Reporting Levels + Standard of Value + Discounts and Premiums = Business Value
March 05, 2020
By Kriste Rodriguez
When determining the value of a business, the reporting level depends on the purpose of the valuation and the scope of the engagement. The reporting levels are full detailed reports, summary reports, and calculation of value reports. Similarly, the standard of value used, whether fair value or fair market value, depends on the valuation purpose as well as statutory and state law. Discounts and premiums are often applied when determining the fair market value of a business. The reporting level, standard of value, and whether discounts and premiums are applied must be determined before a valuation can be reached.
Business Valuation Reporting Levels
Business valuations are used for determining the value of ownership interests in a litigation setting for purposes such as shareholder disputes, economic damages, or property settlement disputes in a divorce setting. A business valuation is also useful for gift and estate tax purposes. There are different levels of valuation reports, depending on the organization certifying the business appraiser. A full, written detailed report requires compliance with the American Institute of CPAs’ business valuation standards. A less-detailed report, where the narrative is reduced, is known as a summary report.
The third and final report is known as a calculation of value report. This report does not result in an opinion of value, but rather a determination of value based on a limited-scope calculation, which is agreed upon by the client. This type of valuation report is best used for cases that are expected to remain outside the courtroom and will not require expert testimony, such as buy-sell negotiations or marital dispute settlement negotiations.
Standards of Value
The two principal standards of value are “fair market value” and “fair value.”
- Fair Market Value - According to the Internal Revenue Service under Revenue Ruling 59-60, fair market value is defined as: “the amount at which property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts.” Fair market value is commonly used to value businesses for sale and for estate and gift tax purposes. Fair market value often considers discounts or premiums to reflect a business interest’s degree of control and/or lack of marketability.
- Fair Value - The second principal standard of value is fair value. This is defined by state law or legal precedent and is commonly used when valuing business interests in shareholder disputes or marital dissolution cases and typically does not consider discounts. In a marital dissolution case, it is important to review all statutory and case law. The rules vary from state to state. In many states, fair market value is used in a divorce setting, whereas other states, like New Jersey, fair value standards are applied—similar to those in shareholder disputes.
Discount for Lack of Control and Marketability and the Control Premium
As mentioned, the standard of value known as fair market value often considers premiums and/or discounts. The principal premium is known as the “control premium,” and the two discounts are known as the “minority interest discount” (aka “discount for lack of control”) and the “discount for lack of marketability.” As expected, a controlling ownership interest is more valuable than a minority interest. This is because a controlling interest has the right to do things non-controlling interests are not allowed to do, such as ascertaining officers’ compensation, determining dividends and establishing business policy. Conversely, a discount for lack of control reflects a minority owner’s inability to control the operations of the business, thereby making a non-controlling interest less valuable than a controlling interest.
The existence of a ready market for a company is of definite value to the owner or potential buyer, and a company that possesses such a ready market is worth more than another similar company that does not have such a market. Ready marketability adds value to a business interest, however, lack of marketability detracts from the value of a given business interest when it is compared to one that is otherwise similar but readily marketable. A willing buyer should realize that a business has no ready market and the interests are in an unregistered, closely held company that could only be sold in a private transaction. Clearly, lack of marketability makes an interest in companies considerably less attractive than it would be if it were readily marketable. Obviously, an adjustment to reflect the negative impact upon value of this lack of marketability is required.
The result is the same for each business valuation purpose, regardless of the reporting level, standard of value used, or whether discounts are or are not applied. Essentially, what is the business worth, and what method(s) should be used to determine the value?