Business valuations are used in a number of different situations. Primarily, a valuation is conducted for:
- Transaction Purposes - buying or selling in an open market;
- Regulatory Purposes - taxation or judicial decisions;
- Accounting Purposes - financial reporting needs; and
- Planning Purposes - either for managing the business or managing wealth.
The Breakdown of Fair Market Value
The outcome of any valuation, regardless of the purpose should be to determine the fair market value (FMV). But even this term can be parsed to give three composite value terms and three individual constituent terms as follows:
Let’s discuss which term is most relevant in each valuation scenario.
The reference concept of value should be market value, meaning value viewed as the consideration (usually money from one party and shares of a business from the other) that is changing hands in an exchange transaction that two arm’s length parties have agreed to as a consequence of a suitable process of analysis and negotiation. An adequate valuation process must effectively consider both a bid and an ask perspective on worth - one that is very concerned about taking on risk (the buyer) and one that is very concerned about giving up opportunity (the seller). Strange as it may seem, in logical terms they are searching for an indifferent point value, i.e. one at which neither of them ultimately cares whether the deal goes down or not (each would be happy to have or not to have the money, and to have or not to have the business).
The term most applicable in this situation is fair market value. Essentially, because the context of valuation is one in which a dispute is inherent and its resolution will frequently require consideration of issues of fairness, balance and equity among the disputing parties in the development of a solution - something that is inherently expected from the judicial decision making process. It is a concept that has emerged from judicial proceedings in which an arbiter of a dispute must make a finding that fairly balances the (in some measure, ambiguous) claims and contentions of the opposing parties. There are also certain regulatory contexts where the term, fair value, may be used, but the context actually involves a FMV perspective subject to a prescribed adjustment. For example, this arises in securities regulatory contexts when deduction of a minority discount is prohibited in valuations for going private transactions.
Value considered in this context should be fair value, largely because accountants operate in a realm of their own design to measure and report on the financial position and operating results of businesses. This is a form of regulation, of course, but it functions as support for a process other than dispute resolution and, accordingly, needs its own perspective. For this purpose, the accounting process contends it needs to be independent of how the regulatory dispute resolution process inherent in the concept of fair market value may have prescribed valuation results because those ideas may not fit well with the financial reporting perspective. A core background requirement of the accounting orientation is that businesses are comprised of individual assets and liabilities ("units of account") and it is ultimately these that have to be valued - and the values involved tend to be approached on a pretax basis because that is how asset amounts flow into business accounting. The developed accounting perspective on fair values includes a triune structure for disclosing how readily it can be established that a developed value amount is supported by market sourced information.
The reference concept of value could be any of the above with the appropriate selection depending on the focus of the planning process. A business planning process might well be concerned with fair value because the plan may need to be related to what the financial reporting process may show. Or, such a process might relate to market value because its key concern could be the potential realization of capital value and the planning defines what is an offer. And if the planning process is related to something like a corporate reorganization in the form of non-arm’s length transactions or, perhaps, an inheritance and ownership succession plan, the valuation focus might well be fair market value because of the relevance of taxation and equity concerns to the potential outcomes.
In some cases, the planning process will be more concerned with the challenges of growing business value than it is in the current or any particular future level of such value. In these instances some mix of different value generation dynamics and reference concepts of worth may be relevant to the process of thinking about business value.
What is Fair, Market and Value?
As a complement to this outline of composite concepts of value, a brief consideration of the individual terms is warranted. While the core concept is value, it takes on particular significances in relation to the other fair and market terms. In this regard, an initial need is to recognize that the word, fair, inescapably involves a normative idea - it is itself a value concept and can never be viewed simply as a descriptive term. That is in some measure why it arises in regulatory and dispute resolution contexts - the objective of the process is intended to result in an outcome that is fair to both parties to a dispute or other context of conflict. If there is no need for such a concern - no effective issue of "economic or commercial ethics or fairness" involved - then fair market value may well not be the right value concept for consideration.
More likely, the need is to address the matter in the simple sense of a market. But what is that sense of "market?" In one reasonably useful take on the meaning of that term, a market is simply "other people" with suitable recognition that different people develop different views on matters like economic values (and many other things as well, of course). And that tends to mean that one must think about the core value concept as very much a relativistic notion - "value is in the eye of the valuator," as it were, or in the language that is sometimes used, "valuations are ultimately subjective."
Finding Common Ground
An obvious concern might be that this seems to imply that values are always uncertain and people should be averse to acting on valuation information no matter what concept of value it purported to represent. But that clearly cannot be the case because people, in fact, act on value information all the time. In an effort to make these valuation concepts operational, relevant and effective, it is crucial to process relevant information in ways that are responsive to recognized valuation principles.
Given an inescapable need to apply valuation concepts to a combination of facts and expectations in order to develop an estimate of value - whether it be fair market value, market value or fair value - there will always be some risk of different interpretations and evaluations of such variables by different parties at interest. But, so long as those requirements are dealt with in some way that is responsive to the body of knowledge in the literature of economics, finance, accounting, law and valuation, there will be reasonable prospects that possibly disparate perceptions of worth can be collapsed into an acceptable basis for a transaction to occur.