If you discuss business valuation with a professional, chances are you will hear the notion of standard of value. Think of this value standard as a measuring stick the appraiser uses to come up with the business value.
Selecting the correct standard of value can make a difference to the result. The circumstances and facts of each business valuation dictate the best choice. Here are a couple of central definitions of business value:
Fair market value 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 value is typically used in cases of dissenting shareholders’ rights to business appraisal. This would be the case, for example, of company sale on the terms the shareholder finds objectionable.
This standard of value varies from state to state. The most common definition comes from the Model Business Corporation Act:
Fair value of a company is determined immediately before the conclusion of a corporate action to which the shareholder objects (e.g. company sale at a certain price and terms); using customary and current valuation concepts and techniques; and without discounting for lack of marketability or shareholder minority status. Here minority refers to ownership of less than controlling block of company shares.
The Financial Accounting Standards Board offers a good definition of 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”. Note though that this definition is still open to interpretation.
Most business appraisals are done to the fair market value standard. If you get a formal business valuation report, the selected standard of value should be stated along with the reasons why it was chosen.
According to the IRS Revenue Ruling 59-60, you should consider a number of factors if you choose to determine your business value to the fair market value standard:
- The nature of the business and its history from its inception.
- The economic outlook in general and the condition and outlook of the industry the company operates in.
- The book value of the stock and the financial condition of the business.
- The company’s earning capacity.
- The dividend paying ability of the company.
- Whether the company has intangible assets including goodwill.
- Sales of the stock and the size of the block of stock to be valued.
- The market price of the stocks of corporations in the same or similar line of business having their stock actively traded in a free and open market, either on an exchange or over the counter.
Most business valuation methods you are likely to encounter can be used to value a business under either fair market value or fair value definitions. One possible exception to this is the market based valuation methods. Business sales that are used to develop valuation multiples for these methods are usually done by unrelated business sellers and buyers. So the fair market value definition makes the most sense here.