One of the first pieces of information that should be determined in any valuation engagement is the standard of value. The standard of value provides a roadmap for the valuator to reach a conclusion of value. Oftentimes, the standard of value is dictated by the purpose of the engagement. The three primary standards of value are explored below.
Fair Market Value (FMV)
The Fair Market Value standard is required for all federal tax-related engagements. Federal tax-related engagements generally include estate tax compliance, gift tax compliance, and what are referred to as 409A valuations. Fair Market Value was defined by the IRS over five decades ago. The definition has withstood the test of time and although required in tax-related engagements, it is often used in non-tax engagements as well.
The Fair Market Value definition in IRS revenue ruling 59-60 is as follows:
“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 of relevant facts.”
Although the definition appears somewhat technical, one of the main takeaways is the fact that the buyer and seller are both hypothetical as opposed to specific. With the FMV standard of value, the valuation cannot be impacted by the motivations of a specific buyer. A specific buyer may be willing to pay a higher price for the property due to the buyer’s unique set of circumstances. These unique circumstances cannot be considered under the FMV standard of value.
The Fair Value standard is most often seen in a litigation setting or in financial reporting engagements. Fair Value can be difficult to grasp as there is no true singular dictionary definition of this term. Fair Value for litigation purposes is generally defined and interpreted by the specific jurisdiction where the case is being litigated. Valuators may need to look at precedent in the specific jurisdiction of the litigation engagement to determine what Fair Value means and how it will impact the conclusion of value. Fair Value for financial reporting purposes is defined the Financial Accounting Standards Board (FASB). This definition can differ from the Fair Value definition in litigation settings.
While Fair Market Value does not consider the unique motivations of the buyer and seller, the Investment Value standard is just the opposite. The Investment Value standard allows the valuator to consider the specific circumstances of the buyer and/or seller. Investment Value is most often used in a transactional setting, arising in merger and acquisition engagements. The conclusion of value is altered based on the unique situation of the buyer. For example, if a strategic buyer is attempting to determine the value of an acquisition target that is in the same industry, the valuation will reflect the potential synergies that could be realized upon acquisition. This will generally yield a higher conclusion of value than if the FMV standard were used. It can be the case that the specific buyer is willing to pay a higher price for acquiring the target company due to synergies related to reduced overhead expenses, increased efficiencies, or a wide range of other reasons.
The standard of value is arguably the most important and impactful item to be determined in any valuation engagement. Once the standard of value is correctly identified, the valuator can begin his or her work in determining the value of the subject interest. It is often the case that the same subject interest will yield different conclusions of value based on the standard of value. Due to the differing conclusions that can be reached, it is imperative that everyone involved in the engagement is on the same page in regards to the standard being used to measure the subject interest.
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