ESTATES AND TRUSTS

May 2000

FAIR MARKET VALUE FOR BUSINESS VALUATIONS

By Lawrence W. Palaszynski, CPA

CPAs are often called upon to determine the value of an interest in a closely held company. These ownership interests can range from a small percentage to 100% control. What CPAs are really valuing are the ownership rights of that interest in the company, be it a partnership interest or shares of stock in a corporation. Unless there is 100% ownership, CPAs are not valuing the entire company, even though that may be a consideration. The real focus is the value of the individual shareholder or partner ownership rights in that company. For example, the value of a 10% interest is normally worth less than 10% of the company's total value because the owner may have virtually no say concerning such things as company business strategies and dividend distributions. Shareholder agreements are another significant item affecting value determination.

Some inexperienced evaluators make the mistake of computing the value of an interest based solely on the financial statements without giving appropriate consideration to the ownership rights of the investment holder. In valuing a minority interest the rights of the minority investor are important. To use approaches that start with minority interest calculations that are grossed up to control level and then reduced to a minority value leaves room for error and misjudgments.

The IRS takes an opposite position, as seen in numerous proposed changes to the gift tax code. Most notable is a proposal to require valuations of minority interests to also present the value for 100% of the business. When purchasing shares of IBM, a buyer does not need to know its total market capitalization.

Another attempt by the IRS to introduce irrelevant issues is evident in the check-the-box requirement on Form 709, necessary if a valuation discount was taken. Fair market value is fair market value and the fact that a discount enters into a calculation should not be considered a red flag. There are also proposals in the works that would not allow discounts. Value is not a matter of legislation or congressional action; market forces determine value.

Determining Fair Value

In determining fair value, the following factors should be considered:

* Book value is only an accounting term and does not recognize a company's goodwill.
* Strategic value is the price a buyer is willing to pay because of synergies unique to the two entities.
* Financial value is the price a buyer is willing to pay based mainly on financial return.
* Liquidation value can be based upon either an orderly winding down (i.e., over a year to get the best price) or a quick fire sale.
* Fair market value may be defined by a governing body, state statutes in matrimonial actions, and shareholder agreements.

Fair Market Value for Estate and Gift Tax Purposes

According to Treasury Regulations section 20.2031-1(b), and as restated in Revenue Ruling 50-60, fair market value is--

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 one sentence contains a world of insight as to what Congress had in mind as acceptable asset valuations for tax purposes. There are three basic premises: a willing buyer and seller, no compulsion, and reasonable knowledge.

The first part of the definition calls for a willing buyer and willing seller. In attempting to apply the definition, a number of questions come to mind. Does one transaction involving a willing buyer and a willing seller establish a market price, let's say, with regard to the shares of a closely held entity? For example, the price paid at an auction may not represent fair market value due to lack of negotiations and because it is simply the highest price one investor was willing to pay. To what extent should the identities and holdings of the sellers be considered in establishing a value? This issue was raised in Rev. Rul. 93-12 when it set aside family relationships and restated the notion of the hypothetical buyer and seller.

In determining fair market value, must there be a number of similar transactions to reach a consensus of value? The fact that the government pays $400 for a hammer does not mean all hammers in a hardware store are worth $400.

An active market is one in which there is sufficient competition between buyers and sellers to prevent individuals from being exploited. Offers and options are only marginal indicators of value and may set a ceiling and floor; however, they are not completed transactions. Often, appraisers consider only what a willing buyer would pay, thereby creating downward pressure on values. The evaluator must also ask what a reasonable seller would be willing to accept. The price a charity would accept for an item donated to it might not represent fair value, since it would constitute a gift at no cost.

The second aspect of the definition is that the buyer and seller not be under compulsion to act. Forced sales are normally undertaken without the typical marketing and negotiating activities. Transactions caused by the pressures of bankruptcy and foreclosure will not yield good indications of fair market prices. An example of this can be found in a case where redemption of stock by a family corporation to enable shareholders to pay estate taxes was considered forced. Sale of non-dividend-paying stock was also considered a forced sale when a family needed money to care for an ill stepmother.

On the other hand, a buyer may be under pressure to pay more than fair market value. For example, a buyer may purchase at a higher price to protect a substantial investment or to beat the expiration of an involuntary conversion time restraint.

The third major item in the definition is reasonable knowledge of the relevant facts. Knowledge of relevant facts does not mean insider information. Reasonable knowledge is not the kind that might be obtained by auditing the company records. Reasonable knowledge is the amount of knowledge the average investor has before investing in the market. For example, how much knowledge does the average investor have before investing in a publicly traded stock? The average investor would not have performed due diligence as if she were buying the entire company. Most CPAs will know more about the entity being valued than is contemplated in this part of the definition. Because of their extensive knowledge regarding the company, their opinion may be biased.

Don't Forget the Market

Having examined the IRS definition of the conditions leading to fair value, it must be clearly emphasized, however, that the best indicators of value are similar market transactions. This means that if market conditions change, so should the value of the ownership interest. In the public stock market, prices change constantly without the issuance of new financial results.

Many business valuations are based solely on financial performance, regardless of the market or the company's industry situation. For example, if the prime rate suddenly goes up two points, relying only on income multiples does not change the company's value. All things being equal, however, the company's value should decline due to the lower amount of acquisition financing available. The company's cash flow will not support debt service based on a higher interest rate. This forces the affordability (and price) of the investment down.

In another scenario, the company's industry affects its demand and value. An industry can suddenly be in or out of favor. What if the client's industry became hot, such as Internet companies, where demand was rampant despite low or nonexistent cash flow and earnings? On a smaller scale, consolidators are paying a higher price and multiples for small businesses in certain industries, such as HVAC contractors, tour bus operators, and temporary services. Here the markets are setting higher values because of demand rather than financial results. Market research must be included in the computation of fair market value. *