What entrepreneurs and businesses owners need to know
As entrepreneurs, founders and business owners, understanding the value of your company is crucial for various reasons — from raising equity and securing loans for growth, to compensating employees with equity, to exit planning. The two most common valuation standards you will encounter when talking to private equity firms, VCs, bankers, and accountants are Fair Value and Fair Market Value. Like much terminology in finance, these terms look and sound similar but can lead to different valuation when applying them. Let’s break it down:
Fair Market Value: The Gold Standard for the IRS
Fair Market Value (FMV) is the most common valuation standard encountered by entrepreneurs and business owners. If you’ve ever issued stock-based compensation to an employee, you’ve likely come across FMV.
The IRS defines it as:
“[t]he amount 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.”
Another widely accepted definition comes from Raymond C. Miles, a renowned American business valuation expert and author. He states:
“Fair market value is the price, in cash or equivalent, that a buyer could reasonably be expected to pay and a seller could reasonably be expected to accept, if the property were exposed for sale on the open market for a reasonable period of time with buyer and seller being in possession of the pertinent facts, and neither being under any compulsion to act.”
In simple terms, FMV represents what your business would likely sell for if it were available to potential buyers who are interested and informed. This assumes both you and the buyers have sufficient time to consider the deal and aren’t under pressure to complete the sale.
When Fair Market Value Matters to you:
- Tax matters and the IRS: This includes situations like gifts, estates, and equity-based compensation.
- Divorce Proceedings: When your business is considered an asset to be divided (Note: rules may vary by state).
Fair Value: Mind the GAAP
Fair Value (FV) is commonly used in accounting reports under GAAP standards and in legal contexts. According to the Financial Accounting Standards Board (FASB), it is defined 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. The transaction is assumed to occur in the principal market or, if absent, the most advantageous market from the reporting entity’s perspective. Fair value measurement is determined from the viewpoint of a market participant holding the asset or owing the liability, focusing on the exit price rather than the entry price.”
In simple terms, FV is the estimated price you could get for selling your business (assets and liabilities included and separately accounted), assuming normal market conditions. It takes into account the best market available to you. The value is based on what a typical seller would expect to receive, not on what it costs to acquire the asset.
When Fair Value Matters to you
- Mergers and Acquisition: When you acquire another business, you need to account for the assets and liabilities of the acquired business in your books. This process, called Purchase Price Allocation (PPA), is based on FV.
Key Differences that Impact the Valuation
Rules based
As you may have noticed from the FASB definition of FV, it is highly rules-based. FV aims to make valuations comparable across companies by applying specific templates and rules that analysts must follow. For example, it requires analysts to:
- Prioritize observed market data over assumptions.
- Assume the best available market for the transaction.
- Use real buyers and sellers in their evaluations.
These rules are not requirements for FMV. FMV is a more flexible concept, allowing for different applications depending on the context and purpose of the valuation.
Application of Discounts
When valuing a minority share of a private business under FMV, it is common to apply discounts for lack of marketability and lack of control. These discounts reflect:
- The limited ability of a minority investor to influence the business’s operations and decisions.
- The difficulty a minority investor might face in quickly selling their stake, as there is no readily available market for private company shares.
These discounts account for the limitations and risks associated with owning a minority stake in a private company.
In contrast, under FV, which follows GAAP rules, applying discounts for lack of marketability and control is much less common. GAAP prioritizes consistency and comparability in financial reporting, reducing the need for such discounts.
Why all these matters to Entrepreneurs and Business Owners
Tax Implications:
Using the appropriate standard for any numbers reported to the IRS ensures compliance and can potentially save you money and headaches!
Financing for Growth:
When speaking with bankers, VCs and Private Equity, understanding the lens which they are viewing and valuing your business can help you present a more compelling case and enable you to raise the money at the lowest cost.
Financial planning:
Understanding which valuation standard to apply helps you get a more accurate picture of the worth of your business for strategic planning.
Exit planning:
Similar to financing for growth, if you are considering selling your business in the future, understanding both standards helps you set realistic expectations and plan effectively.
Dispute Resolution:
In the case of disputes between partners or legal issues, knowing the valuation standard being applied is crucial to the preparation of the case and can significantly impact the outcome.
We understand that as business owners and entrepreneurs, you have a ton of competing priorities – managing cash flows, hiring and retaining talent, and navigating economic uncertainties. Deciding which valuation standard to apply and how it impacts value should be the least of your worries. That’s where we are here to help.
Our valuation experts are here to help you navigate the complexities of Fair Value versus Fair Market Value, ensuring you have the accurate, relevant information you need to make informed decisions. Don’t let valuation confusion hold you back; we are just an email or phone call away.