Fair market value

There are many misconceptions as to the meaning of "fair market value." In many cases the users of the phrase haven't the slightest concept of its meaning. First and foremost it is a standard; a goal that the appraiser is trying to reach. Fair market value is just one of several types of standards. While each state and each appraisal organization has its own definition of fair market value, they are all very similar:

"The price that a willing hypothetical buyer would pay, that a willing hypothetical seller would accept, all parties being in possession of the pertinent facts, no one being compelled to act and the property being exposed to the market place for a reasonable period of time."

The definition would apply to all types of property whether real (real estate) or personal (business, machinery, equipment, fine arts, etc.). So let's examine the basic definition.

The price: Price is what you pay! Value is what you receive!

Hypothetical, willing buyer: Based on actual transaction data obtained from proprietary data banks as reported by business brokerages, accountants, law firms and lenders that indicate details of businesses and what they've sold for.

Whereas real estate appraisers rely on public records and Multiple Listing Services for their transaction data, no such public records exist for buyers or appraisers of businesses. Even if a person knew at what price a business sold, it would have little relevance without also having access to the financial records of the business and also knowing the components that made up the purchase (sale) such as:

* What inventory was included and at what value?

* What fixed assets were included?

* Who is responsible for paying the accounts payable?

* What long-term debt is being assumed or paid off?

* What has the seller contracted for that the buyer must honor (i.e. gift certificates)?

* Did the buyer buy assets or shares in a corporation?

* Are the financial statements based on accrual or cash reporting?

Business transaction data is maintained in data banks that can only be accessed by members or subscribers. While there are at least four such data banks, the largest by far is that of the Institute of Business Appraisers with over 35,000 transactions that have taken place in every part of the United States.

Hypothetical, willing seller: A seller who creates terms and conditions that a reasonable buyer could never accept may not be consider as a "hypothetical, willing seller."

Some examples:

1. "You (the buyer) must agree that you will never fire my manager and will keep him as long as he's willing to work for you."

2. "I (the seller) will not sign a covenant not to compete even though you are paying me top dollar for my business. I will not guarantee that I will not become a competitor."

How many buyers of new cars would actually buy if the dealer refused to give a new car warranty?

In possession of the facts: Especially if the interest being purchased is a minority interest (50 percent or less). Buyers and sellers should know and understand that, unless otherwise provided for in a contract such as in a buy/sell agreement, minority interest owners (partners, shareholders, members) have no control, their interests may have very limited marketability, and their interests may be very difficult to sell. Minority interests typically do not have the same value as majority interests.

An example:

A 20 percent interest in a $1 million company could be valued as follows:

Total company value $1,000,000

20% interest $200,000

Discount for lack of control (25%) $50,000

Total $150,000

Discount for lack of

marketability (40%) $60,000

Total value of 20% interest $90,000

(Note: The above discounts are for illustration purposes only. Businesses with multiple ownerships should always have a buy/sell agreement that spells out how various interests are to be valued.

A typical problem is a buy/sell agreement that read as follows or very close to as follows:

"The seller shall receive fair market value of his (minority) interest without discount."

This immediately creates a problem because it conflicts with the standard of fair market value. If the intent is that there should be no discounts, then the buy/sell agreement should state in detail that the standard of value is fair value, and it should define fair value, which is generally considered to be a "proportionate share of the whole."

Not compelled to act: No one should have a gun to the head of the buyer or seller. Of course, there may be special personal circumstances that compel a sale, such as pending foreclosure, litigation or bankruptcy.

Exposed to the market for a reasonable time: When a buyer chases a seller until the seller finally succumbs, it typically mans that the buyer is willing to pay more than fair market value.

An example: Company A is a national company without a local branch. They do not want to pioneer a new branch so they are willing to buy existing Company B and pay more than fair market value in order to get started in the local market.

Jerry F. Golanty, is a business appraiser and consultant and is President of BIZVAL in Reno.. Contact him at 332-4881 or through www.bizval.net.