In the world of business valuation, the standard of value and premise of value are two important concepts that play a crucial role in determining the value of a business. The standard of value refers to the basis of valuation, while the premise of value refers to the underlying assumptions and conditions under which the valuation is performed. Let’s explore the correlation between the standard of value and the premise of value in business valuation.
Understanding Standard of Value (SV)
The SV is the basis of valuation that is used to determine the value of a business. Three primary standards of value are used in business valuation:
- Fair Market Value: Fair market value is the price that would be agreed upon between a willing buyer and a willing seller in an arms-length transaction. It assumes that both the buyer and seller are knowledgeable about the business and that there is no pressure on either party to buy or sell.
- Investment Value: Investment value is the value of a business to a particular buyer, based on the buyer's unique investment criteria. It assumes that the buyer has specific synergies with the business, such as access to proprietary technology, distribution channels, or other strategic advantages.
- Intrinsic Value: Intrinsic value is the true underlying value of a business, based on its financial and operational performance. It assumes that the business is being valued on its own merits, rather than as part of a transaction.
Understanding the Premise of Value (PV)
The PV refers to the underlying assumptions and conditions under which the valuation is performed. Three primary premises of value are used in business valuation:
- Going Concern: Going concern assumes that the business will continue to operate as a viable entity for the foreseeable future. It assumes that the business will continue to generate revenues, maintain its customer base, and operate its assets.
- Liquidation: Liquidation assumes that the business will be sold in an orderly liquidation, where assets are sold off and liabilities are paid off. It assumes that the business will not continue to operate as a going concern.
- Value in Use: Value in use assumes that the business will continue to operate, but that it will be used for a specific purpose or by a specific user. It assumes that the business will generate cash flows that are specific to the intended use or user.
Correlation Between SV and PV
The SV and PV are closely correlated in business valuation. The SV determines the basis of valuation, while the PV determines the underlying assumptions and conditions under which the valuation is performed.
For example, if the SV is fair market value, the valuation assumes that the business will be sold in an arms-length transaction between a willing buyer and a willing seller. The PV, therefore, assumes that the business will continue to operate as a going concern and generate cash flows into the future.
If the SV is investment value, the valuation assumes that the business will be sold to a specific buyer who has unique synergies with the business. The PV, therefore, assumes that the business will continue to operate as a going concern and generate cash flows that are specific to the intended buyer.
If the SV is intrinsic value, the valuation assumes that the business will be valued on its own merits, rather than as part of a transaction. The PV, therefore, assumes that the business will continue to operate as a going concern and generate cash flows that are specific to the business.
Examples of the correlation between the SV and PV in business valuation:
- Fair Market Value and Liquidation Premise: If the SV is fair market value, and the PV is liquidation, it assumes that the business will be sold in an orderly liquidation, rather than in an arms-length transaction. In this case, the value of the business will be lower than its fair market value because the assets will be sold off at a discount, and there may be costs associated with winding down the business.
- Investment Value and Going Concern Premise: If the SV is investment value, and the PV is going concern, it assumes that the buyer has specific synergies with the business and that the business will continue to operate as a going concern. In this case, the value of the business will be higher than its fair market value because the buyer is willing to pay a premium for the synergies that they will receive.
- Intrinsic Value and Value in Use Premise: If the SV is intrinsic value, and the PV is value in use, it assumes that the business will continue to operate, but that it will be used for a specific purpose or by a specific user. In this case, the value of the business will be based on the cash flows that it will generate for that specific purpose or user, rather than its fair market value.
- Fair Market Value and Going Concern Premise: If the SV is fair market value, and the PV is going concern, it assumes that the business will continue to operate as a going concern and that the value of the business will be based on its future cash flows. In this case, the value of the business will be higher than its liquidation value but may be lower than its investment value, depending on the buyer's specific synergies with the business.
- Investment Value and Value in Use Premise: If the SV is investment value, and the PV is value in use, it assumes that the buyer has specific synergies with the business that will allow them to generate cash flows that are specific to their intended use or user. In this case, the value of the business will be higher than its intrinsic value, as the buyer is willing to pay a premium for the unique cash flows that the business will generate for them.
Case laws
The selection of the appropriate SV and PV can be a contentious issue in business valuation, particularly in the context of legal disputes.
- Estate of Gallagher v. Commissioner: In this case, the United States Tax Court addressed the issue of whether the appropriate SV for valuing an estate's interest in a closely held business was fair market value or investment value. The court ultimately determined that the appropriate SV was fair market value because the estate's interest was being sold to a third party, rather than a specific buyer with synergies with the business.
- Delphi Corporation v. The Boeing Company: In this case, Delphi Corporation alleged that The Boeing Company had breached a contract by failing to provide Delphi with the benefit of its negotiated prices with certain suppliers. The court addressed the issue of whether the appropriate PV was going concern value or liquidation value. The court ultimately determined that the appropriate PV was going concern value because Delphi was seeking damages based on the value of the business as a going concern.
- Mason v. Commissioner: In this case, the United States Tax Court addressed the issue of whether the appropriate SV for valuing a minority interest in a closely held business was fair market value or intrinsic value. The court ultimately determined that the appropriate SV was fair market value because the minority interest being valued did not give the holder the ability to control the business or access its unique cash flows.
These cases demonstrate the importance of carefully selecting the appropriate SV and PV in a business valuation, and the potential impact that this decision can have on the valuation outcome in the context of legal disputes.
The SV and PV is crucial in determining the value of a business in a valuation exercise. The SV establishes the basis of valuation, while the PV sets the underlying assumptions and conditions of the valuation. Understanding the correlation between the SV and the PV is essential in ensuring accurate and reliable valuations of businesses. Therefore, it is vital for business valuators to carefully consider both the SV and the PV when performing a business valuation.