By Greg P. Saunders, CPA, Senior Associate | Valuation and Forensic Services Team
Identifying and defining the applicable standard of value is critical to any business valuation. Erroneously relying on an incorrect standard of value can result in a vastly different valuation than would have been realized under the proper standard. In addition, the use of an inappropriate standard of value in a litigation matter may lead to the exclusion of the valuation opinion in its entirety. As you review a valuation report, understanding the purpose of the assignment and the standard of value used by the appraiser can help determine if the subject company’s value has been properly determined. The five most frequently used standards of value include the following:
- Fair market value: One of the most well-known and commonly applied standards of value, fair market value, is defined by the U.S. Treasury regulations as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” In addition, fair market value also assumes an arm’s length deal and that the “hypothetical” buyer and seller are able and willing. Shareholder-level discounts for lack of control and marketability are usually considered under this standard of value. The fair market value standard applies to almost all federal and state tax matters, as well as for divorce cases in several states. However, definitions and applications may vary between jurisdictions.
- Investment value: This standard of value refers to the value of an asset or business to a specific buyer or seller. Therefore, contrary to the “hypothetical” buyer or seller assumption used under fair market value, the investment value standard considers the owner’s or buyer’s knowledge, abilities, expectation of risks and earning potential, and other factors. Investment value may also consider synergies available to the specific buyer, such as cost savings and/or revenue enhancements from the combined operations. Consequently, this standard of value is often used when valuing a company being considered for potential acquisition.
- Intrinsic value: Intrinsic value is considered to be the value inherent in the property itself. While investment value is more dependent upon characteristics adhering to a particular purchaser or owner, intrinsic value represents an estimate of value based on the perceived characteristics adhering to the investment itself. This standard of value is not often applied in valuations of closely held businesses and is not a legal standard of value in any federal or state statute as the term is defined here. (It should be noted that Virginia case law makes reference to “intrinsic value” as the applicable standard for divorce. However, the definition of the term in the case law differs from that presented here).
- Fair value (state rights): Fair value is the standard of value for certain types of shareholder litigations, such as shareholder oppression and dissenting rights cases. In many states, fair value refers to fair market value without any discounts for lack of control or marketability. Accordingly, the value of a particular ownership interest under this standard of value can be viewed as the value of the pro rata interest in the total value of a company’s equity. However, its definition can be quite different from state to state, so it is critical to understand the statutes and relevant case law for the particular state.
- Fair value (financial reporting): An alternative definition of “fair value” is applicable for financial reporting for U.S. generally accepted accounting principles (“GAAP”). Fair value in this context is defined by the Financial Accounting Standards Board 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.” This definition is similar to the fair market value standard used in estate and gift tax regulations; however, it does not require the buyers and sellers to be as well informed. In addition, the value derived under this standard is an “exit” value.
As discussed above, the application of a particular standard of value has important implications regarding the assumptions, methodologies, and techniques that will be used by the appraiser in a valuation. It is critical to understand the purpose for which a subject company is being appraised in order to determine the appropriate standard of value and to ensure the appropriate value of the business is determined.
Greg is a Senior Associate in Keiter’s Valuation and Forensic Services Group. He performs business valuation services for purposes of mergers and acquisitions; estate, gift, and income taxes; litigation and shareholder disputes; employee stock ownership plans; reorganizations; marital dissolution; business planning; buy/sell agreements; and financial reporting. In addition, he performs litigation consulting services including damages and lost profits calculations. Greg also performs forensic accounting services, including financial investigations and litigation consulting services. Read more of the Valuation and Forensic Services Group’s insights on our blog.
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.