Lawyers aren’t expected to be valuation experts. That’s why they choose to hire professional appraisers when their clients need a company or business interest valued for tax, litigation or other purposes. But having a basic understanding of the various standards of value allows you to work more effectively with your expert — and better serve your client.
The ins and outs of FMV
Did you know that the most widely recognized standard of value is fair market value (FMV)? It’s 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.”
Fair market value reflects the price at which a transaction would occur under the conditions that existed as of the valuation date. For many 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 if the owner has actually chosen that use for the property.
Understanding “Fair Value”
According to the Financial Accounting Standards Board (otherwise known as FASB), fair value is the price it would take (in an orderly transaction between market participants) to transfer a liability or sell an asset in the market where the reporting entity would typically transact for the asset or liability.
The fair value standard is often applied for financial reporting purposes. But it’s also used in shareholder or divorce litigation, and is typically defined by state law in such cases. In many states, fair value for litigation involving dissenting shareholders is considered to be the pro rata share of a controlling level of value. So, control and/or marketability discounts generally aren’t applied.
Understanding Investment Value
Investment value (also known as “strategic value”) represents the value of an asset to a specific investor. For real estate purposes, it’s often defined as the value of an investment to a particular investor or class of investors based on their investment requirements. Value is determined by discounting an anticipated income stream while also considering potential benefits from synergies such as lower expenses or revenue enhancement.
Investment value varies from FMV for a couple of reasons, such as contrasting estimates of future income and different perceptions of risk. There may also be income status differences and synergies with other operations that are owned or controlled by the investor.
When it comes to shareholder litigation, investment value carries a different meaning, however. Here, investment value is based on earning power, but the appropriate capitalization rate or discount is typically a consensus rate that isn’t specific to any investor.
Understanding Intrinsic Value
Intrinsic value is usually employed when valuing an equity share to determine its “real worth.” Intrinsic value (also known as fundamental value) is calculated by looking at an asset’s primary value factors. Relevant factors include:
- The value of the company’s physical assets,
- Expected future earnings,
- Expected dividends payable and future interest, and
- Expected future growth rate.
It’s true: Defining intrinsic value can be rather tricky. Many appraisers use the term to refer to investment value, while others use it to describe the independent analysis of an investment analyst, banker or financial manager. Trouble is: Courts don’t always clearly define the term, either. So, appraisers are challenged to establish an upfront, clear definition with their clients and attorneys.
Understanding the options
So, with so many options to choose from, how do valuation experts decide which standard to apply when performing a business valuation? The appropriate standard is often determined by specific court orders, state or federal statute, or case or administrative law. Corporate documents, such as articles of incorporation or buy-sell agreements, also might dictate the applicable standard.
A valuator’s professional judgment factors into the decision, as well. For this reason, it’s important that you work with an experienced and qualified appraiser. It might just mean the difference between testimony that’s accepted in court or that which is rejected.