November 12, 2019 — Ask a professional a question about the value of your business and most often the answer will be, “It depends." This may seem counterintuitive, but the value will differ depending on the purpose of the engagement. We see this concept play out in mergers of publicly traded companies.
For instance, in late June of 2019, the markets had priced shares of Allergan, a pharmaceuticals company, at $129.57 a share. However, rival pharmaceutical company AbbVie viewed Allergan as a strategic acquisition and according to the Wall Street Journal, they “...agreed to buy Allergan for about $63 billion in a bet by the two drug makers that a combination will deliver new sources of growth that they have struggled to find on their own. The takeover is worth about $188 a share in cash and stock, the companies said. The price represents a 45% premium over Allergan’s closing share price.” Cara Lombardo, Jonathan D. Rockoff, and Dana Cimilluca, Wall Street Journal
While both share prices for Allergan accurately represent the value of the company, the differences are attributable to the purpose of the value and the differing definitions the term “value” holds.
By gaining an understanding of the differing rules and definitions associated with the various standards of value, business owners can elevate their own discussions as it relates to the value of their business.
Valuation Blog Series 4 of 6
Valuation Series 1: What Factors Contribute to the Valuation of a Company?
Valuation Series 2: The Difference Between Business Calculation and Valuation Reports
Valuation Series 3: Business Valuation Approaches: Asset, Income and Market Approach
Before you can start the process of valuing a business, it is critical to define the standard of value. The standard of value relates to and is driven by the purpose of the valuation, with the aim to answer the question, "What do you mean by value?"
The standard of value and the context in which it is used will influence the approaches and methodology used in the valuation, so the applicable standard of value should be identified and defined as part of any valuation engagement. There are four main standards of value discussed below.
Fair market value is one of the most widely recognized and accepted standards of value. Given its use for virtually all federal and state tax matters, the most prominent definition for fair market value comes from the U.S. Treasury regulations.
They define fair market value as the price (expressed as cash or cash equivalents) at which the property would change hands between a hypothetical willing buyer and a hypothetical willing seller, acting at arm’s length, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
Fair value is a more complex standard of value as there are numerous definitions that are dependent upon the context to which they are being applied. Fair value can be the prevailing standard of value utilized for a number of situations including financial reporting, dissenting shareholders, some litigation or matters of shareholder oppression, and certain transactions.
For matters involving financial reporting, fair value is defined by the Financial Accounting Standards Board as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
This definition is fairly similar to the definition of fair market value—which leads many to the conclusion that fair value applies the same underlying analysis and assumptions in the application of the approaches and methodologies—but it differs by not considering any valuation discounts.
Also, note that for valuations concerning dissenting shareholder actions or in shareholder oppression cases, the definition of fair value can become a legal question as many states now have statutory fair value definitions.
This standard of value considers the value of a company from the perspective of a buyer or current owner. For example, to a corporate acquirer, the investment value of a business incorporates any revenue growth or cost-cutting measures the potential buyers believe they can achieve as a result of the synergies gained through the acquisition.
For use in a transaction, a valuation analyst can help the buyer determine the investment value of a specific business; however, from a sell side perspective, the buyer’s assumptions are typically not known or knowable and investment value cannot be determined.
This standard of value is not often used in any meaningful way for business valuation purposes but the concept in and of itself is worth noting. The dictionary definition of intrinsic value is “being desirable or desired for its own sake without regard to anything else.” Likewise, the intrinsic value of a closely-held business is what someone believes it to be worth.
While this sounds slightly like investment value, it is important to note that investment value is derived from the beliefs and thoughts of a particular owner or individual, while intrinsic value represents the perceived value based on the characteristics of a particular company.
While defining each standard of value helps develop a base understanding, questions still remain regarding the practical application of the various standards of value. Let’s start with fair value. In theory, this value reflects the ability to control the business and run it optimally in an effort to generate the highest returns. For instances in which a valuation analyst is determining the value of an ownership interest of less than 100%, under fair value the subject interest will always be the proportional interest of the whole. This is why fair value is most often the standard of value utilized in dissenting shareholder/oppressed shareholder actions—this methodology does not penalize minority position owners for decisions outside of their control.
Alternatively, if we were determining the value of a minority position using fair market value the application of discounts would result in a lower valuation than under fair value. With fair market value, analysts consider what the detriments to minority interest values amount to given their lack of marketability and the lack of control. As a result, the fair market value standard of value can result in the sum of the parts equaling a value lesser than the whole.
Now, let’s tie this back to the example at the beginning of the post and assume that Allergan is a private company that does not trade on the New York Stock Exchange. It is widely considered that publicly traded stock values are very closely aligned to the definition of fair value for financial reporting. Therefore, we can reasonability say the fair value of a share in Allergan was worth $129.57.
In order to determine the fair market value, the valuation analyst assesses the detrimental impact the lack of control would have on value. Additionally, the analyst considers what someone is willing to pay for the stock given that there is no active market—if that buyer wanted out of the stock they couldn’t just take a couple minutes out of their day and sell it through an online brokerage account. While the degree of discounts will vary for each particular engagement, it is not unreasonable to conclude that the fair market value of the Allergan stock could be valued at $100 after accounting for the impact of the lack of marketability and control.
We can also incorporate investment value into this example, which would be the offer price of $188. This is the value per share that AbbVie believes it to be worth in their hands assuming they get all the stock outstanding.
In my practice I deal with many business owners whose main exposure to “value” is fair market value through the gifting of shares over time during their ownership period, and then investment value when they later exit. Given the drastic differences in dollars per share in the example above ($188 v $100) - how does fair market value compare to an actual market transaction? The answer is that it doesn’t. When valuing a business under fair market value it is analogous to a thought experiment of what the value would be under improbably perfect conditions.
Breaking down the components of the fair market value definition, we can see how this starts to diverge from reality. The definition of fair market value:
Most businesses are not transferred by the buyer writing a check to the seller on the transaction date with both parties then going their separate ways. I do, however see many deals that involve items such as seller financing, contingent earnouts, non-compete agreements, employment agreements, stock-for-stock deals, management rolls and other factors that can cloud the value for cash or cash equivalents.
This assumes there is always a perfect, rational market of buyers and sellers at any given time. For a valuation analyst, it is important to remember to consider not only what a rational buyer would be willing to pay but also what a rational seller would be willing to accept. This concept of the hypothetical, rational transaction value between willing buyers and sellers seems to be at odds with real life, where in my experience deal participants are more apt to rely on their perceptions of intrinsic value and sellers can continue to hold an investment and buyers can find other opportunities to invest their dollars.
In reality, many transactions can come about as the result of a specific reason to buy or sell; for example, transaction values can be shaped by issues like bankruptcy, insolvency, or other needs requiring liquidity. Often, actual transaction values are negotiated amounts determined by participants whose true motivations may never be disclosed.
In a real transaction, deal terms will be negotiated with asymmetric information.
These drastic differences in application of fair market value versus reality can really create large deviations that are important to be aware of when discussing values of a business.
With an understanding of the differences in how “value” can be defined and in which circumstances these standards may apply, business owners should be better prepared for conversations on the value of their business and avoid the mistake of relying on inappropriate values that would not have been concluded had the proper standard of value been in place to match their purpose for the engagement.