Standard of value in business valuation defines who the buyer and seller are presumed to be which then impacts assumptions and methods the valuation analyst will use.
Think of it this way, if we were valuing a car, a race car driver looking to buy or sell race car is going to view things very differently than a family looking to buy or sell a car for the family. Therefor standard of value can produce very different values and is a starting point of all business valuations.
Fair market value is the most common standard of value in business valuation but there are many standards of value. Standards of value are usually determined by legal contracts and agreements, regulatory bodies that require the valuation report (IRS or SBA or Department of Labor) or state law statutes and case law (divorce, partnership or corporate ownership matters).
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The standard of value that usually produces the highest value is called “synergistic value”. This value assumes that the buyer has synergies or factors inherent in the BUYER that allow that buyer to make more money after the purchase of the seller’s business than the seller can make before the transaction.
An example of a synergistic buyer is two delivery companies that have trucks going down the same roads every day. If one of the delivery companies buys the other, the remaining company will be able to make all the deliveries with less trucks and drivers than they could as separate companies. This will produce more profit for the combined company than the two separate companies could. These are synergies, and if the buyer chooses to the buyer can pay more since they will make more money from the purchase than other buyers without those characteristics (in this case overlapping routes).
Related to synergistic buyers are an investment buyers. In this case the buyer is a known specific buyer (XYZ Company is the buyer) and the valuation is performed based on that specific buyer and the specific seller’s situation. A synergistic buyer is an investment buyer that has competitive advantages over other buyers. If there are not competitive advantages for the specific buyer verses other potential buyers then the standard of value is called Investment Standard.
The fair market value standard assumes hypothetical buyers and sellers (not a specific buyer or a specific seller) with fair information, reasonable motivation, but no compulsion. Synergies are not to be applied if they may exist with the actual buyer and seller. Fair market value also assumes payment in cash or cash equivalents (payment that can become cash in three days). Most small businesses take months to sell so this creates the need for discounts in order to further adjust the estimate of value found. This is the most common valuation standard but note that it often will not produce the highest value. This is different than real estate valuations where highest and best use is part of fair market value. Fair market valuations are often required for compliance type purposes such as estate and gift tax reporting, ESOPS, SBA required business valuations, and divorce in some jurisdictions.
Finally there is fair value and other variations of fair value. (For instance for divorce in Virginia, intrinsic value is used which is related to fair value). Fair value is generally used in partnership and corporate dispute resolutions (but not always) and is generally specified by an agreement between the parties or state statute. Fair value is used in some jurisdictions for divorce. Fair value is similar to fair market value but usually assumes a controlling interest ownership even for minority owners. Fair value tends to be used by courts of equity which have wide latitude to adjust for fairness.
Standard of value will greatly influence the value found in business valuations because different buyers and sellers in different circumstances will view value differently. Make sure you, your advisors, and your valuation professional are using the standard of value required for your business valuation purpose in your jurisdiction.