When people talk about what something is worth, they often think there’s just one “true” value. But in the world of business valuation, the answer is more complicated. The value of a business depends on the purpose of the valuation and the standard of value being used. The most common standard is called fair market value, but there are others, like investment value and fair value. Choosing the right standard of value is one of the most important steps in the valuation process.
This article will explain what fair market value is, when it is used, and how it differs from other standards of value. By the end, you’ll see that there isn’t one “right” value for every situation—the right value depends on the context.
Fair market value (“FMV”) is defined by the Internal Revenue Services (“IRS”) as “the price at which a business 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.”
Think of it like selling a house. The fair market value of the house is the price that an informed buyer would pay an informed seller if neither one was desperate to make the transaction happen. The same idea applies to the value of a business or business interest.
Fair market value assumes a hypothetical buyer and seller, not specific people with special reasons to buy or sell. It is designed to reflect a price that would be reasonable in the open marketplace.
Fair market value is the most widely used standard of value in valuations. It often comes up in legal, tax, and financial reporting contexts. Some common examples include:
In all these cases, the goal is to find a neutral, market-based number.
While fair market value is the most common standard, it’s not always the right choice. Sometimes the context requires a different lens, with two of the main alternatives being investment value and fair value.
Investment value is the value of a business to a particular buyer and/or seller, based on those parties’ specific and unique needs and expectations. Unlike fair market value, which assumes hypothetical buyers and sellers, investment value looks at a real, specific, and identifiable buyers and sellers.
For example, imagine a competitor wants to buy your business. Because combining the two companies could save costs and create new opportunities, the competitor may be willing to pay more than fair market value, based on certain synergistic considerations. That higher number reflects investment value.
Investment value is common in:
The key difference is that investment value is subjective—it depends on the particular parties’ situations.
Fair value is another important standard, often used in legal and financial reporting settings. It is not the same as fair market value, despite sounding similar.
Fair value is typically defined by state law or accounting standards. In shareholder disputes, for example, courts may require that minority shareholders be bought out at “fair value.” In many states, fair value does not include valuation discounts, such as discounts for lack of control or lack of marketability, which are often part of fair market value determinations.
Fair value also comes up in financial reporting, especially under accounting rules for business combinations. In those cases, it reflects the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction.
In divorce proceedings, "fair value" oftentimes refers to the process of valuing marital property and debts to achieve an equitable distribution, which is a fair, not necessarily equal, division of assets. The court determines the value of marital assets as of the date of negotiation, separation, or trial and then uses statutory factors, such as each party's contributions and the circumstances of the marriage's dissolution, to decide a fair monetary award.
In short, fair value is often more protective of shareholders and may produce a higher value than fair market value.
Using the wrong standard of value can lead to serious problems. For instance, imagine a shareholder dispute where one side argues for fair market value with discounts, while the court requires fair value without discounts. The difference could amount to millions of dollars.
Similarly, if you’re working on a merger, relying on fair market value might cause you to underestimate what a strategic buyer would pay for your business. On the other hand, using investment value in an estate tax filing would not meet IRS requirements and could cause your estate to owe more taxes than what it should.
That’s why one of the first questions in any valuation should be: What is the purpose of this valuation? The purpose drives the standard of value, which in turn drives the final conclusion of value.
Here’s a simple way to remember the differences:
No one standard is always “the right value.” Instead, the right value depends on the situation and the rules that apply.
Valuation is not just about crunching numbers, it’s about context. Fair market value is the most common and widely accepted standard, but it is not the only standard, nor is it always the right standard. Investment value and fair value can lead to very different numbers, and they are better suited to certain purposes.
So, is fair market value really the best value? Sometimes yes, sometimes no. The real question is: What is the purpose of the valuation? Once you answer that, the right standard of value becomes much clearer.