Attorneys aren’t expected to be valuation experts. That’s why they hire professional appraisers when clients need a company or business interest valued for litigation, tax, or other purposes. But a basic understanding of the various standards of value enables you to work more effectively with your expert—and better serve your clients.
Fair Market Value
The most widely recognized standard of value is fair market value (FMV), which is almost always used for valuing business interests for estate and gift tax purposes. The IRS defines FMV as “the price at which the property would change hands between a hypothetical buyer and seller who have reasonable knowledge of the relevant facts and are under no compulsion to enter into the transaction.”
FMV reflects the price at which a transaction would occur under the conditions that existed as of the valuation date. For some standard-setting bodies, FMV represents the highest and best use that the property could be put to on the valuation date, taking into account special uses realistically available. It doesn’t matter whether the owner has actually chosen that use for the property.
According to the Financial Accounting Standards Board (FASB), fair value (FV) is the price it would take—in an orderly transaction between market participants—to sell an asset or transfer a liability in the market where the reporting entity would typically transact for the asset or liability.
The FV standard usually is applied for financial reporting purposes. But it’s also used in shareholder or divorce litigation and is generally defined by state law in such cases. In many states, FV for litigation involving dissenting shareholders is considered to be the pro rata share of a controlling level of value. Thus, control and/or marketability discounts generally aren’t applied.
Investment value represents the value of an asset to a specific investor. For real estate purposes, it’s typically defined as the value of an investment to a particular investor or class of investors based on their investment requirement. Value is estimated by discounting an anticipated income stream while also considering potential benefits from synergies, such as revenue enhancement or lower expenses.
Investment value can vary from FMV for several reasons. These include contrasting estimates of future income and different perceptions of risk. There may also be income status differences and synergies with other operations owned or controlled by the investor. In shareholder litigation, investment value is based on earning power. But the appropriate discount or capitalization rate typically is a consensus rate that isn’t specific to any investor.
Intrinsic value usually is employed when valuing an equity share to determine its “real worth.” Also known as fundamental value, intrinsic value considers an asset’s primary value. Relevant factors include:
- The value of the company’s physical assets;
- Expected future interest and dividends payable;
- Expected future earnings; and
- Expected future growth rate.
Some appraisers use the term “intrinsic value” to refer to investment value. Others use it to describe the independent analysis of an investment analyst, banker or financial manager. Courts don’t always clearly define the term, either. Therefore, appraisers are challenged to establish a clear, upfront definition with clients and attorneys.
Sifting The Options
How do valuation experts decide which standard to apply when performing a business appraisal? Professional judgment certainly factors into the decision. The appropriate standard is often determined by state or federal statute, case or administrative law, or specific court orders. Corporate documents, such as buy-sell agreements or articles of incorporation, also might dictate the applicable standard.
If you have questions about the various standards of value, or need someone to speak with your lawyer about these terms, contact us for help.
In the meantime, download this article to keep available when you are ready to price your business for lending reasons, selling, or tax purposes.