Four Faces of Fair Market Value

Four Faces of Fair Market Value By Grover Rutter, CPA, ABV, CVA, BVAL That person is two-faced! I remember the very first time I heard that expression. With only five years of experience in this world, my mind conjured up the caricature of a humanoid monster with two faces. The face on the front of the head was recognizable as that of a normal human being. The imagined leathery-tough and contorted facade of the rear face was more than enough to frighten the bejeebies out of this five year old. And most horrible of all, was the fact that whenever I garnered the nerve to actually try and sneak a peak at the back of some two-faced person s head, it looked just like any other person s head! How could the grown-ups recognize these two-faced people? In not too many years, life s experiences taught me some important lessons. Soon, I realized that two-faced was merely a figurative expression while the turmoil surrounding the actions of a twofaced person could be quite literal. The above scenario can also be analogous with the term fair market value. In business valuation fair market value is a phrase used quite frequently by a host of interested parties. The Internal Revenue Service, other governmental organizations, civil litigants, their attorneys, and judges all struggle with the task of identifying fair market value. This fact is easily documented by the voluminous number of court cases dealing with the subject. It is easy to identify fair market value when an actual arm s-length sale or transaction occurs between willing and able buyers and sellers. However, in situations where an arm s length sale will not occur, fair market value is an elusive monster that can easily camouflage itself amongst facts, figures, and fictions. In those non-sale situations, everybody talks about fair market value but very few recognize it. 1 Unfortunately, this is also true of some business valuators. This article is intended to assist in the identification of fair market value, which I refer to as the fourfaced monster. Learning to recognize the key elements (faces) of fair market value will assist valuators and users of valuations in identifying the fair market value of most equity/investment interests when an actual sale of the interest in not anticipated. For simplicity, I have organized the four faces of fair market value into two categories. Each category contains two elements. The first category is the Standards Category, while the second category is the Participants Category. The following discussions examine the four faces of fair market value. Also, I am providing some actual examples of arguments that have been made by valuators on different sides of the fair market value question. Standards Category Two separate definitions can generally apply to the standard of fair market value. Some states and jurisdictions may also have statutory definitions of fair market value. However, for purposes of this article, I am assuming a lack of jurisdictional statutory definition. In the absence of such statutory definition, the two general standard definitions are provided by Revenue Ruling 59-60 International Glossary of Business Valuation Terms. While the definitions provided by each of these authoritative sources are similar, the strict literal adherence to either definition can cause different results under each definition. Let s take a closer look at each definition. 14

Revenue Ruling 59-60 Definition This is probably the most common definition of fair market value and the one discussed most often. Revenue Ruling 59-60 defines fair market value as:... the amount at which the property would change hands between a willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. This definition is commonly used by the IRS, the courts, and valuation consultants. It assumes a hypothetical arm s length sale without regard to a specific buyer or seller. This definition is what I consider as the first face of fair market value. International Glossary of Business Valuation Terms Definition Jointly approved by the AICPA, ASA, Canadian Institute of Chartered Business Valuators (CICBV), NACVA, and IBA, this Glossary of Business Valuation Terms provides some slight variations to the old definition of fair market value as set forth by Revenue Ruling 59-60. The International Glossary defines Fair Market Value as The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. (te: In Canada, the term price should be replaced with the term highest price. ) I consider this definition as the second face of fair market value. So, what is the difference between the two definitions that can cause valuators to arrive at different results under each definition? A practical observation is that the primary difference is the phrase expressed in terms of cash equivalents that can be found in the definition provided by the International Glossary of Business Valuation Terms. While this appears to be only a slight variation, it can often be the cause of heated debates between litigants, their attorneys, and business valuators. Here is an example that I recently encountered. The business valuator engaged by the out-spouse prepared a valuation of the subject accounting firm using the Fair Market Value standard established by Revenue Ruling 59-60:... the amount at which the property would change hands between a willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. The valuator acknowledged within the report that accounting firms are quite often sold on an earnout basis. That is, the gross sales price paid for the firm will be paid over a set period of time (generally from three to five years) based upon some percentage of fee revenues generated by the firm. However, in his valuation, the valuator opined the fair market value as being an amount based upon a multiple of anticipated firm revenues. The valuator did not consider or discuss the prospect that the actual sales price (based upon his calculations using multiples) may be paid over a number of years. In essence, the valuator did not consider or discuss the present value of the transaction. 15

What was his defense to the approach of not recognizing the present value? He said, I relied upon the literal definition of fair market value as established by the Internal Revenue Service in Revenue Ruling 59-60:... the amount at which the property would change hands between a willing buyer and a willing seller when. My conclusion represents that amount for which the property would change hands. The standard s definition imposed no further requirement. The out-spouse s valuator did not mention it, but many business brokers also think of value in terms of transaction values, where the total of all consideration passed at any time between the buyer and seller for an ownership interest in a business enterprise represents the value. 2 My engagement was with the attorney for the in-spouse, and I also used the fair market value standard. However, the standard on which I relied was the definition of fair market value as provided in The International Glossary of Business Valuation Terms: The price, expressed in terms of cash equivalents, etc. In addition to other methods, my valuation analysis also considered price to revenue multiples for accounting firms. In fact, the other valuator and I used the same data and price multiples in our calculations. However, citing the earn-out method that is frequently used in the sale of CPA practices, I set forth an assumption of a 25% down payment with the balance to be paid over five years based upon assumed even collections (no indication that gross collections would decrease). I converted the expected stream of collections into a present value using the mid-term Applicable Federal Rate (a published rate) that had been in effect for the valuation date. Of course, my indication of value based on this market approach was lower than the indication of value calculated by the other valuator. We both contended that the definition of fair market value, on which we each relied, supported our findings! In the foregoing situation, the parties attorneys argued back and forth about the valuation issues, filed motions, and went through the standard legal procedures that stall cases and drive clients to insanity! Finally, the attorneys convinced their respective clients that compromise was the best answer, and the issue was settled by the parties using a simple average. How might business valuators assist attorneys and their clients in avoiding some of the pitfalls in issues concerning fair market value? The answer may sound too simple. First, seek the exact legal definition of fair market value in the jurisdiction. If there is no established statutory authority or case law that specifically defines fair market value, then why not suggest the parties consider stipulating to the exact definition of the valuation standard to be used? Do the parties agree to adhere to the older Revenue Rule 59-60 definition, or the newer International Glossary of Business Valuation Terms definition? This takes some additional effort on the part of the business valuator; educating attorneys as to the subtle differences between the two definitions of fair market value may be time well spent. The table on the following page allows us to compare the basic defined requirements of fair market value: 16

Comparison of Requirements Requirements Rev. Ruling 59-60 Glossary of Business Valuation Terms Hypothetical Seller Required? Hypothetical Seller Willing? Hypothetical Seller Able? Seller under Compulsion? Seller: Knowledge of Facts? Seller: Acting at Arms-Length? Seller: Open & Unrestricted Market? Seller: Seeking Strategic Buyer? 3 Hypothetical Buyer Required? Hypothetical Buyer Willing? Hypothetical Buyer Able? Buyer under Compulsion? Buyer: Knowledge of Facts? Buyer: Acting at Arms-Length? Buyer: Open & Unrestricted Market? Buyer: Can Buyer Be a Specific Buyer? 4 Is Price Expressed in Terms of Cash Equivalents? Implied Implied Participants Category The next two faces of fair market value concern the seller and the buyer. I refer to the seller and buyer as having the third and fourth face of fair market value, respectively. In the definition of hypothetical fair market value, a valuator must consider the positions of EACH the seller and the buyer. I don t know how many times I have reviewed business valuation reports (claiming to render an opinion of value based upon the Fair Market Value Standard ) that devote page after page of discussion, analysis, and calculations dealing with the hypothetical buyer. In some reports I have seen nothing at all mentioned about the considerations of the hypothetical seller! In my opinion, such reports may be opining an investment value rather than a fair market value. Why? Because the valuator was concerned only with the value to the purchaser! Yet, the valuator will swear up and down that the value represents fair market value! So, what is hypothetical fair market value, and how is it recognized? Both of the previously mentioned standards give us a definition of fair market value. But the trick seems to be in implementing the analysis leading up to the conclusion of fair market value. This is where I refer to recognizing the third and fourth faces of fair market value. To assist the reader of my reports to follow my logic, I have added a paragraph right below the definition of the standard being used (I have been using the FMV definition prescribed by the International Glossary of Business Valuation Terms). This additional paragraph further explains the basic characteristics of both the seller and the buyer: The concept of hypothetical Fair Market Value is one involving the determination of a range of values, with the hypothetical Fair Market Value falling somewhere within that range. The low end of the range is the lowest amount that a willing seller, who is seeking the highest amount, will accept and still consummate the transaction. The high end of the range is the maximum amount that a willing buyer, who is seeking to pay the lowest amount, will pay and still consummate the transaction. Then, in the Valuation Methods section of the report, further discussions can also address those methods that may be considered by the seller and the purchaser, and the reasons why each may consider a 17

particular approach or method. We must remember that the hypothetical seller is not being forced to sell, and the hypothetical buyer will only enter into the transaction up to the point where the price no longer makes sense to that buyer. Failure to examine the faces of both parties may indicate the valuator s failure to meet the requirements imposed by the Fair Market Value Standards. The table on the next page is intended to assist users of valuation reports in identifying the faces of the hypothetical seller and buyer, respectively. The items listed within the table may not be allinclusive and are intended to give the reader an idea of the general considerations that attach to the seller and also to the buyer. continued on next page... 18

Attributes of Hypothetical Sellers and Hypothetical Buyers Hypothetical Seller GOALS Willful Sale 1 Maximum Price Success of Buyer Collect Full Price (Endnotes) 1 See citations at 3 and 4 above, and continuing, However, the seller (hypothetical) must be willing to sell under conditions that exist as of the valuation date. SELLER WILL: Keep Business Going Analyze Valuation Scenarios Assist in Transition t Compete Assist Employee Retention Provide Some Training Provide Assistance Speak Well of Buyer Assist in Maintaining GW SELLER WON T: Refuse to Sell Close Business Frighten Buyers Compete Next Door Steal Employees Refuse to Train Refuse to Assist Bad-Mouth Buyers Bad-Mouth Business POSSIBLE VALUATION METHODS Market Approaches Asset Approaches Income Approaches COMMENTS P/R Multiples may provide higher valuations if earnings are lower than in the industry. Depending upon business type, seller may place higher values on tangible and intangibles. Seller also interested in tax consequences. Generally when the business generates higher than average earnings in industry, seller may rely more heavily on Income Approaches. Also, direct capitalization rates should be representative of the current market place. Hypothetical Buyer GOALS Willful Purchase Lowest Price Achieve Set Goals Pay for Purchase Possibly, Enjoy ROI BUYER WILL: Analyze Feasibility Perform Due- Diligence Analyze Valuation Scenarios Seek Assurances from Seller Seek Assistance from Seller May Seek Seller Financing Negotiate Price to some point BUYER WON T: Breach Confidentiality 1 Make Threats 2 (Endnotes) 1 In the hypothetical willing buyer scenario, specific buyers are generally excluded. Thus, while certain unfriendly buyers may leak information, or make economic threats, etc., we do not generally consider such specific buyers in the hypothetical setting established by the FMV standards. 2 Ibid, 6 above. POSSIBLE VALUATION METHODS Income Approaches Asset Approaches Market Approaches COMMENTS Buyers are concerned with cash flow, ability to finance the acquisition, and ROI issues. A DCF method may be expected. Also, the purchaser may consider using discount rates based on the purchaser s cost of capital and risk perceptions. Purchasers may be interested in values of under-lying assets, collateral issues, and tax considerations. Anticipate Seller Get Market Feel Anticipate Bids Determine Limits continued on next page... 19

In conclusion, valuators and users of valuation reports will find that identifying hypothetical fair market values may be much easier when each of the four faces can be identified: Summary of the Four Faces of Fair Market Value First Face Second Face Third Face Fourth Face Is the Standard of Fair Market Value set by Rev. Rule 59-60 (may not be adjusted for present value considerations)? Is the Standard of Fair Market Value set by definition provided in the International Glossary of Business Valuation Terms (considers cash equivalents)? Have the hypothetical seller s positions and concerns been considered in the valuation analysis? Are those considerations consistent with what one could expect from a seller of the interest? Have the hypothetical purchaser s positions and concerns been considered in the valuation analysis? Are those considerations consistent with what one could expect from the purchaser of the subject interest? Just be thankful that I did not title or model this dissertation on the famous TV star that allegedly has sixteen personalities! Grover Rutter, CPA, ABV, CVA, BVAL, devotes 100% of his practice to business valuations and litigation support services. Grover is a frequent contributor of articles to and has also had articles published in other legal and business valuation publications. Grover is based in Findley, Ohio, and provides valuation, litigation support, and consulting services throughout the United States and in the British West Indies. He is a member of NACVA, IBA, AICPA, OSCPA, and AICPA Consulting Division, and the OSCPA Small Business Section. He can be contacted at gruttercpa@aol.com or 1-419-1564. His website address is www. gruttercpas.com. (Endnotes) 1 In situations where an actual sale is not expected to occur, I will refer to hypothetical fair market value in various sections of the article. This is done because the definitions of fair market value discuss hypothetical willing and able sellers and buyers. 2 The transaction value has been adopted by the International Business Brokers Association (IBBA), and the full definition can be found in the Business Brokerage Glossary. 3 Valuing Small Businesses & Professional Practices (Third Edition) by Pratt, Reilly and Schweihs, page 39, In the legal interpretations of fair market value, the willing buyer and willing seller are hypothetical persons, dealing at arm s length, rather than any particular buyer or seller. In other words, a price would not be considered representative of fair market value if it is influenced by special motivations not characteristic of a typical buyer or seller. 4 Valuing Small Businesses & Professional Practices (Third Edition) by Pratt, Reilly and Schweihs, page 39, That is not to say, however, that the concept of fair market value precludes identifying groups of willing participants. Quite the contrary, the valuator (spelling corrected) should be able to identify categories of willing purchasers. 5 See citations at 3 and 4 above, and continuing, However, the seller (hypothetical) must be willing to sell under conditions that exist as of the valuation date. 6 In the hypothetical willing buyer scenario, specific buyers are generally excluded. Thus, while certain unfriendly buyers may leak information, or make economic threats, etc., we do not generally consider such specific buyers in the hypothetical setting established by the FMV standards. 7 Ibid, 6 above. 20