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Fair market value (FMV), open market value, real market value – are these terms interchangeable, or do they have distinct meanings? What are their uses, and how can you determine them?
In this article, we’ll explore market value from a tax perspective, as it directly impacts tax outcomes.
What is the FMV?
FMV stands for the fair market value of an asset, for example, a share in a company or an option to obtain a share.
The market value of a share is the price at which the share can be bought or sold in the open market. The supply and demand dynamics determine it, and it can fluctuate based on various factors.
Fair market value is a valuation that aims to be as objective as possible, reflecting market conditions and the shares’ true value. It assumes the seller and the buyer have reasonable knowledge of the market and they are not under any pressure to enter into the transaction.
Fair market value and market value can differ. Market value is influenced by recent market fluctuations and reflects the current price of an asset. In contrast, FMV provides a more accurate valuation, assuming the transaction occurs under ideal conditions.
Why do you need the market value?
Market value is used in various situations, such as:
- determining the worth of business transactions,
- assessing the value of traded assets in financial reporting,
- evaluating property for legal disputes,
- setting fair prices for sales or compensation, and so on.
Fair market value also plays a crucial role in taxation, impacting gift and estate taxes, capital gains, and other tax calculations.
If a company offers compensation in the form of company shares or other non-cash benefits, FMV is needed to ascertain the taxable amount and report it correctly for tax purposes.
Granting employee shares for free or with a discount means granting them at a price lower than their market value. The difference between the market value and the actual price paid by the employee is typically considered as a benefit and taxed as a bonus in many countries.
This is also why some employers may avoid giving shares for a discounted price or for free, as this may entail tax obligations to the employer or the employee.
When do you need the market value?
Understanding when the market value, or fair market value, is required is essential for making informed decisions.
Regarding the share options the question of market value arises at various stages in the lifecycle of a share options program:
- At grant: Market value is required in countries where favourable tax treatment depends on setting the exercise price at market value. This is common in countries like the UK, France, or Belgium.
- At the exercise: In most countries, market value must be determined when exercising share options unless the options qualify for a tax deferral until the sale of shares. This value is crucial for calculating taxes on the benefit received from the shares as it directly affects the tax result.
- When selling the shares: Determining the market value is important to ensure that the price offered for your shares is fair.
Where do you find the market value for tax calculations?
Finding the fair market value of your shares in a company depends on many factors, including which stage the company is in and what financial or other important information can be used.
- A public company's shares are traded on the stock exchange. The price of quoted shares represents their current market value. As the price at the stock exchange cannot be easily manipulated, the price of the quoted shares is also their market value.
- Private company share value is harder to find as the shares are not freely tradable, and the price formed by supply and demand is more difficult to determine. In such cases, a specific valuation is often needed to find the market value.
- Last financing round valuation. The valuation determined during a startup's funding indicates a market value very well, as it reflects what investors are willing to pay for a stake in the company at that time. Just keep in mind that the value can change over time, and the agreed price may include discounts or premiums.
- For example, in Spain, the market value of shares at the exercise is determined based on the last investment round only if the investment was made by independent third-party investors during the previous year.
- Book value. Accounting standards in certain countries, such as Germany, may provide guidelines for calculating share value for tax and accounting purposes. However, a share's book value typically does not equal its market value; it is generally lower. Still, it reflects the value of a share that can sometimes be used as a basis for tax calculations.
Do you need an expert valuation?
While tax authorities in many countries may prefer an expert valuation to determine the market value of share benefits, only a few have precisely defined valuation rules. For example:
- in the United States, the IRS requires a 409A valuation to ensure that the stock's exercise price is consistent with its fair market value.
- in the United Kingdom, HM Revenue & Customs (HMRC) may accept a company's valuation, but in some cases, they require a formal valuation agreement. For the Enterprise Management Incentives (EMI) scheme, the granting company must propose an "unrestricted market value" (UMV) or an "actual market value" (AMV) and have it accepted by the tax authority.
Most countries, at least in Europe, do not have precise valuation regulations. A lack of valuation rules or guidelines means that the taxpayer has less certainty about the tax result but more freedom to choose the right evaluation method for the case.
💡 It’s essential that the method chosen by the company or expert is both defensible and accurately reflects market value; failure to do so may lead tax authorities to dispute the outcome.
It is also worth mentioning that expert valuations, though they may take time and involve careful analysis, have expiration dates. Typically, these valuations are valid for a specific period, such as 6 or 12 months, or they may expire after certain events, like a new fundraising round, which can significantly impact a company’s valuation.
- US 409A valuation is valid for 12 months or until a material event occurs, such as a fundraising round.
- UK’s EMI valuation agreement is valid for 90 days.
What are the common valuation methods?
Experts use more complex valuation methods, financial metrics and databases that can provide more objective results.
Common valuation methods, typically also used by experts, have their own unique approach and are best suited for specific types of businesses or scenarios, depending on a company's maturity and financial situation.
- Discounted Cash Flow (DCF) is a valuation method that estimates the value of an investment based on its expected future cash flows, which are projected and then discounted to their present value using a discount rate. This approach accounts for the time value of money and is well-suited for companies with predictable cash flows. It is widely used in valuing businesses across various industries.
- Asset-Based Approach values a company by determining the net asset value (NAV), which is the fair market value of its assets minus its liabilities. This method is commonly used for holding companies or firms with substantial tangible assets. It is straightforward and useful in liquidation scenarios where asset values are paramount.
- Market Approach values a business by comparing it to similar companies using valuation multiples derived from market data, such as Price-to-Earnings (P/E) or Enterprise Value-to-EBITDA (EV/EBITDA). This method reflects current market conditions and is particularly useful for industries with active markets and frequent transactions. Market fluctuations and the lack of direct comparables can impact the accuracy of this approach.
- Income Approach evaluates a company based on its potential to generate future earnings, often through methods like Discounted Cash Flow or Capitalisation of Earnings. This method emphasises the company's profitability and cash flow potential, making it suitable for businesses with strong earnings prospects. The approach is versatile but can be complex and assumption-driven.
What about the Black-Scholes formula?
While the above methods are used to determine company value, there is also a specific formula for evaluating share options as financial instruments.
The Black-Scholes-Merton formula was developed by American economists in 1973 after a long search for an accurate method to value call options using classical valuation techniques.
While the formula may seem complex at first glance, many online calculators can help you perform the calculations if you have the necessary data:
- Current market price of the stock
- Exercise price of the option
- Option’s expiration date
- Expected volatility of the stock's price over the option's life
- Risk-free interest rate
- Expected dividends during the option's life
It's important to note that this model is essential for calculating the fair value of the options, not the underlying shares or the overall value of the company. The fair market value (FMV) of the underlying shares is typically higher than the value of the options, as options are merely the rights to purchase shares at a specific price.
Valuing the options is necessary for financial reporting and understanding the overall cost and value of stock options, which can also impact the company's valuation.
For tax purposes, the value of options may become relevant in countries where the grant of options is a taxable event, or in cases where the options are tradable and could create a taxable benefit.
How do you value a share in a startup company?
Determining the fair market value of a company or asset is a crucial task that requires expertise, knowledge, and accurate information. Interestingly, valuing a young startup can be more elaborate than assessing a well-established company's stock.
While startups often face challenges like limited historical financial data, uncertain future prospects, and a reliance on intangible assets such as intellectual property, these factors make the valuation process more complex. However, this complexity can be navigated with the right approach.
For those needing a precise FMV for tax purposes, consulting an experienced valuation expert is a wise choice. On the other hand, if you’re exploring different scenarios for your equity compensation, feel free to use our Stock Option Tax Calculator. This tool allows you to estimate your tax results with unlimited FMV scenarios, all while keeping things straightforward and avoiding any complications with tax authorities.
