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Fair Value or Fair Market Value?

February 28, 2012 | Comments: 0 | Views: 151

Fair market value is a standard typically used for real estate valuation, certain tax issues, and employee stock ownership plans. Fair value in a legal context is a standard typically used for business interest valuation for estate tax and business litigation. Fair value in a financial reporting context is appropriate for the preparation of financial statements. The terms fair market value and fair value are typically used in business-owner buy-sell agreements without proper consideration of the confusion these terms can cause.

Fair market value is defined by the Internal Revenue Service as the price at which a property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. It is implicit in the definition of fair market value that the sale is consummated as of a specific date and the title pass from seller to buyer under the following conditions: buyer and seller are typically motivated, both parties are well-informed or well-advised, each participant is acting in what they consider their own best interest, a reasonable time is allowed for exposure of the business in the open market, and payment is made in terms of cash. Compare this to a typical negotiated transaction where differences from the market value conditions may occur in the sophistication of the parties, the information available to the parties, competing offers, tax implications, time to complete the transaction, and payment terms. Negotiated prices occur at fair market value only by coincidence. Investment value is the value to a particular investor for a specific transaction based on individual investment requirements and expectations. Fair market value, which emphasizes average buyers and sellers that are equally well-informed, is derived from multiple negotiated investment value based decisions on a comparison basis.

The Financial Accounting Standards Board (FASB) defines fair value 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. Under many state statutes fair value is the standard of value used to determine the cash price dissenting and oppressed shareholders will received in exchange for their shares of stock. Although much debated, this standard of value is widely understood to mean the proportionate value of the whole value of the business. Courts increasingly have interpreted fair value to be a pro rata share of the value with respect to the owner rather than the value a share (typically a minority share) might bring at market. While the general trend in many states is not to allow or limit the use of minority and marketability discounts to a proportionate share, some states still allow the discounts either by precedent, a court's discretion, or special circumstances.

A contractual agreement may specify a value, a formula, or a standard to be used to determine value. If a standard is specified, the agreement may further define the standard and the application of the standard to specify the price for the transaction.

Where business owners enter into a buy-sell agreement, valuation is initiated on the value of the entire business. Then the business owners must struggle with the determination of value of each of their respective interests under varying circumstances. The value for each interest should be the value of the proportionate ownership interest in a going concern. While that value may be the fair market value of the entity multiplied by the percentage of proportionate interest owned, it is not that value further reduced by marketability and minority interest (or lack of control) discounts. While a third-party buyer (someone not currently involved in the business) might pay for certain intangibles (good will or know-how) valued in the fair market value of a business, it is unlikely that owners buying entity interests from one another would be willing to pay for those intangibles they already possess. Moreover, the price will vary with the trigger event, and the payment terms for the interest will vary with the circumstances of the triggering event for the transaction.

The funding for the operation of the buy-sell agreement generally will come from the business that is the subject of the buy-sell agreement. One very practical test for the value standard and procedure for setting the price of a buy-sell valuation is to ask if the business is capable of generating the funds to enable payment of the price. In judging capability, not just the price but also the terms become the critical issue in determining whether the buy-sell strategy can be supported. For example, the death trigger will often cause an immediate payment to become due, whereas a disability trigger may cause a series of payments over time to complete the purchase. With these considerations in mind, the buy-sell agreement must specify in detail the standard of value and the application of the standard of value. Use of the terms fair market value and fair value will not sufficiently define the value or the process used to specify the price for the transaction.

Rick Riebesell is the Principal Consultant and Manager of Business Transition Consulting LLC ( ). Rick finds solutions for the problems of owners of closely-held (owner-managed) businesses. He is experienced in business transactions of all types and understands sophisticated estate planning. Rick was a practicing lawyer for over thirty years.

To download the E-book Implementing the Buy-Sell Agreement see

Business Succession Planning - Forms and Practice Manual published by Data Trace Publishing Company is Rick's latest book. Rick conducts presentations concerning business succession issues.

Source: EzineArticles
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