What’s This All For? Defining Standards of Business Value and Why They Matter
Have you ever met anyone selling a house, a boat, a business, or any other asset that said, “It’s worth what someone is willing to pay for it”? I have never been a fan of that phrase, as I do not think it holds true in most cases. If it were up to me, the phrase would be, “It’s worth what LOTS of people are willing to pay for it.” The idea behind this is the definition of fair market value. You may often hear the terms value, fair value, price, and fair market value used interchangeably. The fact is there are major distinctions between these definitions.
The IRS has defined fair market value in Revenue Ruling 59-60 as:
“The amount at which the property would change hands between a willing buyer and 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.”
This definition is widely accepted as one of the best for fair market value in the practice of business valuation. In fact, it is one of the better pieces of verbiage put out by our government for use by the citizens in the past one hundred years.
The keyword we are discussing here is “market.” Physically, picture a farmer’s market with one vendor selling squash. You and your family show up for the big farmer’s market and see one lone stand selling one product. Not much of a “market” is it? Therefore, I do not believe that an asset is necessarily worth what one person is willing to pay for it, and most valuators do not consider one potential buyer to comprise a market for a business.
Picture for a moment that I have a boat for sale and I am trying to determine a reasonable asking price for it. I ask my friend what he would pay for it, and he tells me he would not pay a penny over $45,000 for it. I am unsure of using the opinion of only one person, so I tell ten coworkers everything about the boat, show them pictures, and ask what they would pay for it. All ten of them say that they would pay somewhere between $60,000 and $65,000 for the boat. Would you rely on the opinion of the one friend or the ten coworkers? Obviously, I am pointing you toward the ten coworkers, yet it still depends. According to the fair market value definition, both parties should have reasonable knowledge of the relevant facts.
We often hear a client say either the price they were hoping to get for their business, or a price one suitor was willing to pay for it at some point in time. In reality, the valuator should explain to the client the differences between fair market value and a potential asking price. When performing a business valuation under a fair market value standard, a valuator must distance themselves from the perspective of the current owner and a specific buyer, as fair market value assumes a hypothetical buyer and seller. The value to a specific buyer would be referred to as investment value and has nuances to consider if it is agreed to use this standard.
A good way to illustrate investment value compared to fair market value that I like to use is through the lens of a classic baseball card collector. Let’s say a collector has every original baseball card for the 1927 New York Yankees baseball team except for outfielder Bob Meusel, and it just so happens that the elusive Meusel card has come up for auction. The card is rare and inherently has value; however, once our collector has this card in hand, he will have a card for every player on the entire team, which will skyrocket the value of his complete card collection. Our collector will likely be willing to pay beyond the
fair market value of the auctioned card to ensure that he wins it and realizes the immediate increase in the value of his collection. This card has strategic value to the collector and the value he is willing to pay is likely its investment value, rather than fair market value. Excluding the card collector and accepting bids from the public would lend itself more to fair market value, as the specific objectives of the card collector are not influencing the price.
This same concept works for business as well. Often when performing a valuation under the market approach, samples of comparable transactions will have outliers whereby it appears that a purchaser paid beyond what the other purchasers in the market paid for similar companies. This is a strong indicator that there was additional consideration paid by the purchaser to ensure a transaction went through. Perhaps the target company had a customer or supplier relationship that could stand to benefit the acquiring company instantaneously, or perhaps the acquiring company was considering setting up a competing business nearby but opted to purchase a local competitor instead to ensure their entry into the market.
It is important to discuss the standard of value with the client in advance of performing analysis. This will help the valuator and the client discuss the results of the project and prevent a disconnect or “sticker shock” that can sometimes occur when there is a gap between fair market value and the client’s internal thoughts on value. Often the standard of value is prescribed for regulatory purposes, such as using fair market value for filings with the IRS. All this is to say that it is essential for the valuator and the client to establish the standard of value and then to make sure each party is on the same page as to the purpose of the engagement before proceeding.