The standard of value the appraiser uses, for practical purposes, is the definition of value the appraiser uses to complete the appraisal assignment. Among the most important things standard of value defines, is value to whom. One of the most common standards of value used in business valuation is "Fair Market Value." While definitions vary slightly, one of the definitions commonly used, as outlined by the US tax code, states:
The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. (26 C.F.R. sec. 20.2031-1(b))
Key Items About this Standard of Value
- Fair market value is typically a cash standard of value, meaning that it assumes that the transaction will occur in cash. If the terms of a transaction require that payments be made over time, this transaction would not meet the fair market value standard of value.
- Fair market value, as noted in the language of the definition quoted above, is not a forced transaction. Rather it is a price agreed to willingly by both the buyer and seller, and neither is under duress that would force their actions.
- Fair market value suggests that both buyer and seller are reasonably informed. The buyer has done her due diligence, and the seller has been forthright in disclosing all the pertinent details about the business. This does not necessarily mean that they both know everything, but the key facts have been disclosed.
- Fair market value suggests value in exchange, meaning an assumption inherent in the definition is that the opinion represents a price at which a transaction would occur.
- Because an appraisal is being performed, it is likely that a transaction did not occur, but the appraiser is trying to determine the price at which an exchange, meaning cash for stock, would have occurred.
- Fair market value does not assume any particular buyer or seller. Instead, fair market value tries to determine a market consensus view of what the business is worth.
Besides fair market value, there are other standards of value. "Fair Value" can mean different things, but one definition would be the value determined under fair market value, but without any discounts for lack of marketability or lack of control. "Investment Value" typically attempts to determine value to a particular person or entity. As an example, a business may be willing to purchase another business for more than another person, or more than fair market value because of some synergy they anticipate getting from that business. Investment value then, in contrast to the assumptions of fair market value, tries to determine worth to a particular person or buyer.
The key point on standards of value is that in order to understand any appraisal, the reader must understand the standard of value used. Some reasons for an appraisal, such as a gift tax return, require a specific standard of value. Other times, the required standard of value may be vague or undefined. Even if the required standard of value is vague, the appraiser should be clear on what standard of value she is using. A good appraiser will always state, and define so there is no ambiguity, the standard of value that she is using in the appraisal. Make sure you can identify the standard of value the appraiser uses, and that you understand the implications the standard has on the assumptions the appraiser uses to determine her opinion.
The Premise of Value
Premise of value typically means what is expected of the business in the future, and generally speaking there are three common premises of value. First is called, going-concern, which means that the appraisal assumes that the business will continue its business purpose and operations in the future.
A second premise of value is orderly liquidation. This assumes that the business operations will wind down over a period of time, sufficiently long enough to allow the business to maximize value as it seeks to convert its assets to cash.
A third premise of value assumes a fire sale liquidation, or the value that could be obtained if the company sought to convert assets to cash immediately. Depending on the nature of the company and its operations, any of these premises of value could be the key to maximizing the value of the entire company. The appraiser may not know initially what premise of value results in the highest value of the company; however, before she concludes her appraisal, a premise of value is determined and should be stated in her report.