By Amber Hoover, CPA/ABV
Senior Analyst, Valuation and Litigation Services
When valuing a business or partial equity interest in one, the valuation analyst relies on a “standard of value” as the definition of the value being determined. The standard of value is typically dependent upon the intended purpose of the valuation, and thus different standards of value may result in different values.
The following is a discussion of the more frequently utilized standards of value and an example of their respective application. This highlights that not “one size fits all” when valuing a business. So careful application of the appropriate standard of value is a critical step in valuation process.
The term Standard of Value is defined by the International Glossary of Business Valuation Terms (the “Glossary”) as: the identification of the type of value being utilized in a specific engagement.
The most popular Standard of Value is Fair Market Value.
Fair Market Value (FMV)
IRS Revenue Ruling 59-60 defines FMV as: The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
This definition of FMV is most often utilized in valuations for reporting to the Internal Revenue Service (IRS). This definition is also frequently utilized in many other valuation contexts, because of its recognition and acceptance by the IRS as the FMV, Standard of value.
Court decisions on the use of this definition state the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and be well informed about the property and its marketability.
The Glossary defines FMV as: The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
This definition has been accepted and endorsed in the standards of the following organizations that train and educate valuation analysts: the American Institute of Certified Public Accountants (AICPA), American Society of Appraisers (ASA), National Association of Certified Valuation Analysts (NACVA) and Institute of Business Appraisers (IBA).
Because of the endorsement by these organizations, this definition has become the one frequently applied when valuing a business (or partial ownership) outside of an IRS reporting situation, e.g., a dispute, marital dissolution, merger, acquisition or sale, buy/sell value, etc.
Fair Value (FV)
Fair value differs from FMV and is another frequently utilized standard of value. Fair value is typically defined in the particular context it is being utilized/required. For instance, many states have a statutory definition for Fair Value that is required to be utilized in certain litigation.
Indiana State Statute defines FV with respect to a shareholder dissenter’s shares as: The value of the shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.
Thus in Indiana, in the context of a dissenting shareholder litigation proceeding, FV would be the standard of value that should be utilized.
Another popular venue for FV is in the context of financial reporting. Generally Accepted Accounting Principles (GAAP) require certain assets and liabilities of a business be reported at their fair value.
GAAP defines FV as: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Source: Financial Accounting Standards Board Accounting Standards Codification glossary.
This Standard of Value is used for financial reporting purposes, i.e. the determination of the value of goodwill for impairment analysis.
Investment Value
Investment value is defined by the Glossary as: The value to a particular investor based on individual investment requirements and expectation.
This standard of value is best utilized in a sale, merger or acquisition transaction where a known buyer or seller wants to identify/justify a specific value using a specific set of criteria.
As you can see, these three standards of value have very different definitions. Thus, applying the different definitions should lead to dissimilar results. Knowing which standard applies in a particular situation is critical to obtaining a value for a business or partial ownership interest that is relevant and reliable for the circumstances.
Make sure you utilize a knowledgeable and qualified valuation analyst when you need to value a business. They can help you choose the right standard of value, and thus obtain a value that meets the needs of your situation.
If you have any questions about standards of value, please contact Amber Hoover at (317) 613-7844 or [email protected].