Back to Basics: Fair Value and Fair Market Value Explained

In the world of valuation, we often hear terms like fair value (FV) and fair market value (FMV) when discussing the value of equity securities granted to employees (think stock options or profit interest units). To the uninitiated, these “standards of value” may sound interchangeable. However, there are important distinctions that help us communicate clearly and apply the right concepts in the right contexts.

What do these terms really mean, and why should stock plan administrators care about the differences when working with grant values, expense recognition, and tax compliance?

In this article, we strip away some of the complexity surrounding these terms and explore their practical implications.

Setting the Valuation Framework

It helps to start with some definitions and key considerations. When working with FV, the goal is to establish an appropriate value for financial reporting purposes. For tax purposes, we generally rely on FMV.

Fair Value ASC 820

FV for GAAP in general is codified in ASC 820 and defined as:

“The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

Fair Value ASC 718

When dealing specifically with equity compensation, ASC 718 provides a slightly different definition:

“The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.”

Fair Market Value Under IRS Revenue Ruling 59-60

For tax purposes, FMV is used, with specific conditions for equity compensation under Internal Revenue Code Section 83:

“The price at which an asset would change hands between a willing buyer and a willing seller, neither being under compulsion to buy or sell and both having reasonable knowledge of relevant facts.”

Although the wording—and sometimes the resulting values—differs, the underlying concept is largely the same:

• The security’s value is based on a hypothetical transaction between willing buyers and sellers
• Both parties act in their own best interests and have sufficient knowledge of the relevant facts
• The transaction reflects an orderly market transaction, not a forced or distressed sale

With this framework in mind, we can think more holistically about common equity compensation instruments such as stock options.

Stock Option Considerations

Fair Value/Fair Market Value vs. Intrinsic Value

Many companies, both public and private, issue employee stock options. These grant the right, but not the obligation to buy stock at a fixed price (the strike price, also called exercise price) at a fixed future date.

Imagine you’re granted an at-the-money option with a stock price of $5 today and a strike price of $5 which you can exercise a year from now. If the stock price rises to $6 after one year, you can exercise the option, buy at $5, and immediately sell at $6, realizing a $1 profit. If instead the stock price falls to $4, exercising would make no sense. You would simply let the option expire, realizing no loss. In a simplified world where these outcomes are equally likely and the only ones possible, the value of this option would be around $0.50.

This example highlights a common misunderstanding about stock option value. Many people assume an option’s value is simply its intrinsic value, the difference between the current stock price and the strike price. In fact, prior to the issuance of FAS 123R, now codified as ASC 718, in December 2004, companies expensed only this intrinsic value, which was $0 for at-the-money grants.

The problem is that intrinsic value doesn’t tell the whole story under an FV or FMV framework. Even when intrinsic value is $0, no rational holder would simply give the option away. Companies were transferring meaningful value to their employees without recognizing any expense. Moreover, even when an option is in the money, its FV will be at least as high as its intrinsic value because of the holder’s ability to wait and choose whether to exercise.[1]

This type of valuation is captured in common option pricing models such as Black-Scholes or lattice models, which is why ASC 718 requires companies to recognize the cost of these options.

Internal Revenue Code Section 409A

Another value concept associated with public company stock is the “409A value.” This term comes from Section 409A of the Internal Revenue Code, which treats in-the-money options (for example, the right to buy stock for $1 when its current value is $10) as a violation of deferred compensation rules.

To avoid this outcome, option strike prices must be set at or above the stock’s price on the grant date. As a result, companies typically perform an analysis of the underlying stock value, often called a “409A valuation.” In practice, this term is often used more broadly (and sometimes inaccurately) to describe any common stock valuation.

Profit Interest Units (PIUs)

Another type of equity compensation is the profit interest unit (PIU). These units are granted in partnerships or LLC corporations and give holders the right to participate in future growth in exchange for services as employees. Holders can receive distributions from operating profits or from appreciation in the value of the business. Junior units have less value than senior units because they sit lower in the distribution pecking order.

PIUs are granted with a liquidation value of $0 at issuance. That is, if the company were sold immediately, holders would receive nothing. Despite this, PIUs still have positive FV because of their potential future upside, much like stock options.

Here’s where the analysis becomes more nuanced. The IRS has created special rules just for PIUs under Revenue Procedures 93-27 and 2001-43. If certain conditions are met,[2] the FMV of PIUs at issuance is $0, meaning no taxes are due upon receipt. In effect, this creates a tax safe harbor created by the structure of the rules themselves. In reality, PIUs do have value because of the time value of money discussed earlier.

PIUs are unique to the US because of the pass-through nature of LLCs and partnerships. Similar arrangements may not work in international market structures (e.g., German GmbH or British LLCs) without substantial restructuring to avoid upfront taxation.

Key Takeaways for Stock Plan Administrators

While FV and FMV are often used interchangeably in casual conversation, they have distinct definitions and create unique challenges in practice. For private companies, these differences directly affect grant pricing, expense recognition, compliance, and employee expectations.

By understanding how each standard applies to common equity instruments like stock options and profit interest units, administrators can better navigate valuation discussions, ask the right questions of advisers, and ensure their plans are both compliant and well understood.

For additional resources, visit the Private Company Stock Plans and Accounting for Stock Plans sections on NASPP.com.