Different States have different standards for determining the business value in litigation settings.  Typically the standard of value will be Fair Market Value or Fair Value.  The standard of value sets the requirements for the development work needed to be completed by the business valuator.  The standard of value describes the circumstances under which the transaction would take place.[1]

For instance, in the case of fair market value, the buyer and seller are assumed to be hypothetical and the transaction is assumed to take place under normal conditions (as opposed to under duress). In other words, the standard of value addresses the question of “value to whom?” and “under what circumstances?”[2]

Fair Market Value

Fair Market Value, derived from Revenue Ruling 59-60,  is the basis for all business valuations in the United States and internationally.  When using the term Fair Market Value, the business valuation expert has indicated that they have the elements of Fair Market Value that are widely accepted in the definition of Fair Market Value.

Definition of Fair Market Value

The definition of Fair Market Value is “As the 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.”[3]

Fair Market Value Factors to Consider

The following factors, although not all‑inclusive are fundamental and require careful analysis in each case:

(a) The nature of the business and the history of the enterprise from its inception.

(b) The economic outlook in general and the condition and outlook of the specific industry in particular.

(c) The book value of the stock and the financial condition of the business.

(d) The earning capacity of the company.

(e) The dividend‑paying capacity.

(f) Whether or not the enterprise has goodwill or other intangible value.

(g) Sales of the stock and the size of the block of stock to be valued.

(h) The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over‑the‑counter.

Each of these factors has additional information on topics that should be considered when preparing a business valuation.  The recognized treatises have extensive information on the application of each of these factors.  This information is too extensive to be included here.  I would highly recommend that a copy of Revenue Ruling 59-60 is downloaded from the internet and reviewed to have an understanding of what is expected to determine Fair Market Value.

There are a number of treatises on business valuations that go into more detail on the various techniques available for the analysis of a closely held company.

Calculation of Value

A Calculation of Value is defined by the American Institute of Certified Public Accountant as:

“A valuation analyst performs a calculation engagement when (1) the valuation analyst and the client agree on the valuation approaches and methods the valuation analyst will use and the extent of procedures the valuation analyst will perform in the process of calculating the value of a subject interest and (2) the valuation analyst calculates the value in compliance with the agreement.  The valuation analyst expresses the results of these procedures as a calculated value either as a single amount or a range.  A calculation engagement does not include all of the procedures required for a valuation engagement and if a valuation engagement had been performed, the results might have been different.”

Why is a Calculation of Value NOT a Fair Market Value standard of valuation?

There are three approaches to determine Fair Market Value.  They are the Asset or Cost Approach, the Market Approach and the Income Approach.  Each of these three approaches has multiple methods that can be applied.

The Asset or Cost Methods consist of the Adjusted Book Value and a Liquidation Value.

The Market Methods consist of using Guideline Public Company Multiples and Sale Transactions related to private company sales multiples.

The Income Methods consist of the Discounted or Capitalized Cash Flows, Discounted or Capitalized Earnings.

A Calculation of Value is an agreement between the client and the business valuation expert on what should be performed.  This typically does not allow for the business valuation expert the flexibility to review which method is most appropriate, does not allow for a complete and thorough analysis of the procedures indicated in Revenue Ruing 59-60, the cornerstone definition of Fair Market Value.

No universal formula exists for all businesses.  Therefore, it’s essential for experts to explain why they chose a specific method (or methods) over all the possible options or indicate why various methods were not used.

Summary

I help attorneys by converting complex financial matters into understandable concepts.  This makes it easier for the attorney explain the complex issues to their clients.

I have earned the most difficult business valuation designations for valuations of closely held companies.

I have earned a Master’s Degree in Business Valuations and apply those skills to my everyday business valuations.

Richard Claywell has been valuing closely held companies since 1985.  He has earned two of the highest designations in the business valuation field , the Certified Business Appraiser (“CBA”) and Accredited Senior Appraiser (“ASA”),  Richard is a Certified Public Accountant, has a Master’s in Business Valuation (MBV)  and holds the ASA, CBA, ABV, ICVS, CVA, MAFF, CFD, ABAR, CVGA, ICVS-A credentials.

I welcome and encourage comments and feedback. If you are benefiting from this series, please recommend to your friends and colleagues and suggest that they sign up to receive posts regularly.

[1] Pratt, Shannon P. Niculita, Alina V. “Why the Standard of Value is Critical in Divorce Business Valuation”, Family Lawyer Magazine, April 19,2021

[2] Pratt, Shannon P., Niculita, Alina V. “Valuing a Business: The Analysis and Appraisal of Closely Held Companies”, Fifth Edition, 2008, p. 41.)

[3] Revenue Ruling 59-60,Section 2.02