Fair Market Value vs. Fair Value: Why the Standard You Use Changes the Number

Two experts can start with the same financial statements and the same discount rate and still reach different conclusions, because they were asked to value different things. The standard of value defines the assignment. It is a legal question, and the financial consequences are large.

The standards you will see

• Fair market value. The price at which property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither under compulsion, both reasonably informed. It is the definition used in IRS Revenue Ruling 59-60 and in most professional valuation standards.

• Fair value. The meaning depends on the context. In shareholder dissent and oppression statutes it often means the owner's proportionate share of the enterprise value, without discounts for lack of control or lack of marketability. Fair value in financial reporting has yet another meaning.

• Investment value. Value to a particular buyer, based on that buyer's synergies and expectations.

Which standard applies in a divorce is determined by the law of the state and sometimes by the court's approach in the individual case. Confirm it with counsel before the engagement letter is signed.

The insight: the standard decides the discounts, and the discounts are where the biggest swing sits

The hypothetical sale in fair market value usually brings two discounts into the discussion:

• Discount for lack of control, for an interest that cannot direct the business

• Discount for lack of marketability, because a closely held interest cannot be sold on an exchange

Under a fair value approach, those discounts are often excluded. A report that applies them and a report that does not can be far apart with no disagreement at all about the business's earnings.

The practical question: no sale is going to happen

In a divorce, one spouse typically keeps the business. Many courts decline to apply marketability or control discounts for that reason, since no hypothetical sale is occurring. Others follow fair market value strictly. The rule is not uniform, and the expert should not be left to guess which one applies.

What to do when two reports use different standards

Rather than arguing about the final numbers, ask for a reconciliation. List each step that differs between the two reports, and show how much of the gap each explains. Often most of the difference sits in one or two items, and the question becomes the legal one of which standard governs.

Questions to ask your expert

• Which standard of value did you use, and who determined that it applied?

• Can you show the value under the alternative standard as well?

• Which discounts were applied, and what supports their size?

• How did you treat the fact that the owner is keeping the business?

• If the other expert used a different standard, how much of the difference between the reports does that explain?