Understanding the Concept of Standard of Value

Posted by on Jul 5, 2017 in Business Valuation

We business appraisers value all kinds of businesses for all kinds of purposes. In Portland, Oregon it is almost impossible to focus your practice on one industry or type of business. What business owners, CPAs, and attorneys often don’t realize is that any good business appraiser needs to first understand and explain to the client the appropriate standard of value for the proposed engagement at hand.

Business appraisers accredited by the American Institute of CPAs must follow the business valuation standards set out in the Statement on Standards for Valuation Services No. 1 (SSVS-1).  In paragraph .12 of SSVS-1, the Standards state that, “In determining whether he or she can reasonably expect to compete the valuation engagement with professional competence, the valuation analyst should consider, at a minimum, the following: … d.iii. Applicable standard of value…”

The International Glossary of Business Valuation Terms defines standard of value as, “the identification of the type of value being utilized in a specific engagement; for example, fair market value, fair value, investment value.” What I’ve found is that this concept of “standard of value” is not well understood, and yet it is vital to preparing a well-constructed business valuation.

Let me briefly define and discuss the three most common standards of value; Fair Market Value, Fair Value, and Investment Value. The International Glossary of Business Valuation Terms defines two of these standards of value as follows:

Fair Market Value—the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

Investment Value—the value to a particular investor based on individual investment requirements and expectations.

Fair Value is not defined in the glossary because the term “fair value” does not have just one meaning. For financial statement reporting purposes under Generally Accepted Accounting Principles (GAAP), fair value is defined in the Financial Accounting Standards Board (FASB) Statement No. 157.  The definition and framework for the application of fair value accounting in this context is of a financial statement disclosure nature. The FASB definition “focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price).”[1]

Fair value is also determined in the Courts as it relates to dissenting shareholder and shareholder oppression cases. As such, courts across the country have defined fair value in different ways. Many times the courts have found that determining the fair value of a minority interest in a company will disregard otherwise applicable discounts for lack of control or marketability that would otherwise be considered in rendering a fair market value.

So when I am asked by a business owner, attorney, CPA, or other professional to estimate the cost and timing to value an ownership in a closely held business, I must always make sure everyone is clear on the standard of value appropriate for the engagement. Is the value going to be determined with or without lack of control and marketability discounts applicable under fair market value, or is the value going to be determined in some strategic context overlaying the unique characteristics of the buyer or the seller under investment value?

Fair market value would be appropriate for carrying out a valuation for gift or estate tax reporting purposes to the IRS, but investment value may be more appropriate to use as the standard of value when determining the value of a company to a buyer who is a competitor in the industry. Can that buyer benefit from synergies or economies of scale from the transaction? Would the buyer be willing to share those benefits with the seller?  As you can see, setting the stage by defining the appropriate standard of value is critical to getting any business valuation started off on the right foot.

[1] Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 157, Pg. 4