What does my business valuation really mean?
The Goal: To cut through the jargon and make sure you understand what your business valuation really means. The key is to understand that different standards of value will likely produce different results (a different valuation number) and hence the reason that one valuation should not be used for multiple valuation purposes.
Key point: Value, used in the context of business valuations are referred to as valuation standards, really does have different meanings. Let’s review the primary valuation standards we work with, which are, Fair Market Value, Fair Value, and Investment Value.
1. Fair market value – this is where we spend most of our time, the granddaddy of our valuation and business sales/acquisitions engagements. This value, defined by the IRS during the days of prohibition when at that time, the owners of breweries and distilleries were being compensated for being closed by the government, is based on certain key assumptions: the seller and buyer are hypothetical (ie no specific purpose), both willing to do a deal, neither party compelled to do so, both parties are properly informed and each with the resources and rights to make it happen. Note that fair market value includes valuation discounts and premiums associated with limited marketability and minority ownership interests. It’s true, not all ownership shares are created equal!
2. Fair value – wish they called it something else, easy to confuse with fair market value. This definition is in constant motion, always on the move. Why? The definition changes with new local/jurisdictional case law rulings and decisions. So, the more we learn from real world experience, the better we understand the issues and challenges in preparing realistic valuations with greater clarity (well, not always). And, valuation discounts associated with lack of marketability and minority interests are generally excluded from fair value valuations. So fair value is really driven by jurisdictional decisions and interpretations. Ex: you will find the definition of fair value used in Florida will likely be different than the California meaning of fair value, even when it’s the same valuation issue. And if you live in Virginia, you’ll find that the term intrinsic value is used instead of fair value. Jurisdictions prevail.
3. Investment value – this value, commonly referred to as “synergistic value” looks at value through the eyes of a specific buyer, not the hypothetical buyers assumed in the fair market value standard, who is interested in acquiring a specific targeted company. Generally, the “synergistic buyer” has made certain assumptions regarding the “synergistic benefits” anticipated with the potential acquisition of a targeted business ie added customers, new markets, cost savings and has factored such benefits in the valuation.
Ok, now that you have a good understanding of what the typical “valuation standards” are, what difference does it really make? Good question.
Key point: It’s important to make sure that the proper valuation standard (above) is consistent with the purpose of having the business valuation prepared. Otherwise, you might end up valuations that are wrong. We’ve summarized this for you:
1. Fair market value:
a. Business sales and acquisitions
b. Acquisition financing
c. Estate and gift tax planning
d. Business succession planning
e. ESOPS’s (employee stock option plans, a specific type of retirement plan)
f. Calculating built-in-gains tax for C-corporations converting to S-corporations
2. Fair value
a. Owners dispute
b. Partner/shareholder ownership “earn-in” provisions
c. Dissolution (orderly, not forced)
d. Public to private ownership changes
e. Financial reporting requirements
3. Investment value – sales and acquisition between known parties
4. Other common valuation situations include:
a. Buy sell agreements – the value is whatever the parties agree to in the buy/sell agreement (hint: if you have one, is it current? And does it reflect what you really want? If you don’t have one, should you?)
b. Marital dissolutions/family law matters – we’ve seen both fair market value and fair value (intrinsic value in VA) standards commonly used.
Hope this helps. Just make sure the valuation standard used is consistent with the purpose of the valuation. If you ever have a question, do not hesitate to call.