The Difference One Word Makes

Written by Dalton Hopper, CFE, CVA

There are few situations in which one word can make all the difference. In this example, we’re examining the difference between fair market value and fair value when valuing a business. As business owners form a business, one of the last items on their mind is their operating agreement, or bylaws. It’s often a legal formality that is left up to their attorney and there’s little thought into what goes into it. However, when drafting these documents, it’s important to understand the difference because one word can make all the difference.

When valuing a business, there are multiple standards of value. These include fair value and fair market value, among others. While these two may seem the same, or may be used interchangeably, there’s a drastic difference when it comes to the value of your business. Fair market value, when valuing a business, is defined by the IRS in Revenue Ruling 59-60. While this guidance from the IRS is certainly decades old, it is still the widely accepted standard. Revenue Ruling 59-60 defines fair market value as,

“the price at which the property 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. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.”

When we talk about fair market value, we are often considering a valuation for IRS context, such as gift or estate planning. Fair market value allows for an important, and often disputed, item to be considered in the valuation: discounts.

Discounts in a business valuation[1] can be significant, especially in gift and estate planning. The two most common discounts include a discount for lack of control and a discount for lack of marketability.  These discounts can reduce the value of a business interest by anywhere from 10% to 50%, or even more given the circumstances. For example, if a business is determined to be worth $1,000,000, then a pro-rata 10% interest in that business would be worth $100,000. However, when considering applicable discounts under a fair market value standard, this 10% interest could be worth between $50,000 to $90,000. That is a huge difference.

Remember when we mentioned the difference a word can make? The difference in fair market value and fair value is usually the applicable discounts. While fair market value is the applicable standard for tax purposes, fair value is often the standard of value for business disputes, dissenting or oppressed shareholder disputes, marital dissolution and property separation, and financial reporting purposes. Fair value does not usually consider discounts for lack of control or lack of marketability. In situations like the example above, one word could mean the difference in $50,000, if not more.

It’s important to understand the language in an operating agreement, company bylaws, or a buy-sell agreement, especially if you may be the buyer or the seller someday. Knowing the difference between fair market value and fair value can be the difference that allows you, your family, and your business to accurately plan for the future. There is no right or wrong when it comes to planning and choosing between a standard of value, it’s simply knowing the difference that one word can make.

[1] A business valuation is the structured process of determining the value of a business, business interest, or asset that is closely held (not publicly traded) and where no market quotes are available.