What is market value? When referencing the “market value” of a business, the actual definition of market value is usually left out of the conversation. Market value, it’s assumed, is simply the amount a hypothetical buyer and seller would be willing to pay/take for a particular business.
The Internal Revenue Service uses a term called “fair market value” and defines it as such:
The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.
The International Glossary of Business Valuation Terms has a similar definition of fair market value:
Fair market value is the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
Many people use these definitions of fair market value interchangeably with market value.
However, neither definition takes into account the fact that operating businesses are rarely sold for 100% cash. The overwhelming majority of sales are a combination of cash and non-cash compensation, usually in the form of debt instruments (and sometimes equity in the case of larger transactions). Determining a “cash equivalent” for subordinated debt and restricted equity is very challenging….some would say impossible since there are no comparable sales. There are insufficient 100% cash sales of similar businesses, nor are there sufficient sales of restricted stock or subordinated debt in privately-held companies to utilize as a comparison.
It makes far more sense to determine a market price in the context of market terms and conditions in similar business sale transactions. This is more certainly more useful to the reader.
For example, if a business is estimated to be worth $200,000 with $100,000 paid in cash at closing, and the remaining $100,000 as a promissory note, does it really make sense to attempt to discount the note, and present this discounted “cash equivalent” number to the client/owner. If the client/owner reads that his business is worth $180,000 (with the $100,000 note discounted to $80,000), and relies on this information, he or she is going to have a very unrealistic idea of what he or she can expect in a real-world sale scenario. It would be much better for the client/owner (not to mention more accurate) to present the estimated market value of the business at $200,000 under normal terms of 50% in cash and 50% as a promissory note.
The Appraisal Standards Board through their publication, Uniform Standards Professional Appraisal Practice (USPAP) gives a general definition of market value as:
…a type of value, stated as an opinion, that presumes the transfer of a property (i.e., a right of ownership or a bundle of such rights), as of a certain date, under specific conditions set forth in the definition of the term identified by the appraiser as applicable in an appraisal.
However, USPAP stresses that the appraiser must make the final, specific definition of market value, stating:
Appraisers are cautioned to identify the exact definition of market value, and its authority, applicable in each appraisal completed for the purpose of market value.
Consequently we define the market value of a privately-held business enterprise as follows:
Market value is the estimated price, terms and conditions at which a privately-held business would sell under normal selling conditions, including an arms-length, non-distress, and appropriately marketed sale of the business.