Why the standard of value matters in business valuation

Valuing a private business requires a custom approach. One size doesn’t fit all companies, especially when it comes to the appropriate standard of value. Applying the wrong one can lead to disputes, unfavorable tax and accounting consequences, litigation exposure, and inequitable outcomes. Here’s a breakdown of the three main standards of value, including when they might apply and how a valuation professional’s analyses and assumptions might differ under each option.

1. Fair market value

The most widely recognized standard of value is fair market value (FMV). It’s almost always used for valuing business interests for gift and estate tax purposes. The IRS defines FMV as the price at which the property would change hands between a hypothetical buyer and seller who have reasonable knowledge of the relevant facts and are under no compulsion to enter into the transaction.

FMV reflects the price at which a transaction would occur under the conditions that existed as of the valuation date. For tangible assets, FMV is often interpreted to represent the highest and best use that the property could be put to on the valuation date, taking into account special uses realistically available. It doesn’t matter whether the owner has actually chosen that use.

2. Fair value

According to the Financial Accounting Standards Board, fair value (FV) is the price it would take — in an orderly transaction between market participants — to sell an asset or transfer a liability in the market where the reporting entity would typically transact for the asset or liability. This definition is applied when valuing long-lived assets, investments, goodwill and other intangibles for financial reporting purposes.

However, the FV standard may also be used in shareholder or divorce litigation. In such cases, it’s generally defined by state law. In many states, FV for litigation involving dissenting and oppressed shareholders is the shareholder’s pro rata share of the company’s entire value without applying discounts for lack of marketability or control. However, when applying this standard, courts may also consider the overall fairness of the outcome and may have discretion to adjust the valuation based on case facts.

3. Investment value

Investment (or strategic) value represents the value to a specific investor (or class of investors). It’s typically reserved for valuations prepared for internal decision-making or for mergers and acquisitions. It’s based on one party’s investment requirements and may consider potential synergistic benefits, such as revenue enhancement or lower expenses.

Investment value can vary from FMV for several reasons. These include contrasting estimates of future income and different perceptions of risk. There may also be operational differences and synergies with other entities owned or controlled by the investor.

Investment value isn’t generally used as the governing standard in shareholder litigation, but parties may introduce it as a reference point. In this context, investment value is based on the company’s earning power, but the appropriate discount or capitalization rate typically is a consensus rate that isn’t specific to any investor.

Sifting through the options

How do business valuation experts decide which standard of value to apply? Professional judgment certainly factors into the decision. And the appropriate standard often is determined by state or federal statute, case or administrative law, or specific court orders. Corporate documents, such as buy-sell agreements or articles of incorporation, also might dictate the applicable standard.

Contact us to determine what’s right for your situation. We can help you evaluate the options and explain how each alternative might affect our financial analyses and value conclusion.

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