Value means different things to different people. So, before starting any appraisal assignment, it’s imperative to map out the appropriate “standard of value” to ensure that everyone arrives at the same point. If not, the parties are likely to end up off course — or in need of backtracking.
A well-written appraisal report clearly defines which of the following four standards of value is right for your current appraisal needs.
This is the most common standard of value, especially for gift and estate tax purposes and shareholder buyouts. IRS Revenue Ruling 59-60 defines fair market value 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 of relevant facts.”
When estimating the fair market value of a business, it’s important to remember that there are two sides to the coin: a willing buyer and a willing seller. Fair market value is essentially a compromise between the “universe” of hypothetical bid prices (the buyer’s position) and ask prices (the seller’s position).
Strategic (or investment) value — the value unique to one party — is the preferred standard in business combinations. Investment value considers a specific investor’s expectations, risks, tax situation and synergies.
When quantifying investment value, appraisers frequently focus on the discounted cash flow method over other valuation techniques. Key inputs include management’s projected cash flows, expected growth rates and the combined entity’s expected cost of capital.
In successful business combinations, the value of the combined entity usually exceeds the sum of the parts operating independently. This incremental value commonly is referred to as “synergy.”
Fair market value is a logical starting point for valuing synergy, but rarely an ending point. Instead, sellers hold out for strategic buyers, who often are willing to pay a premium for control attributes and synergy.
In many ways, fair value for financial reporting purposes is similar to fair market value as defined in the Treasury Department regulations. Both standards of value assume an exchange price that involves hypothetical buyers and sellers with both parties knowledgeable, unrelated, and able and willing to transact. In addition, buyer-specific synergies are excluded from the company’s fair value.
There are some subtle differences between the two terms. Fair value may contain some elements of investment value. For instance, in September 2006, Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157), introduced the concept of “market participants,” which refers to buyers and sellers in the principal (or most advantageous) market for the asset or liability.
Thus, the pool of market participants in a hypothetical fair value transaction may be smaller than the entire universe of potential buyers and sellers considered when estimating fair market value. The principal market is also entity-specific and may vary from company to company.
The term “fair value” may also be statutorily defined. Legal statutes and precedent use this term so they’re unencumbered by IRS and U.S. Tax Court interpretations of “fair market value.” Fair value in a legal context is often guided by an underlying principle of equity.
For example, courts deciding marital dissolutions or shareholder oppression cases may seek the fair value of a business interest in the hands of the controlling shareholder, rather than to a hypothetical shareholder. That’s because the application of discounts for lack of control or marketability may provide controlling shareholders with a windfall when divvying up marital assets or buying out minority shareholders. In essence, the transaction is frequently between a willing buyer and an unwilling seller. In addition, fair value may exclude all (or part) of the company’s goodwill in marital dissolutions in some jurisdictions.
Get it right
Measuring the wrong standard of value may cause an expert’s conclusion to be excluded from evidence — or lead to misinformed business decisions. A little extra attention to standard of value on the front end can eliminate big problems on the back end.
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.