What Is Fair Market Value (FMV) and Why Does It Matter?
To introduce the concept of fair market value (FMV) and explain why it matters to private companies, let’s look at two hypothetical employment scenarios.
In Scenario 1, a public company has offered you a job. Your job offer includes an equity grant with options to buy 1,000 shares of common stock at a certain date and price. Before accepting your offer, you want to know how much 1,000 shares of that company’s common stock are actually worth. Where can you find this information? Well, if this isn’t already spelled out somewhere in your equity agreement, you could simply look up the company’s ticker symbol online and see how much it’s trading for today. Easy!
Scenario 2 is similar, but this time you receive a job offer from a private company. This company is also offering an equity grant with options to buy 1,000 shares of company stock. But you can’t just search for the company’s ticker symbol on Google and figure out how much a share of company stock is worth. In the absence of an open market with willing buyers and willing sellers to set the stock’s price, you need some other type of agreed-upon mechanism to help you understand that stock’s value. This is where fair market value (FMV) comes into play.
In this guide, we’ll walk through the basics of fair market value and how it applies to equity at private companies. Keep in mind that there are other types of fair market value used in industries such as real estate and insurance; we’ll touch on these briefly, but this guide focuses primarily on the fair market value of stocks.
- What is fair market value (FMV)?
- How a 409A valuation determines a stock’s fair market value
- What is the difference between market value and fair market value?
- Other uses for fair market value
- What is the fair market value of my company’s stock?
What is fair market value (FMV)?
In a general sense, an asset’s fair market value is the sale price of that asset in an “arms-length” transaction, i.e. a transaction in which both parties are informed, independent, and acting in their own self-interest.
More specific to our focus, the fair market value of a private company’s stock is how much one share of that stock would be worth on the open market. A private company’s stock is by definition not traded on the public markets, so the price discovery mechanism of said markets can be inaccurate. In this case, the fair market value of that stock must be determined in some other way.
Fortunately, there is a mechanism that can determine the fair market value of a private company’s stock. It’s called a 409A valuation.
How a 409A valuation determines a stock’s fair market value
A 409A valuation is an independent, unbiased appraisal of how much a private company’s common stock is worth.
The 409A valuation gets its name from Section 409A of the Internal Revenue Code. This should clue you in to why it’s important for a private company to complete a 409A valuation—namely, because the Internal Revenue Service (IRS) wants to ensure that companies value themselves as accurately as possible.
But knowing the fair market value of your company’s stock is about more than staying on nice terms with the IRS.
Any private company that wants to issue shares to its employees must have a price attached to those shares. After all, it’s difficult to cobble together a compelling equity package if you can’t tell a prospective employee what a share of your company’s stock is worth!
Overview of the 409A valuation process
Fair market value may not be an easy thing to determine. In other words, you can’t simply read a Pulley guide (no matter how helpful and informative!) and crunch a couple numbers to satisfy the IRS.
The valuation process typically require an accounting of quantitative and qualitative factors, including but not limited to:
- Your company’s cap table
- Your company’s past, present, and future cash flows
- Your company’s past financial statements and forward-looking financial projections
- A comparative market analysis of similar companies (i.e. companies in a similar industry or at a similar stage of growth)
- Any intangible assets (i.e. copyrights, trade secrets, and other hard-to-evaluate company assets)
For this reason, many startups enlist the help of a 409A valuation firm. Such a firm will typically employ a professional appraiser (or a team of appraisers) to review the relevant facts and estimate the enterprise value of the company. Once that value is divided up between all the types of equity in the company’s cap table, the firm should be able to determine the fair market value of a single share of common stock.
Other factors, such as a discount to account for the fact that the shares are illiquid and can’t be sold on the open market, may also affect the FMV.
What is the difference between market value and fair market value?
Though they share two words in common, fair market value is not the same thing as market value.
Market value—otherwise known as open-market valuation, or OMV—is the price at which an asset can be sold in an open marketplace. The market value of a public company’s stock is easy enough to find on a public stock exchange. But market value may also refer to how much a company itself can be bought or sold for, in which case it’s calculated by multiplying the current share price by the number of outstanding shares.
Other uses for fair market value
When searching for information on fair market value, you may come across the same term used in different contexts across a number of different industries. To save you some confusion and give a more well-rounded view of FMV, we’ve briefly summarized some other common uses below.
Fair market value in the real estate market
If you’ve ever bought or sold a home, you may have heard the term “fair market value” used within the context of real estate.
In order to determine the fair market value of a property in the current market, a real estate agent may compare the recent selling prices of similar properties in the area and include other factors such as property taxes in a roughly estimated value. Many homes also have an appraised value calculated by a professional appraiser, and this value may be slightly different from FMV.
Fair market value in the insurance industry
Insurance companies may also use fair market value in order to appraise the value of items in insurance claims. Since many valuables—a used car, a stolen piece of jewelry, etc.—don’t have a universally agreed-on price, FMV can be used to help determine how much the insurance company pays out.
Fair market value for other tax purposes
The IRS may require a fair market value appraisal for gifts of a certain size. For example, if someone gifts a rare painting to a relative for $1, the IRS may use FMV to calculate the actual fair market value of that painting for gift tax purposes.
Fair market value can also help to determine the size of the tax deduction associated with a charitable donation.
What is the fair market value of my company’s stock?
Whether you’re the founder of a private company or a prospective employee trying to assess the value of an equity package, fair market value is something you’ll want to understand.
As a founder, you’ll need to work with your team to complete a 409A valuation if you haven’t done so already. And as a prospective employee, you’ll need to make sure you understand the value of any equity package that’s presented to you.
Competitive equity packages are typically structured in such a way that any stock options are granted to the employee as a tax-free event—incentive stock options, or ISOs, are an example of this. This requires the company to conduct its 409A valuation in such a way as to qualify for “safe harbor” from the IRS. You can read more about this in our guide on 409A valuations, but the bottom line is that FMV isn’t just an interesting number; it can have big-time repercussions on taxes and the overall valuation of an equity package.
Want to learn more about FMV and how to get an accurate 409A valuation over and done with? Schedule time with Pulley’s experts to learn how we can help you with an audit-ready 409A valuations and cap table, all in one.