What's Fair About Fair Market Value?

By Laura Markee, CFA, ASA, Markee Valuations September 2020 Bar Bulletin September 1, 2020

Imagine a circumstance in which your customers are divorcing, and the better half is an effective psychologist. For the sake of the example, assume even more that her practice is so successful that she makes over $500,000 each year in her practice, much greater than the industry standard of $250,000 for solo specialist psychologists with her level of education.

In a divorce in Washington State, attorneys should be aware of when and how Washington's "reasonable worth" requirement might enter play in determining the worth of a privately held company. In certain circumstances, reasonable market worth (FMV) and reasonable worth analyses will lead to significantly different conclusions and lawyers who are uninformed of the application of fair worth might encourage their customers to accept a value for their organization interest far listed below what could be granted.

Definition of Value

In company appraisal, appraisers are usually engaged to figure out worth under the reasonable market price requirement. Fair market price (FMV) is specified by the American Society of Appraisers as:

"The rate, expressed in terms of cash equivalents, at which residential or commercial property would alter hands in between a hypothetical ready and able purchaser and a hypothetical ready and able seller, acting at arm's length in an open and unrestricted market, when neither is under obsession to buy or sell and when both have sensible knowledge of the appropriate realities."

Although FMV is the standard of worth in a marital dissolution context in numerous states, in Washington, the reasonable value requirement is used. Unlike FMV, there is no typically accepted definition for reasonable worth. In the AICPA's released SSVS,1 it is noted that, "for state legal matters only, some states have laws that use the term fair value in investor and partner matters. For state legal matters just, therefore, the term might be specified by statute or case law in the specific jurisdiction."

In dissenter's rights actions in Washington State, courts identify the "fair worth" of the investor's interest, as opposed to the "fair market worth."2 In Washington, for the purpose of a shareholder oppression fit, it is concurred that "fair worth" does not include a discount for minority status.3

"Fair worth" is not synonymous with "fair market value."4 While FMV is pertinent to identifying fair worth, the circumstances of a specific case are important to figuring out reasonable value.

If the parties are getting separated and they own 100 percent of a profitable business, the application of fair worth versus FMV will frequently not enter into play due to the fact that the FMV of a 100 percent ownership interest in a lucrative organization is frequently equal to reasonable worth.

However, in certain cases, identification and recognition of the fair worth standard is important to showing up at the correct value conclusion for the customer.

Example # 1: The Professional Practice

Let's return to the example of an other half's growing psychology practice. Fair market price (FMV) and fair worth analyses will result in significantly various conclusions in this case.

In figuring out FMV, many would agree that the "asset technique" to appraisal should be applied, which designates worth to the concrete possessions minus liabilities. In this engagement, tangible assets would consist of cash, accounts receivable, and likely computers, desks, and furniture, web of liabilities. However, the worth would not consist of any intangible worth, or "goodwill," for the basic truth that her clients and files are confidential. It would violate HIPAA5 and her ethical standards to divulge this details; for that reason, there is no open and unlimited market for offering it to a third celebration. The presence of her above-benchmark level of payment establishes that there is goodwill worth, however under the FMV standard, there is no market for offering this goodwill.

On the other hand, using fair worth in the State of Washington, the court would likely designate value to the practice in the hands of its existing owners.6 A common approach for valuing expert goodwill is to establish market level payment (replacement payment) and to the extent that the owner/operator earns more than market level compensation, the difference is capitalized to get to a value conclusion.

The initial step in this kind of analysis is to establish the existence of goodwill. Goodwill is specified in the International Glossary of Business Valuation Terms as: "The intangible property that occurs as a result of name, track record, client commitment, location, and comparable elements not independently determined."

The analysis must develop that the owner of the professional practice is producing revenues at a level above his or her market level payment consistently with expectation that such profits level is fairly expected to continue in the future. Without the establishment of professional goodwill, the worth of the professional practice is the exact same under the FMV and the fair worth standard, utilizing the property method (tangible assets minus liabilities).

Attorneys who are unaware that worth can be designated to a could possibly harm their client by the extra legal expenses connected with debating the issue among evaluation experts and potentially taking an unsupportable position all the method to trial.

Example # 2: The Minority Interest

As discussed, in a typical fair worth project, factor to consider is provided to the value of a minority shareholder's ownership interest due to unreasonable or overbearing acts devoted by the majority investor or investors. In this context, the principle of reasonable value is that the minority investor has actually already been mistreated and is looking for solution from the court. It would be "unfair" to further minimize the value of this oppressed shareholder's shares for discounts for lack of control and lack of marketability, having actually currently suffered at the hands of the majority investor.

In a marital dissolution in Washington, envision performing an appraisal of a one-third interest in a moving business where the other 2 owners are unassociated service partners. The decision of FMV of this one-third interest would require to include discounts for lack of control and absence of marketability, as it is commonly accepted that the market sees the worth of a minority interest as less than the professional rata worth of the entire. If this one-third interest was not discounted, it would not represent the true worth to the marital estate. So, in this case, FMV and reasonable value would be the very same.

Now consider that the subject one-third interest was slated to convert to a 52 percent interest in 6 months. Further, picture that the partner and his organization partners had actually signed sale arrangements 10 years earlier that laid out that on this particular future date, the subject interest was going to convert to a bulk interest. In this situation, the worth conclusion from a reasonable value analysis will diverge from that of FMV.

The subject interest would almost surely be incumbered by limitations on transfer, avoiding transfer to a 3rd party. Such constraints would protect the owners from having an unapproved celebration as a 3rd owner. With these restrictions on transfer, the FMV analysis would need to consist of the application of the discount rates for absence of control and lack of marketability as is usually applied to minority interests.

However, the reasonable worth analysis would consider this future conversion to a bulk interest. The one-third interest, in the hands of the existing celebrations, will convert to a majority interest in a fairly short time period and for that reason, discount rates for absence of control/marketability would not be used.

In this case, the worst-case situation would be that the partner employed a lawyer and an organization appraiser from out of state, both of whom were unaware of how to apply reasonable worth. The result would be that the lawyer would have recommended the customer to accept the FMV determination of the company interest, an amount far below reasonable worth. It is regularly the case that lawyers who do not have a grasp of the fair value principle will require to end up being educated on this concern, eventually harming the customer by the increased billings associated to researching and understanding its application.

Conclusion

In specific scenarios, reasonable value, as used in marital dissolution cases in Washington, can diverge substantially from FMV. In order to finest serve their clients, it is crucial that attorneys engage business evaluation professionals who recognize with the suitable approaches and considerations utilized by the courts in Washington.

Laura Markee, CFA, ASA is the owner of Markee Valuations LLC (markeevaluations.com). Over the past 20 years, Ms. Markee has actually finished over 2,000 appraisals and has actually testified as a specialist more than 35 times. Her company of 4 full-time staff members conducts company appraisals for a variety of reasons, including marital dissolution, investor disagreements, present and estate tax reporting, sale, and bank funding.

Laura can be gotten in touch with at 360 601 0713 or laura@markeevaluations.com.

1 Statement on Standards for Valuation Services: Valuation of a service, service ownership Interest, Security, or intangible Asset (2007 )

2 Matthew G. Norton Co. v. Smyth, 112 Wn. App. 865, 873,51 P. 3d 159 (2002 ).

3 Robblee v. Robblee, 68 Wn. App. 69, 78-80, 81 P. 2d 1289 (1992 ).

4 Columbia Management Co. v. Wyss, 94 Or App 195, 202, 765 P2d 207 (1989 ), rev den 307 Or 571, 771 P2d 1021 (1989 ).

5 Medical Insurance Portability and Accountability Act

6 Matter of Marriage of Fleege, 91 Wash. 2d 324, 588 P. 2d 1136 (1979 ).

This information is not intended nor should it be interpreted as legal or tax suggestions. You might want to consult with other expert consultants regarding how this info associates with your personal situations.