In his blog post of September 30, 2009, Lee Crawley did a great job of clarifying the business valuation process and he made reference to the fine business valuation article written by Gary Parker. Lee touched on the standard of value by raising an important initial question in a business valuation engagement: What is its purpose?
It may seem odd to some readers that you can value the same stock of a company and arrive at very different results just by a change in the standard of value. The standards of value include fair market value, fair value, investment value, liquidation value, marital value, intrinsic value, etc. For this blog post, I will address the three common standards of value – fair market value, fair value and investment value.
Fair Market Value
For all federal tax cases which contain a valuation issue, the standard of value is fair market value. This standard of value applies to the federal estate, gift and generation-skipping transfer tax as well as certain issues pertaining to the federal income tax. For example, if property is given to a charitable organization, the standard of value to apply in valuing the property is fair market value. Another example might be restricted stock given as compensation to an employee. Even with stock being subject to certain restrictions and an available election under IRC Section 83(b), the standard of value is fair market value.
Treasury Regulation Section 20.2031-1(b) provides the following definition of fair market value:
“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.”
Fair market value is assumed to be a cash value and it is important to note that the buyer and seller are hypothetical (i.e., not a specific buyer or seller). As we all know, in the world of mergers and acquisitions, there are strategic buyers and there are financial buyers. And the objectives of these different buyers vary significantly.
So what about synergistic (or strategic) value? With very few exceptions, fair market value does not consider synergistic value. The rather unusual federal tax case that comes to mind is BTR Dunlop Holdings, Inc. and Subsidiaries v. Commissioner 78 TCM 797 (1999), where synergistic value was taken into consideration since there were six potential strategic buyers of one of the entities in the case. With respect to the business valuation literature, synergistic (or strategic) control value is one of the levels of value when we are talking about control related premiums and discounts, and the valuation discount for lack of marketability.
The standard of value, fair value, is commonly described by state statutes involving dissenting shareholder rights. Here in California, valuation analysts that provide expert witness services refer to these matters as Code Section 2000 valuation engagements (i.e., California Corporation Code Section 2000). Most publicly traded companies based in the United States are incorporated in Delaware. The Delaware Court of Chancery is an equity court and they are very sophisticated about disputes involving business valuation. Members of the legal profession and expert witnesses that work in the area of shareholder disputes closely follow the decisions handed down by the Delaware Court of Chancery.
Delaware Code Section 262(h) provides a definition of fair value, in pertinent part, as follows:
“Through such proceeding the Court shall determine the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation, together with interest, if any, to be paid upon the amount determined to be the fair value. In determining such fair value, the Court shall take into account all relevant factors.”
So the statute in Delaware gives the Court of Chancery a lot of room in determining fair value. It is the case law from the court that gives the valuation analyst a better idea of how the court views fair value.
The standard of value, fair value, is also found in accounting literature. Just to make things even more confusing, fair value in the accounting literature is not the same as how the courts view fair value in connection with shareholder oppression litigation.
For several years now, Generally Accepted Accounting Principles in the U.S. (“GAAP”) has been converging with International Accounting Standards (“IAS”), which is very much about fair value accounting. GAAP was originally about historical cost, not fair value. In September 2006, Statement of Financial Accounting Standard (SFAS) 157 was issued by the Financial Accounting Standards Board (FASB). Here is the definition of fair value under SFAS 157:
“Fair value is 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.”
On the surface, the definition of fair value does not look much different than the definition of fair market value. However, SFAS 157 describes a three level hierarchy for deriving fair value. By using the approach described by SFAS 157 and the view of “market participants,” the result can be quite different than a valuation with fair market value as the standard of value.
With respect to the business valuation literature, investment value is the value to some particular buyer or seller rather than a hypothetical buyer or seller as we have with fair market value. Investment value does include synergistic (or strategic) value or a premium, above just a control premium, that a buyer will pay in a business acquisition. So with regard to transactional work of an investment banker for purposes of a merger or acquisition of a controlling business interest, investment value is generally the preferred standard of value to use.
As investment bankers, we have a good understanding of business valuation and we are ready to help you gain a better understanding of the value drivers for improving the value of your business.
Posted by David DuWaldt.