The terms “fair value” and “fair market value” are sometimes used interchangeably. To a business valuation professional, however, they have very different meanings. Adding to the confusion, “fair value” may be statutorily defined for shareholder litigation and divorce purposes — and that definition may vary depending on the case’s venue. Moreover, fair value means something entirely different when it’s used for financial reporting purposes. (See “Fair value under GAAP.”) Ultimately, an expert’s conclusion can differ significantly, depending on which standard of value is appropriate.
Fair market value
Fair market value is probably the most widely recognized valuation standard. It’s commonly used to value businesses or business interests for sale and tax purposes. The IRS defines fair market value in Revenue Ruling 59-60 as “[T]he 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.”
Fair market value is determined based on the expected price in an open and unrestricted market. This standard isn’t the same as “strategic” or “investment” value, which refers to a business’s perceived value to a specific investor.
Under Rev. Rul. 59-60, a valuation expert considers eight factors when estimating fair market value:
- Nature and history of the business,
- Economic outlook for the general economy and industry,
- The company’s book value and financial condition,
- The company’s earnings capacity,
- The company’s dividend-paying capacity,
- Goodwill and other intangible value,
- Previous sales and the size of the block of stock, and
- Market prices of comparable stocks.
Depending on the size of the business interest and restrictive agreements, fair market value also may incorporate discounts to reflect a business interest’s lack of control or lack of marketability.
Fair value is a term — defined by state law and/or legal precedent — that may be used when valuing business interests in shareholder disputes or marital dissolution cases. Typically, a valuator uses fair market value as the starting point for fair value, but certain adjustments are made in the interest of fairness to the parties.
For example, dissenting shareholder litigation often involves minority shareholders who are “squeezed out” by a merger or other transaction. Unlike the hypothetical, willing participants contemplated by fair market value, dissenting shareholders are neither hypothetical nor willing. The fair value standard helps prevent controlling shareholders from taking advantage of minority shareholders by forcing them to accept a discounted price.
In many states, fair value is defined as a shareholder’s proportionate share of the fair market value of the company as a whole, without regard to any discounts for lack of control or marketability. To avoid providing a windfall to dissenting shareholders, fair value generally doesn’t include any strategic or synergistic premiums that might otherwise increase the company’s fair market value. In addition, it’s common to exclude from fair value any appreciation or depreciation in value in anticipation of the transaction that gave rise to the litigation.
In a divorce context, it’s important to review all applicable statutory and case law that governs valuation. The rules vary substantially from state to state. In many states, valuation in divorce cases is based on fair market value, but some states apply fair value standards similar to those in dissenting shareholder cases. A few state statutes simply use the term “value,” or don’t address valuation at all, so it’s critical to examine the courts’ interpretation of the term.
Even in states that purport to use fair market value, adjustments may be required. For example, more than half of states exclude the value of a spouse’s personal goodwill from the marital estate. Some states exclude both personal goodwill and enterprise goodwill — that is, goodwill associated with the business itself — while others include all goodwill in the marital estate.
Get it right
Whenever it’s necessary to determine the “value” of a business or business interest, it’s critical to learn about valuation standards and work with experts who understand the subtle nuances. The definition of fair value varies dramatically from state to state (or even from court to court), and fair market value may depart from its traditional definition in some contexts.
Fair value under GAAP
U.S. Generally Accepted Accounting Principles (GAAP) define fair value as “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.” This definition — found in Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements and Disclosures — is similar to the definition of fair market value, with some subtle differences.
For example, rather than an open and unrestricted market, fair value for GAAP purposes only considers participants in the principal, or most advantageous, market. In addition, ASC 820 establishes a three-tier hierarchy for valuation inputs: It gives the highest weight to quoted prices in active markets for identical assets or liabilities, a lower weight to comparable assets and liabilities and the lowest weight to an entity’s cash-flow models or other internal data.