We all use terms in our area of expertise that make people outside our fields scratch their heads. When you start discussing business valuations with a valuation expert, two terms you often might hear are Fair Market Value and Fair Value. They sound like they could be interchangeable, but they are, in fact, very different. The Standard of Value chosen is fundamental to the valuation itself and can lead to different values, even if the interest being valued is exactly the same.
Fair Market Value
The most commonly known and accepted standard of value is fair market value. It is defined by the Internal Revenue Service (IRS) in its Revenue Ruling 59-60 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 or relevant facts.”
Fair market value is the number that reflects what the business would be valued in a sale between a buyer and seller who both have full knowledge of the facts and are under no duress. Basically, absent synergistic or investment value, it’s the amount you would expect to receive if you put your business out for sale into the open market.
The key word in fair market value is “market”. Consider common stock traded on the New York Stock Exchange (NYSE). Investors buy and sell stock of large companies on the NYSE all the time without having any controlling interest. Apply that to a smaller business without shares being actively traded on an exchange. A valuation that uses fair market value as a foundation searches for the market equivalent for a closely held business share.
For business valuation purposes, fair market value is typically used in the following cases:
- Inheritance, estate, and gift transfers of assets
- IRS filings and other transfers governed by IRS rules
- Auction or open market sales of business entities
Fair market value is primarily differentiated from fair value on the basis of application of two valuation discounts. Typically, fair market value considers these discounts:
- Discount for Lack of Marketability: This discount considers the lack of ability to rapidly convert an ownership stake to cash.
- Discount for Lack of Control: This discount accounts for a minority interest impacting the amount of control the seller has over the business. When a minority interest exists, there is often lack of control over matters like salaries, distributions, or entity sale.
Fair value is defined by the Financial Accounting Standards Board’s Generally Accepted Accounting Practices (GAAP) 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” . That sounds similar to the IRS definition for fair market value, but in terms of valuation, there are differences.
As opposed to fair market value, fair value is a legal concept rather than a value set by the market. Fair value tends to be defined by statute. These statutes vary from one jurisdiction to another. Typically, fair value does not take discounts for marketability or lack of control into consideration. It is often used when valuing businesses for these situations:
- Partner and shareholder disputes
- Business owners buy/sell agreements dealing with internal share transfers
- Determining business value in marital dissolutions
Fair market value is typically the starting point for calculating fair value. Adjustments are then made in the interest of treating all parties fairly. In the case of minority shareholders who dissent from agreement to a merger or other transaction, the fair value standard prevents controlling shareholders from forcing minority shareholders to accept a lower price. By definition, the minority shareholders in such a transaction are not the “willing sellers” free from “compulsion to sell” envisioned by the fair market value standard; the fair value standard takes this into consideration to protect the interests of the minority shareholders.
Fair value is defined in many jurisdictions as the shareholder’s proportionate share of the fair market value of the business. Discounts for marketability or lack of control do not apply for obvious reasons: If the sale of the business has already been negotiated absent minority shareholders’ assent, the issue of marketability is moot, and dissenting minority shareholders are being bought out of their stake in the company. In addition, appreciation or depreciation in the business’ value arising from anticipation of the transaction are also commonly excluded in determining fair value.
Fair Value is also referred to as Equitable Value, which is the estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties. Equitable Value requires the assessment of the price that is fair between two specific, identified parties considering the respective advantages or disadvantages that each will gain from the transaction.
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