Gorfine, Schiller & Gardyn’s Chuck Faunce, Director of Business Valuation and Litigation Support, discusses the difference between investment and fair market value and how this information can help business owners make decisions for a profitable future.
Q:Why do business owners need to know the difference between investment value and fair market value?
A: Business owners need to know the difference between these two different standards of value because they can yield wildly different results. Using the wrong standard could result in expectations that keep a deal from happening, or yield an answer that results in paying too much in taxes.
Q: Why would the results be different?
A: The results would be different because investment value and fair market value are based on different assumptions about five areas.
Q:Whatare these five areas?
A:First, is who are the buyer and seller. For investment value, it’s a specific buyer and a specific seller. For fair market value, the parties are hypothetical.
Second, fair market value requires a contemplated transaction to reflect the terms that unrelated parties would agree to, while investment value allows the terms to reflect other relationships between the parties if they so choose.
Third, fair market value requires participation in the contemplated transaction to be voluntary while investment value does not. In an investment value analysis one or both of the parties may be compelled to participate.
Fourth, fair market value requires the contemplated transaction to be open to all potential buyers and sellers while investment value does not. In fact, investment value requires a specific buyer and a specific seller.
And fifth, fair market value requires all parties to have reasonable knowledge of all relevant facts, while investment value does not.
Q:How do those different assumptions lead to different results?
A: Differences in those assumptions can yield major differences in two fundamental elements of value. The first element is the timing and amounts of cash flows a company is expected to generate in the future.
The second element is the uncertainty associated with the timing and amounts of those cash flows.
The differences result from which synergies are included in those cash flows and the uncertainty associated with them.
Q: What exactly do you mean by “synergies”?
A: Synergies are just any combination of increased revenues, decreased costs, or reduced uncertainty that results from combining the seller’s assets with the buyer’s complementary assets, which could include things like a bigger salesforce, more efficient operating processes, elimination of duplicate costs and better access to capital.
The fair market value standard allows synergies available to all or most potential buyers. However, certain buyers may have unique abilities to either generate more revenues or reduce more costs or risks. Those “buyer-specific” synergies are not allowed under the fair market value standard but are the reason to do an analysis under the investment value standard, and can create a big difference in value.
Q: When should the investment value standard be used versus the fair market value standard?
A: It depends on the intended use of the analysis.
Investment value is applicable to transactions and management decision-making, like the decision whether to grow organically or by acquisition. It can also be relevant in litigation when, for instance, a lost profits analysis is required.
Fair market value, on the other hand, is applicable to tax and financial reporting compliance requirements, and sometimes it’s relevant in litigation. For instance, if an individual has the misfortune of going through a divorce and needs to have his or her business valued, the most common standard of value in those circumstances is fair market value.
Chuck Faunce is the Director of Business Valuation and Litigation Support at Gorfine, Schiller & Gardyn and has more than 20 years of experience providing clients with valuation consulting services including financial and tax compliance reporting, economic damages analysis and expert testimony, and buy and sell side transaction analysis.
