In a transaction between parties, it is critical to ensure that the definition of “value” be agreed upon at the outset to avoid misunderstandings and errors in determining that value. A standard of value has to be defined for all. In this article, we are discussing the various “standard of value” used in business valuation, and their impact on the value of an interest in two illustrative examples.
1- Defining the Standard of Value
Although selecting a standard of value seems to be a straightforward concept, different standards may have different meanings in different contexts. Consequently, defining value and adhering to the assumptions inherent in a particular standard of value, especially in cases of valuations for tax, litigation, or regulatory purposes, is often complex. The valuation expert must do his/her due diligence to avoid unpleasant surprises down the road.
2- Fair Market Value Standard
Fair market value is the most well known standard of value and is commonly applied in tax, litigation, and regulatory matters. Federal and State tax matters including estate, gift, inheritance, and income tax as well as many other situations.
3- In Litigation Valuations
Fair Value is a legally mandated standard of value that applies to specific transactions and is commonly used in shareholders oppression and dissenter’s rights cases. In divorce case, the standard of value varies by state and in states that use the fair value standard; there are also different definitions of fair value. In litigation cases, the valuation expert should always work with the attorney to determine the appropriate standard of value applicable in that specific state. Fair value is also considered fair market value without discounts.
4- Fair Value – Strategic/Investment Value
This is the value as perceived by an investor based on particular requirements and expectations. This expected value is measured using the discounted net cash flow for example, that an investor would expect a company to generate in the way that particular investor would operate it.
5- Fair Value - Intrinsic Value
Also called inherent, underlying, or essential value, this represents the perceived value of an investment based on specific characteristics and analyses. The difference between investment value and intrinsic value is that intrinsic value represents an estimate of value based on the perceived characteristics of the investment itself whereas investment value is more reliant on the characteristics of a particular buyer or owner
Below are two examples to illustrate how the standard of value affects the value of a minority shareholder:
Illustrative Examples:
Example 1: ABC Company Inc. has the following predetermined data:
Cash flow (CF) = $200,000 Discount rate (d) = 25% Growth rate (g) = 3%
What is the fair market value for estate tax purpose of a 30% minority shareholder (ms) if DLOC = 30% and DLOM = 20% using the Capitalization of Earnings Method?
Solution: Let's determine the Capitalization rate (Cr).
Capitalization rate = Discount rate – Growth rate = 25 – 3 = 22
Capitalization rate (Cr) = 22%
a- Company value (CV)on a controlling basis:
CV= CF/Cr = $200,000 / 0.22 = $909,000
b- Pre-discounts value (Pdv) of the minority shareholder (ms=30%):
Pdv= CV x ms = $909,000 x 0.30 = $272,700
c- Value of the minority shareholder (Vms1) on a
non-controlling, marketable basis:
Vms1 = Pdv (1-DLOC) = $272,700 (1– 0.30) = $190,890 = (rounded) $191,000
d- Value of the minority shareholder (Vms2) on a
non-controlling, non-marketable basis:
Vms2= Vms1(1-DLOM) = $191,000 (1– 0.20) = $152,800 = (rounded) $153,000
In this example the total discounts is 44% (1 – [(1-0.30) x (1-0.20)]) not 50% (30% + 20%). This is because we applied the discounts sequentially. The discounts are not additive. They are multiplicative.
To verify we do the following:
Multiply the Pre-discounts value of the minority owner by one minus the total discounts applied as follows: $272,700 (1 - 0.44) = $152,712 = $153,000 (Rounded).
Example 2: Same ABC Company Inc. with same predetermined data:
Cash flow (CF) = $200,000 Discount Rate (d) = 25% Growth Rate (g) = 3%
What is the fair value of a 30% minority shareholder (ms) in a shareholder dispute litigation case using the Capitalization of Earnings Method?
Solution: Let's determine the Capitalization rate (Cr).
Capitalization rate (Cr) = Discount rate (d) – Growth rate (g)= 25 – 3 = 22
Capitalization rate = 22%
Company value (CV) on a controlling basis:
CV = CF/Cr= $200,000 / 0.22 = $909,000
Value of the minority shareholder (Vms):
Vms = CV x ms = $909,000 x 0.3 = $272,700 = (rounded) $273,000
Conclusion: Clearly, in a shareholder dispute, there are no discounts; therefore, the minority shareholder value is significantly higher than the minority shareholder value in a fair market value valuation. In this case, there is a difference of $120,000 ($273,000 - $153,000) that represents the two discounts.
N.B: DLOC means Discount for Lack of Control; DLOM means Discount for Lack of Marketability.
Achille Ekeu, MBA, CVA
President/CEO
The Washington Valuation Group (WVG)
Achille Ekeu is a Certified Valuation Analyst (CVA) member of the National Association of Certified Valuators and Analysts (NACVA) in the DC-MD Chapter. He provides valuation services for Estate and Gift Tax, Purchase, Sale of business, Debt Financing, Buy-Sell Agreements, and Litigation Support in Divorce/Shareholders disputes cases. He can be contacted by phone at 240-274-9570 or by email at achille.ekeu@washingtonvaluation.com.