Fair Market Value and Fair Value
Fair Market Value
"Fair market value" can be defined as the amount at which property would exchange hands through an arms length transaction between a willing buyer and seller, when both parties have reasonable knowledge of all of the relevant facts. In other words, an
"arms length transaction" means that the price is not affected by the relationship between the parties. For example, if dad sells his car to his son, this would not be considered an arms length transaction (because dad is much more likely to give his son a "deal"). However, if dad sells his car to a bidder at an auction this would be an arms length transaction.
Fair market value also attempts to value property at its highest and best use. For example, a plot of land might be valued at $100,000 in a residential neighborhood. But, if the zoning is changed to allow that plot of land to also allow commercial use, then the fair market value might jump up tremendously, perhaps to $500,000. Fair market value is commonly used by court systems, the IRS, and many business valuation experts.
Fair Value
According to the Revised Model Business Corporation Act (RMBCA), "fair value" is defined as "the value of shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any depreciation or appreciation in anticipation of the corporate action, unless an exclusion would be inequitable." Huh? That’s sure a mouth full (and also a reason why there’s confusion about "value"). Let’s break this definition down so that it is easier to understand.
Stated in another way, fair value attempts to value shares of a company immediately before the company takes some action that dissenting shareholders object to (i.e. that owners in the company object to). Fair value generally applies to dissenting shareholders, or individuals who object to a particular action taken by a corporation where they own shares in the company. Many factors can go into computing fair value, including:
- The market price of similar companies
- Goodwill of the business
- the value of the business above its hard assets
- this is a very important area in business valuations (and we’ll discuss this in more detail later in this article)
- Book value of the business
- The "hard" value of the business
- Assets – liabilities = book value
- Nature of the business
- Economic industry outlook in which the business operates
- Financial condition of the business
- how much debt and assets that the business has
Ok, so once you know the reason for the business valuation (as previously discussed), you’ll then select the appropriate type of value (such as fair market value or fair value). Then, you’ll go to the third overall step – the method of valuation.
Next, let’s take a look at the 3 main methods used to value a business.