There are two common standards of value that are used by valuation analysts that you may be aware of, Fair Market Value and Fair Value. However, when you and your client have determined the need for a valuation, it is important to understand the other standards of value so that you are best able to apply the most appropriate standard for your situation.
Depending on the purpose of a valuation, a number of standards of value can be applied. Each of the five widely used standards of value discussed below have specific purposes, and selecting one over another can make a difference in the valuation conclusion. Becoming familiar with each of the standards of value will better equip you to make decisions based on the type of valuation needed and the purpose for the valuation – which could benefit both you and your client throughout the process.
Five of the most widely used standards of value are:
- Fair Market Value – The IRS defines fair market value as, “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 the relevant facts.” This standard if most appropriate for estate taxes, gifting, buy-sell agreements with minority shareholders, and other instances where discounts for minority interest or lack of marketability may apply.
- Fair Value – Not clearly defined by statute or valuation doctrine. Generally speaking, it may constitute fair market value without the application of discounts or premiums. This standard of value takes into account the economic principles of free and open market activity. Used more to determine the pro-rata price per share of an enterprise. Most appropriate with shareholder disputes, buy-sell agreements with equal partners, or lost profits or other damage calculations.
- Liquidation Value – This is the net proceeds that the company would receive, after paying off all outstanding debt, if they ceased business operations and sold all company assets in an orderly fashion. This would represent the minimum value for the business and concludes that the business is worth more dead than alive. This method is used in bankruptcy scenarios or in the event of a business breakup where the owners cannot agree to an equitable dissolution of their relationship.
- Enterprise Value – This value represents the gross value of the business operations from the eyes of a potential purchaser. It generally will look at the business on a cash-free, debt-free basis. This method is used in looking at the value of a business from a merger or acquisition standpoint for the potential purchase or sale of the business.
- Holder’s Interest Value – Differing from fair market value, which assumes a hypothetical buyer and seller, holder’s interest approach values the business in the hands of its current owner and does not anticipate a sale of the business. This method is generally used in the valuation of professional practices for divorce purposes, where the personal service and goodwill of the owner is a significant factor in the success of the practice.
Depending upon the purpose of the valuation, the operations of the company, and the parties involved, the standard of value, and thus the conclusion of value, could be substantially different. Be sure that all stakeholders to the valuation fully understand the standard of value chosen and the significance it may have in the overall value. Contact a business valuation analyst at Yeo & Yeo if you have questions about standards of value, which one is most appropriate for your situation, and how selecting one over another can make a difference in the conclusion of the valuation. Yeo & Yeo’s Business Valuation and Litigation Support Services professionals can guide you in determining the fairest and appropriate course of action for you and your client.