected in past results, the valuation won’t support the higher price.  FMV is based on what the business is worth today, not what it might be worth someday.

Example: A buyer pays $1.5M for a restaurant expecting to expand, but its historical cash flow of $100K/year supports only a $1M valuation.

2. Insufficient Free Cash Flow

FMV depends on normalized free cash flow, which is adjusted for market-rate expenses like owner salaries, rent, and capital expenditures. If the cash flow can’t cover loan payments, a reasonable return, and business risks, the valuation will be lower than the purchase price.

Example: A business shows $200K in profits, but after normalizing for market wages and equipment costs, only $50K remains, reducing its value.

3. Understated Owner Compensation

Many owners minimize their salaries to reduce taxes, inflating reported profits. FMV requires adjusting owner compensation to market rates—what it would cost to hire a replacement to do that job. This adjustment often lowers net income, shrinking the valuation.

Example: An owner takes a $20K salary, but the market rate for their role is $80K. Adjusting for this $60K difference reduces profits and FMV.

4. Below-Market Rent Adjustments

When a business leases property from the owner or a related party, rent is often below market rates. FMV requires using fair market rent to reflect true operating costs, which can decrease net income and lower the valuation.

Example: A business pays $1,000/month in rent to the owner, but market rent is $3,000. This $2,000/month adjustment reduces profits and FMV.

5. Buyer-Specific Premiums

Buyers may pay more for strategic reasons, like synergies (e.g., combining businesses), location advantages, or personal goals/emotional drivers (e.g., owning a family business). FMV assumes a hypothetical buyer with no special motivations, excluding these premiums.

Example: A buyer pays $1.2M for a store near their existing business to save on logistics, but FMV, based on a neutral buyer, is $900K.

6. Unreported Cash Sales

Some businesses rely on unreported cash sales, which aren’t reflected in tax returns or financial statements. SBA requires earnings to be verified against IRS transcripts, so unverified income is excluded from FMV calculations.

Example: A retailer claims $50K in cash sales. The valuation ignores this income, lowering the FMV.

7. Overly Optimistic Projections

Buyers may base the purchase price on aggressive forecasts, but appraisers reject projections lacking historical support. FMV relies on reasonable, data-driven expectations grounded in past performance.

Example: A tech firm projects doubling revenue in two years, but its flat historical sales lead appraisers to use conservative estimates, lowering FMV.

8. Non-Arm’s-Length Transactions

Deals between friends, family, or employees often include emotional or lifestyle-driven pricing. FMV assumes a rational transaction between unrelated parties, ignoring these factors.

Example: An employee buys their employer’s business for $800K to keep their job, but FMV, based on normalized cash flow, is $600K.

9. Equity vs. Enterprise Value Misalignment

In stock purchases, buyers may confuse enterprise value (total assets) with equity value (value after subtracting liabilities). FMV for a stock deal reflects equity value, which can appear lower than the purchase price if debt and debt service are overlooked.

Example: A buyer offers $2M based on enterprise value, but the business has $500K in debt. FMV for the stock is $1.5M.

10. Reliance on Broker Multiples

Business brokers often use industry multiples (e.g., 3x earnings) to set prices, ignoring company-specific risks like customer concentration or poor records. FMV is based on normalized cash flow and detailed analysis, not simplified rules of thumb or guesswork.

Example: A broker prices a business at $1M using a 4x multiple, but declining sales and high risks lead to a $700K FMV.

Common Misconceptions About FMV

  • Myth: FMV is the same as the market price. Reality: FMV is a standardized value based on verified data, while market prices reflect buyer motivations.
  • Myth: A low FMV means the valuation is wrong. Reality: FMV protects lenders by ensuring loans are based on supportable value.

FMV, as required by SBA 7(a) guidelines, focuses on verified, historical cash flow and normalized earnings to determine what a hypothetical buyer would pay. When purchase prices exceed FMV, it’s often due to strategic, emotional, or speculative factors that appraisers cannot consider. Lenders can bridge this gap by:

  • Asking borrowers to explain premiums (e.g., synergies or personal goals).
  • Reviewing valuation reports to understand normalization adjustments.
  • Communicating FMV limitations to borrowers early to set realistic expectations.

By understanding these 10 reasons, lenders can better evaluate valuations, streamline underwriting, and ensure SBA-guaranteed loans are grounded in economic reality—not hype or hope.

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