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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' 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 bejebbies 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 two-faced 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] <http://66.132.196.73/manager/valuation.asp> 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 four-faced 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.

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. (Note: 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 earn-out 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.

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] http://66.132.196.73/manager/valuation.asp

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 5 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 following table allows us to compare the basic defined requirements of fair market value:

Comparison of Requirements:

Requirements: Rev. Ruling 59-60 Glossary of Business Valuation Terms

Hypothetical Seller Required? Yes Yes

Hypothetical Seller Willing? Yes Yes

Hypothetical Seller Able? Silent Yes

Seller under Compulsion? No No

Seller: Knowledge of Facts? Yes Yes

Seller: Acting at Arms-Length? Implied Yes

Seller: Open & Unrestricted Market? Silent Yes

Seller: Seeking Strategic Buyer?[3] Assumed No Assumed No

Hypothetical Buyer Required? Yes Yes

Hypothetical Buyer Willing? Yes Yes

Hypothetical Buyer Able? Silent Yes

Buyer under Compulsion? No No

Buyer: Knowledge of Facts? Yes Yes

Buyer: Acting at Arms-Length? Implied Yes

Buyer: Open & Unrestricted Market? Silent Yes

Buyer: Can Buyer be A Specific buyer Assumed No Assumed No

Is Price expressed in terms of Cash Equivalents? Silent Yes

About the Author: Grover Rutter CPA/ABV, CVA, BVAL, CBI is a partner in the firm Grover Rutter Mergers, Acquisitions and Valuations in Findlay, Ohio. Mr. Rutter has over 30 years experience working with owners of privately held companies. He has valued and or sold manufacturers, wholesale distributors, trucking companies, truck dealerships, machine shops, construction companies, veterinary hospitals, propane distribution companies, medical equipment distributors, CPA practices, dental offices, chiropractic offices, civil engineering firms and environmental consulting firms, just to name a few. Mr. Rutter has written numerous articles that have been published in a variety of trade and professional publications. He is also the author of How to Sell Your Business for the MOST Money which is sold through several online retailers.

Grover Rutter CPA/ABV, CVA, BVAL, CBI

Mergers, Acquisitions, and Valuations

1212 North Main Street

Findlay, Ohio 45840

419-427-1564 866-825-8283 Fax 419-422-7202

www.gruttercpas.com

grutter@gruttercpas.com
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Publication:Businesses for Sale: FirstList
Date:Aug 1, 2010
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