Understanding business appraisal standards helps attorneys recognize proper parameters and assumptions surrounding the property being appraised.
By Rob Schlegel, ASA, MCBA, and Tim Mosier
One of the most important – and often least understood – aspects of appraisal work for family lawyers relates to the appropriate Standard and Premise of Value. These “Standards” are basically definitions that a business valuation appraiser uses to direct the procedures applied in the assignment. They should not be confused with more all-encompassing professional standards or guidelines such as Uniform Standards of Professional Appraisal Practice (USPAP), the American Institute of CPA’s Statement on Standards for Valuation Services No. 1 (SSVS #1), or required principles of the Canadian Institute of Chartered Business Valuators.
The Standard of Value is the Viewpoint of Exchange
There are four commonly used standards of business value: fair market value, investment value, fair value, and intrinsic value. In matrimonial assignments, typically either “fair market value” or “fair value” may be referenced in statutory or case law. Of course, “fairness” in the perspective of a price given in a forced exchange is an operative interpretation. It is the duty of the attorney to ensure that the appraiser recognizes proper parameters and assumptions surrounding the property being appraised. In other words, the appraiser doesn’t choose the appropriate standard of value– he (or she) looks to the attorney or the client in accordance with the situation surrounding the assignment. Even though legal references may differ in various jurisdictions, from an appraiser’s standpoint, the accepted definitions of these “Standards” are well known:
Fair Market Value
Fair market value is the most widely used standard by business appraisers. The commonly used definition from IRS Revenue Ruling 59-60 defines fair market value as, “The price at which the 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 and compulsion to sell; both parties having reasonable knowledge of relevant facts.” A second, but still commonly used definition from the American Society of Appraisers is “The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and 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.”
There are several key concepts to understand about fair market value and the underlying assumptions. Fair market value buyers and sellers are hypothetical; there is no presumption about the buyer or the interests the buyer might have in the property other than a financial investment. Some buyers might be willing to pay a premium for a property due to specific circumstances unique to them, but fair market value usually does not take this into account (see Investment Value, below). However, in certain limited circumstances, when there is a known group of potential buyers in the market (such as five competitors willing and able to acquire the business) those facts are sufficient to constitute “a market” for the equity.
An additional thorn of fair market value is a potential presumption of a covenant not to compete that the seller would provide to the buyer as a “typically motivated seller.” This can be touchy in jurisdictions where courts explicitly limit appraisal assumptions to the facts in place on a specific date of value. If, for example, equity in a solo dental practice is being appraised as of the date of filing for dissolution and a covenant not to compete does not exist, the appraiser may have the obligation to reflect the added risk, borne by the buyer, of the dentist competing once the sale is completed. Key elements for determining a competitive threat are desire, ability, and capacity. If all three are immediately present, patients (or clients or customers) would likely flock to the Seller under a new business name, undermining the expectation of continued patronage that provides a basis for entity goodwill.
Investment Value/Strategic Value
Investment value, or strategic value, is the value that a specific buyer would pay for the property. This typically reflects value of the property at a higher exchange price, or a premium, due to certain, special opportunities or conditions for the buyer. A buyer might pay a premium to cross-sell products or services to an expanded customer base, to gain economies of scale, or to increase market share. This standard suggests the reflection of a known buyer who would likely pay more in negotiations to achieve the benefits that a “financial buyer” could not enjoy.
Normally investment value is not considered as a proper standard of value in marital proceedings because the business is expected to operate in the future under the same constraints and methods as it has in the past. However, some exceptions could occur if there is a likely suitor clamoring to buy the business at an investment value price. Under this potential situation, a “financial buyer” under fair market value conditions would pay more for the marital equity, perhaps close to the expected investment value level, but tempered by some risk of the “deal” not going through. This type of behavior is frequently seen in public market stocks; a market rumor of an “impending acquisition” causes the bid/ask prices to rise dramatically in a short period of time. If the acquisition does not take place, stock prices fall back to original “financial” levels of value.
Fair value, to an appraiser, has two different contexts. In many jurisdictions, fair value is defined by statutory law primarily for use in minority shareholder oppression cases and dissention stockholder action suits, an unusual condition for family law. The second context for fair value is for use by an accountant in financial reporting. Fair value for financial purposes is defined 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” (Financial Accounting Standards Board ASC 820).
Financial reporting fair value is in many ways similar to fair market value, but there are also some differences. Under fair value the buyers are unrelated to the business; they have relevant facts and information, both financially and legally willing and able, and are not acting under compulsion. Most often, financial reporting concepts relate only to “whole” company value, so a minority equity interest held within a marital union may have some difficulty and ambiguity if your accountant valuator is allowed to use the financial reporting standard of “fair value.”
Intrinsic value is the final standard sometimes used considering what “the value should be” or what a prudent investor would consider. The prudent investor is slightly ahead of the market and has evaluated all available information. Oftentimes “intrinsic value” is what a stock analyst will provide in terms of a buy or sell recommendation, which is distinguishable from what the stock may be selling for on the public markets on a given day. The intrinsic value will be the market value when other investors reach the same conclusion as the prudent investor. There are some jurisdictions where “intrinsic value” is becoming more defined and accepted in case law, implying that care should be taken by the attorney in educating the appraiser of proper terminology and assumptions.
Premises of Value Addresses Continuity of Operations
There are two basic premises of value: going-concern, as within an operating business that continues to produce appropriate cash flow, and liquidation where the business has bleak (or no) future operating prospects and the value of the assets (both tangible and intangible) are netted with the value to transfer the liabilities to obtain residual value, or the “going-out-of-business” scenario. The selection of the premise of value is the domain of the appraiser, so an attorney should be careful not to mandate a specific premise but rather be able to talk knowledgeably about the interpretation of the facts and business condition with the appraiser.
- The going-concern value premise assumes that the business is going to continue to operate similar to the past. Going-concern usually implies that the business has customers, workers, procedures, estimated future cash flows, and will continue as a functioning system. Such an operating business suggests the existence of goodwill that is saleable in the marketplace. However, if the operating business has such dreary prospects for future cash flow that the anticipated returns do not justify the anticipated risks involved, one can find a “zombie” business that, unfortunately, is worth more dead than alive.
- The liquidation value premise usually has two outlooks: forced, or generally an auction value received in a short time frame (think 30 days or so), and orderly, or individual sale of the assets and disposal of the liabilities over a period of months (think 6 months or so) following adequate exposure to a market of potential buyers. Occasionally, appraisers may consider an assemblage of assets under a liquidation premise suggesting that individual assets are sold as a working group (such as in a non-operating tool and die shop, where the equipment in emplaced, calibrated, and capable of functioning together). The fair market value of the company would be based on a liquidation premise if the company could sell its assets and liquidate at a higher price than the likely future cash flows adjusted by risk would justify.
A liquidation premise does not require the assumption of zero (or negative) cash flows, however. A business earning uneven and small, but generally positive, cash flows could be valued under a liquidation premise given that the totality of future earnings is insufficient to justify a “safe” rate in an alternative investment and the risk involved. Every buyer has a choice of investment: buy the equity in the business or place the money in a “safe” investment such as government securities, treasury bills, or similar instruments which generate small returns. Recently, such “safe” returns have been paltry, paying a fraction of a percent. In earlier years, “safe” returns have often been in the 3% to 5% range. Long-term investing in the stock market in a diversified portfolio could add another 6% or so, and unique factors of the industry, size, or the company could add to the risk. So if the business is likely to generate future earnings (the reward) that are less than what investor could more safely get from an alternative investment (commensurate risk), the “value” of the future cash flows is diminished. If this calculated value is less than what an owner could receive in selling off the assets and paying the liabilities, then the appraiser should be following a liquidation premise.
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Even though the standard and premise of value may vary according to the situation of your family law client, it is important for the attorney to agree with, and perhaps direct, the appraiser regarding how the assignment should be defined. Plan to discuss such standards and premises of value in your initial phone calls. Unfortunate situations arise when a concluded appraisal opinion is challenged on definitional components, and egg is shared on everyone’s face. Don’t make this mistake– talk to your appraiser early in the assignment process and ensure that you both are on firm ground for proceeding.
Rob Schlegel is a Principal in charge of the Indianapolis Office of Houlihan Valuation Advisors, and regularly teaches business appraisal techniques to appraisers, lawyers and accountants for virtually all of the North American professional societies. Rob is a Past International President of the American Society of Appraisers, and holds designations as an Accredited Senior Appraiser and Master Certified Business Appraiser. Tim Moiser is a senior accounting student at the University of Indianapolis, anticipating graduation in May, 2014.