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Fair Market Value

DEMYSTIFYING FAIR MARKET VALUE

A Key to Understanding a Valuation Standard

What is "fair market value"? If you have ever been through a business valuation, you have probably heard the term used. But when it comes down to it, few people really know what fair market value means – or how it applies to their businesses or the transactions they have in mind.

Some people say fair market value is just an opinion or theory, and that practically no deals are actually based on it. Buyers' and sellers' perceptions of value will never be the same, these critics maintain, so a price set by an expert and touted as "fair market" would have to be arbitrary.

According to this view, the vast majority of valuations are based on a negotiated purchase price, which is not the same as fair market value. But fair market value is a concept that regularly comes up in the valuation process. Let's take a closer look at what it means.

How is Fair Market Value Defined?

Most courts and the Internal Revenue Service define fair market value as:

"The amount at which a business would exchange between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts."

But what does this definition really mean?

The premise assumes that there are willing buyers and sellers. Note that the buyers and sellers are not specified. And, to be considered fair market value, a price could not be influenced by any motivations that were not characteristic of a typical buyer or seller:

  • The transaction cannot be conducted under any compulsion or duress. Neither the buyer nor the seller is being forced into it.
  • All parties to the sale have full and complete knowledge of what the situation involves.
  • Enough time is always allowed to find the hypothetical buyers and sellers.
  • The market cannot be rigged, and subjective factors like sentimental value cannot come into play.

It should be stressed that no actual purchase or sale has to take place under this definition of fair market value.

Other Meanings in Other Circumstances

The above definition of fair market value is used in regulations that govern all federal and state tax values. It's the meaning that experts turn to in most circumstances.

But other, more specific meanings of fair market value are used in certain industries and when particular circumstances dictate.

For instance, take a leveraged buyout situation. Fair market value is frequently expressed here as "the amount at which ownership of the property might be justified by a prudent investor or, alternatively, as the present value of future benefits of ownership."

And the former American Institute of Real Estate Appraisers used much more specific wording:

"Most probable price, as of a specific date, in cash, or in terms for which specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self interest, and assuming that neither is under duress."

Two subcategories of the fair market value concept – fair market value in continued use, and fair market value in alternate use – can help you better understand the fair market value concept.

Fair market value in continued use assumes that the business being valued will be used for the purpose for which it was designed and built, or to which it is adapted.

This interpretation usually is applied to a group of assets or to a "business unit" that is an integral part of an ongoing concern. Experts typically use it for tax purposes. They formulate it using a cost approach.

When is the best time to use the fair market value in continued use definition? These conditions should be met:

  • The business should fulfill both an economic demand and also functional utility.
  • The business should have significant remaining useful life.
  • The business should be managed competently.
  • Use of the business in an alternate manner might not be economically feasible.
  • Continuation of the business's existing use should be viewed by the current or future owners as practical.

In most cases, a business, property or assets have a continued use value that is different from liquidation value. It may be substantially higher.

Be aware that the values developed under the continued use premise aren't intended to represent the amount an owner might realize from disposing of the property piecemeal.

The other subcategory of fair market value is fair market value in alternate use. This interpretation considers the use of the property for purposes other than those for which it was designed or built, or to which it is currently adapted.

This concept is usually applied to real estate. It lets the market develop the highest and best use for a property.

For example, say a drug testing TPA is put up for sale. It may have more or less value to future buyers, depending on its various specific attributes. If the business is located in a strategic location, or it has a unique "niche" of clients, future buyers may be willing to pay more for it.

To take this concept one step further, let's assume the TPA has a proprietary IT platform capable of unlimited growth. A business that needs a drug testing IT platform might think the business has substantial worth. But a buyer that already has such an IT platform might not see the added value in the seller's IT platform.

Understanding the Standard

Despite the existence of many terms used to define worth, fair market value remains the most widely recognized and accepted standard.

To put it simply, the concept of fair market value is the cash equivalent price at which a transaction could be expected to take place under the conditions existing at the time of the sale.