What you need to know about valuation standards and their impact

Valuation of a business or an interest in a business may be done for many purposes. What many businesses don’t understand, however, is that the applicable standard of value required in the specific situation has a direct impact on the final result.

Smart Business spoke with John T. Alfonsi, Managing Director at Cendrowski Corporate Advisors LLC, about the impact the purpose of the valuation has on the result.

What are some reasons a business valuation would be called for?

A business or an interest in a business may need to be valued for a sale of the business or interest, gift tax purposes, estate tax purposes, shareholder or partner buy-out/redemption, divorce, litigation purposes, or financial reporting purposes, among others. The same interest in the business may have a different value depending on the purpose of the valuation.

How does the purpose of the valuation affect the bottom line value?

The applicable standard of value dictates what the value may be. The standard of value answers the question ‘Value to whom?’ which has an effect in determining the value of the asset. There are many standards of value, but some of the more common are fair market value, fair value and investment value.

What are the standards?

Fair market value is probably the most common standard and the one people hear most often. It is the applicable standard for all federal tax purposes, whether it is income tax, gift tax or estate tax.

Fair market value is 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, and both parties have reasonable knowledge of relevant facts.

Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and are informed about the property and the market for such property. It is not the value to a specific person or buyer, but is generally thought of as the value to a hypothetical financial buyer.

Fair value has a couple of meanings. For financial reporting purposes, fair value means 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.

It is similar to fair market value but with some subtle differences, for instance it’s meaning for state law purposes.

Fair value in state law shareholder dispute matters is generally defined as the value of the corporation’s shares determined immediately before the effectuation of the corporate action to which the shareholder objects using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal without discounting for lack of marketability or minority.

The valuation analyst needs to be familiar with the applicable standard for the state to which the matter relates, as each state may be different. Investment value is the value to a specific person.

It is most commonly used in a sale or merger transaction as it will capture the synergies of the business with the specific buyer/acquirer.

How do these standards of value affect a 20 percent interest in a closely held business?

Where fair market value is the applicable standard, the value would be the price at which a hypothetical buyer would pay for that 20 percent interest. It may reflect any applicable discounts in that determination, such as a discount for lack of control and a discount for lack of marketability.

In a state law fair value context, the value would be 20 percent of the value of the entire business without regard to any discounts for lack of control and lack of marketability. It generally produces a value, then, which is greater than that determined under a fair market value standard.

Investment value would take into consideration synergies or value with respect to the specific buyer.

It is most commonly applied in valuing the entire business rather than an interest in the business. Investment value would generally produce a value greater than that determined under a fair market value if the buyer is a synergistic buyer rather than a financial buyer. ●

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