We all use terms in our area of expertise that make other professionals scratch their heads. Just listen to an engineer talk about torsion and seismic loads or a marketer discuss customer relationship management and you’ll feel like you are listening to another language. When you start discussing business valuations with an accounting professional, two terms you will often 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.
Fair market value and fair value are both standards of value. Standards of value are the foundation on which business valuation professionals base the determination of the value of your business and determines the methods that can be used for the valuation. The choice is made based on the intended use of the valuation results and is sometimes pre-determined and part of contract requirements, like in a shareholder agreement.
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, it’s the number that you’d expect to see if you put your business out into the marketplace.
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.
Fair market value is typically used when valuing businesses for the following situations:
- Estate, gift and inheritance transactions
- IRS filings and other transfers that are IRS controlled
- Sales of an entity at an auction or on the open market
Part of what differentiates fair market value from fair value is the market and control discounts. Fair market value typically includes the following discounts and premiums:
- The discount for marketability accounts for the cost in time and money to get the business to market.
- The discount for lack of control accounts for 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.
The Financial Accounting Standards Board defines fair value 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.”
The distinction between fair market value and fair value is in some ways as simple as noting that the only difference between the two terms is that one contains the word “market” and the other does not. When fair value is the foundation for your business valuation, consideration of the market discounts does not come into play. Fair value is often considered a hazy concept. Its use is typically determined by state statute and common usage.
- Fair value is usually statutorily determined, and state laws differ as to how fair value is used.
- Fair value typically does not consider discounts for marketability or lack of control.
Fair value is often used when valuing businesses for the following situations:
- Shareholder and partner disputes
- Buy/Sell agreements amongst shareholders to deal with internal transfers of shares
A Slice of the Pie
To better understand the difference between these two standards of values, let’s envision a pie divided into four slices. The value of each slice of pie differs depending on which standard of value is used as a basis for the valuation.
- Using fair value as our foundation, the pie is valued first as a whole pie. Then each slice is valued in proportion to the value of the whole. In this case, each one of the four slices would be valued at one-forth of the value of the whole pie.
- If fair market value serves as the foundation for the valuation, equal portions of the pie will likely have different values. Because of the lack of control, each pie-slice owner cannot control the size of their slice. Additionally, a slice sold in the marketplace will also have less value because a commission has to be paid to the pie vendor that brought the pie to market and sold the pie. In the case of a business, the commission paid to the broker who sold the business in the marketplace has an impact on the value.
Understanding the difference between fair market value and fair value helps you learn the language of business valuation and improves communication between you and your business valuation professional. Plus, it tends to be easier than talking to an engineer! To learn more about how a business valuation can help your business reach the next level, contact Cray Kaiser today. Stay tuned to our blog for the next post in our Business Valuation 101 series.