A standard of value is a choice for the way value is sought in any transaction or the type of value used in a specific transaction. It may be legally mandated based on the situation, or it may reflect the desire of both parties in a transaction. In this case, it’s a measure of the motivation and knowledge of the parties — meaning buyer and seller — as well as other conditions that have a direct impact on the value/price of business. A business needs not only to make money but also to make progressively more money over the years to stay ahead of inflation. Valuation is a process that forces you to look at the viability of an existing business or a business idea and at whether an investment in a particular business will outweigh investment in other things like the stock market, currencies, or other securities. It’s tough to avoid emotion when buying or selling a business, but valuation is a reality check.
The concept may sound a bit technical at first, but we go into more detail on standards of value in this post. Simply keep in mind that people buy and sell businesses for a variety of reasons and under a variety of conditions. Enjoy!
Fair Market Value [The Root Of All Standards]
The standard of value you hear about most often is “fair market value“. Fair market value — a term used colloquially with market value and cash value —describes a business valuation in which a buyer and seller, who are both willing participants in the transaction, can agree on a transaction based on a common knowledge of all relevant facts. The word market doesn’t imply the stock market; it’s basically the market of all buyers and sellers that would potentially be interested in making a particular deal.
Why do we emphasize that the buyer and seller are both “willing participants” in the transaction?
Because someone having an urgent reason to buy or sell can definitely skew the valuation in one of two ways:
- Motivated buyers tend to pay higher prices to unmotivated sellers.
- Motivated sellers tend to accept lower prices from unmotivated buyers.
The valuation process would be so much easier to explain if there were only one or two motivations for a transaction. And of course, valuing businesses would be even easier if both people and businesses weren’t so unique. But the value of any business may get personal, based on the individuals involved. One buyer may have a personal vision of what the business is worth, and of course, a valuation professional may disagree after he or she views conditions from specific data combined with training and perspective.
All these viewpoints — and the desire to possess or give up a business —have a somewhat unpredictable up or down effect on price. Fair market value is an attempt to be objective.
Fair market value implies an equilibrium that, although it may not always be met, represents the theoretical fulcrum point in any deal. That’s why fair market value is the most widely recognized and accepted standard of value, and it’s used in all federal and state tax matters, including the valuations used in estate taxes, gift taxes, inheritance taxes, income taxes, and ad valorem taxes.
Perceptions Of Investment Value
Whereas market value is objective, impersonal, and detached, “investment value” is subjective and personal.
Investment value means that the value of a business is based on expected earnings or monetary return to a specific investor. Investment value, at least for most people, is in the eye of the beholder.
The investment value to one particular owner or prospective owner can be different from the fair market value. Valid reasons for this difference can include:
- Perceptions in estimates of future earning power
- Perceptions in the degree of risk involved
- Differences in tax status
- Things in common with other operations you own or control
Keep in mind that we’re talking about more than the stock of a company when we talk about investment value. For example, real estate is also a business, and investment value is also a standard used when determining whether a property should be bought or sold.
Intrinsic Value [Sometimes Called “Fundamental Value”]
Intrinsic value — sometimes called “fundamental value” — differs from investment value in that it doesn’t have as much to do with the investment as with the investor. Intrinsic value involves an investor who applies his or her own particular analysis and skills to the business as a whole or to individual assets to determine whether the business has value that isn’t reflected in the current market or asking price. It is, as many say, the “true” or “real” worth of an item based on that analysis.
Going Concern Value [Known as Ongoing Business]
A going concern — also known as an “ongoing business” — is a viable operating entity with assets and inventory, staff and management; it’s open for business with no expectation of closing for any reason in the immediate future. If it’s a well-run business, not only is it paying its expenses, but it’s also making a profit. Profitability is one element of value.
Consider: If you’re considering buying a business that’s still operating, you conceivably may pay more for it than you would for one that’s going out of business.
Valuing assets is a different ballgame when valuing an ongoing business as opposed to one that’s on the brink of closure. Here are a few reasons why:
- A business’s brand identity is arguably more valuable as a going concern.
- Customers are still actively coming through the door.
- Products are still in an ongoing state of service and development.
- Marketing and advertising is ongoing.
- Management is still running the operation with intimate knowledge of how to make the business work.
Valuation on a going-concern basis doesn’t necessarily mean that the business is being run at its optimum level. Frankly, you may have some better ideas about how to do that. But because you may apply more than one valuation standard to a specific transaction, looking for intrinsic value as well isn’t uncommon.
“Liquidation value” is the flip side of going-concern value. Liquidation value represents the net amount that can be gathered if the business is shut down and its assets are sold piecemeal. For example, liquidation is common in the restaurant business. If a restaurant closes, the assets such as the kitchen equipment, tables and chairs, and so on can be sold (This is, of course, assuming the owners owned the assets in the first place and the equipment wasn’t leased)
Knowing the kind of liquidation that’s taking place is important because it affects the costs connected with liquidation of the property, including commissions for those facilitating the liquidation (lawyers, accountants, auditors) and taxes at the end of the transaction. That entire outflow affects the final value of the business. Here are the gradations of liquidation value:
- Orderly liquidation: Assets are sold strategically over an orderly period of time to attract the most money for the assets.
- Forced liquidation: Usually, creditors have sued or there’s a bankruptcy filing that calls for liquidation, so everything gets dumped on the market in a hurry.
In calculating the present value of a business or property on a liquidation basis, discount the estimated net proceeds at a rate that reflects the risk involved back to the date of the original valuation.