Fair market value (FMV) is an asset’s estimated value if it were sold today in the current market. FMV is commonly used in real estate to value property, but it’s also used to determine the fair market price for shares of a company’s stock and other financial assets.
This article will focus on what FMV means for stock, how to determine a stock’s fair market value, and why 409A valuations are so crucial for private companies.
What is FMV for stocks?
The fair market value represents what a single share of stock would be worth on the open market. To determine the FMV of most public company stock, you can go online and quickly see the price of shares. This value is influenced by financial and economic factors such as the company’s earnings, comparative market analysis, and other market conditions.
However, publicly accessible FMV isn’t possible with private companies. Private companies must determine their common stock’s fair market value with a 409A valuation. A 409A valuation is not the same as a “ post-money valuation,” which is the market value for the entire company.
How to calculate fair market value
409A valuations by independent appraisers are the primary IRS-accepted way to determine the current fair market value of a private company’s common stock. FMV influences the price employees, contractors, and other common stock option recipients must pay to purchase their stock options (also known as the strike price). The strike price must be greater than or equal to the FMV stated in the 409A valuation.
What factors can affect the fair market value?
When valuing your company, 409A providers look at a few different factors:
How much your assets are worth
The present value of your future cash flows
How much common stock is worth at similar (comparable) companies
How much equity your company has in other similar businesses or industries
Companies need a new 409A valuation every year or each time a material event (such as a new funding round, acquisition, or merger) occurs.
Using the factors listed above for a 409A valuation, the resulting FMV is used to set the purchase price for stock options (exercise price).
Fair market value vs. fair value
On your 409A valuation, you may see two similar but different terms: fair market value (FMV) and fair value (FV).
Fair market value is the standard of value for income tax purposes. It is the stock’s cash price in an open and unrestricted market when both the buyer (e.g. an employee) and the seller (e.g. the company) have reasonable knowledge of relevant facts.
Fair value is the standard of value for financial reporting purposes. FV is the amount at which stock could be bought or sold between willing parties, that is, other than in a forced or liquidation sale.
Download a sample 409A valuation
Why FMV matters
If you needed a reason to care about getting FMV right, here are two: taxes and the Internal Revenue Service.
When establishing FMV, third-party appraisers are obligated to come up with a number that is, in fact, fair. While you and your shareholders may see certain benefits from a lower FMV, the IRS may reject valuations it finds “grossly unreasonable.”
If the IRS rejects your company’s valuation, that would revise the tax treatment of stock options issued under that valuation. If this happens, any employees who received incorrectly priced options could be taxed on those options immediately and may have to pay penalties.
While very early-stage startups may be able to approximate the value of their own stock, this FMV isn’t protected under IRS safe harbor. The safe harbor ensures that the IRS will accept the FMV unless it is deemed to be “grossly unreasonable.” For your company’s FMV to be eligible, you must have a 409A issued from an independent appraiser.
Kick off the 409A valuation process today