By what "standard of value" should a business be appraised? That may sound like a peculiar question at first blush, but it is one that has a significant meaning when one is determining the value of a private business interest.
According to the International Glossary of Business Valuation Terms, "standard of value" refers to the identification of the type of value utilized in a specific engagement. Most often, people who are unfamiliar with the nuances of valuation recognize the term "fair market value" (FMV). However, there are other standards of value -- and even FMV is often misunderstood.
Here are the five generally recognized standards of value and their meanings and uses:
1. Fair market value is "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," according to IRS Revenue Ruling 59-60.
The FMV standard is used most often in valuations for gift, estate, and income tax matters. It's also commonly used in litigation matters and buy-sell agreements. FMV can provide an indication of the value (or range of values) at which a business might sell, but it's not intended to provide an actual transactional value (in other words, the price at which the business might actually be sold or bought for).
If your purpose is to determine an asking price for your business, FMV is more of a guide than an indication of what you'll receive when dealing with a specific buyer. Consult with a valuation professional to pursue this further.
2. Investment (or strategic) value is "the value to a particular investor based on individual requirements and expectations," according to the International Glossary of Business Valuation Terms. This standard might be used, for example, when a business is deciding at what price to buy another business or asset for. In that case, a buyer-specific rate of return might be used to determine the price to pay for the business's expected stream of cash flows.
This calculation would result in the value of the business "to that buyer" or investor, thus an investment value standard. Often particular investors -- such as competitors, joint venture partners, suppliers or customers -- may be willing to pay a premium above fair market value due to synergies between the buyer and the acquisition target.
3. Intrinsic value is "the value that an investor considers, on the basis of an evaluation or available facts, to be the 'true' or 'real' value that will become the market value when other investors reach the same conclusion," according to the International Glossary of Business Valuation Terms. This standard is not often seen in practice when valuing private business interests. Instead, it's used primarily by investment analysts and bankers to seek out the fundamental price of a publicly traded security.
4. Fair value (legal standard) often emanates from state laws dealing with shareholder dissent actions or matrimonial law (but only in certain jurisdictions). The term "value" may be substituted for "fair value" in these statutes. Each statute usually has its own court-determined definition of fair value. Often judicial interpretation of fair value results in the application of one of the other standards, such as FMV or investment value. Often the main difference between fair value and FMV is that the fair value generally excludes any discounts for lack of control or lack of marketability. This is so that the dissenting or oppressed shareholder is not unfairly treated and receives the pro rata value of his or her interest on a controlling basis.
5. Fair value (financial reporting standard) is used by businesses in reporting the values of assets in accordance with Generally Accepted Accounting Principles (GAAP). For example, this standard of value is used in business combinations to allocate purchase prices on the books of acquiring companies.
As you can see, it's important for the user of a business valuation to know what standard of value is being determined. Of course, there are many nuances and differences even within these standards that cannot be covered in an article of this length.
Discuss the appropriate standard when you hire a valuation professional and iron of the details in your engagement letter, before the valuator starts working. In addition, his or her written valuation report should identify and define the standard of value used to appraise the business on its summary page. By clearly defining the standard of value upfront, you will be less likely to encounter any misunderstandings later on.
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