The world of fair market value is not the real world. It is a special world in which the participants are expected (defined) to act in specific and predictable ways. It is a world of hypothetical willing buyers and sellers and of hypothetical transactions. The real world is populated by real people, whose actions are unpredictable, and not subject to consistent definition, who engage in actual transactions with unpredictable results. It should come as no surprise that these two worlds, the hypothetical world of fair market value and the real world, are sometimes in conflict over the question of the value of businesses and business interests.
We begin this article with a review of the definition of fair market value. The second part of the article offers a partial interpretation of the meaning of fair market value from a valuation perspective and looks into the hypothetical world of fair market value.
The definition of fair market value is known as a “willing buyer and willing seller” concept. The Department of Labor’s “Proposed Regulation Relating to the Definition of Adequate Consideration”, which to our knowledge has not been finalized, but is still generally relied upon by appraisers as the authoritative guideline for EOSP valuations, defines “adequate consideration” as the “fair market value” of the asset as determined in good faith by the Trustee or named fiduciary. This definition essentially reflects the well established meaning of fair market value as presented in Revenue Ruling 59-60.
Revenue Ruling 59-60 provides a working definition of fair market value:
2.2 Section 20.2031-1(b) of the Estate Tax Regulations (section 81.10 of the Estate Tax Regulations 105) and section 25.2512-1 of the Gift Tax Regulations (section 86.19 of Gift Tax Regulations 108) define fair market value, in effect, 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 any compulsion to sell,  both parties having reasonable knowledge of the relevant facts. Court decisions frequently state in addition that  the hypothetical buyer and seller are assumed to be able,  as well as willing, to trade and  to be well informed about the property and  concerning the market for such property. [parentheticals added]
This definition provides a bare-bones description of the hypothetical world of fair market value. The parentheticals indicate nine elements in the definition of fair market value for consideration. They will be discussed below. However, it is almost impossible to cite the definition of fair market value without also noting the eight factors enumerated in RR 59-60 for consideration in a fair market value determination. They are so commonly cited in business appraisal reports that Mercer Capital refers to them as the Basic Eight factors (from Section 4.01):
The Basic Eight factors of RR 59-60 are required to be examined in the context of what we call the Critical Three factors of common sense, informed judgment, and reasonableness (from Section 3.01), which “must enter into the process of weighing those factors and determining their aggregate significance.”
The nine [parenthetical] elements of the definition of fair market value are the focus of this article, rather than the Basic Eight factors. However, these nine definitional elements are necessarily interpreted in the broad analytical context provided by the Basic Eight and under the general umbrella of the Critical Three factors of common sense, informed judgment and reasonableness.
We now focus on the nine elements noted parenthetically in the definition of RR 59-60 above. Recall, as was noted above, that the world of fair market value is not the real world. It is a specific definable world in which hypothetical buyers and sellers react in predictable ways.
As can be seen in the definition above, there are several qualifying characteristics that define “the price at which the property would change hands.” Note that the definition references the price, and not the proceeds, of the sale of a property.
Elsewhere in RR 59-60, we find that the fair market value price is paid in terms of money or money’s worth, so the fair market value price is a cash-equivalent concept. It is paid in terms of dollars today or the present value of consideration to be received in the future. Note also that property changes hands. A transaction is presumed in the definition of fair market value.
Appraisers sometimes consider discounts for controlling interests of companies relating to the transactions costs incurred while selling those entities. While transactions costs are undoubtedly real in actual transactions, such costs are deductible to sellers and therefore reduce proceeds, not price. Other costs, such as those related to deferred hirings or maintenance, for example, may well lower value, and thus, price. Appraisers should therefore distinguish between costs that influence price (value) and proceeds (value less transactions costs).
If fair market value is a cash-equivalent concept, how meaningful are stock-for-stock acquisition transactions in consolidating industries (like banking and auto dealerships, to name two) as a basis for determining the fair market value of an entity on a controlling interest basis for estate tax purposes? It is fairly well documented that stock-for-stock deals generally occur at higher dollar-denominated prices than cash deals. If fair market value is a cash-equivalent price, and if the stock-for-stock value indications exceed the price that could be obtained if an entity were sold in a cash deal, business appraisers attempting to determine the fair market value price should probably take this factor into account.
The hypothetical buyer of fair market value fame is a willing buyer and is interested in engaging in a transaction to acquire the subject interest and is inclined to do so “if the price is right.” Hypothetical buyers make their determinations of price based upon rational financial and economic principles applied in relation to a subject interest. In other words, the hypothetical willing buyer is a rational buyer.
The hypothetical seller of fair market value fame is a willing seller. Specific sellers are not always interested in selling, particularly if market conditions are perceived as poor. Yet, they can sometimes be convinced to sell an asset “if the price is right,” to obtain liquidity, or to invest in a higher yielding alternative investment. But note that for a seller, the timing must also be right. If the definition of fair market value is to hold up, the contemplated class of willing sellers must be comprised of a group of potential sellers for whom the timing for a (hypothetical) transaction is favorable.
If a hypothetical seller does not sell, he or she has become, in effect, a buyer who acquires (by retaining) a subject interest. So every hypothetical seller is evaluating the same economic and financial factors under consideration by the relevant group of hypothetical buyers. So the hypothetical willing seller, like the hypothetical willing buyer, is a rational investor. A discussion containing many of the same concepts is found in a recent article in the Business Valuation Review.
The definition of fair market value assumes willing buyers and willing sellers. Some might argue that because someone would not buy a particular interest, it therefore must be next to worthless. Others sometimes suggest that because a holder of an interest would not sell, it should be valued dearly. Both positions may at times be correct, but neither represents fair market value.
The lack of willingness to engage in a transaction by any particular party should not enter into a determination of the fair market value of the subject interest, else the behavioral requirements of the definition are not met. Finding that a seller would not sell because the price is “too low” or that a buyer would not buy because the price is “too high” implies analysis of the motivation of specific sellers or buyers, ignores the need to consider hypothetical sellers and hypothetical buyers, and introduces elements of speculation and subjectivity not contemplated by the definition of fair market value.
Appraisers sometimes use the terms typical buyers and typical sellers as representatives of hypothetical willing investors. These are important concepts. A specific buyer will likely consider the intrinsic worth of an investment to him or to her. A specific seller will also consider the worth of an investment from his or her unique perspective. Such considerations do not constitute a market. A group of typical buyers, on the other hand, collectively represents one side of a market and a group of typical sellers represents the other side. Together they create the hypothetical market of fair market value.
Neither party is assumed to be under any compulsion to engage in a transaction, nor to be under any duress. This point suggests that although willing to engage in a transaction, the parties are under no pressure to do so. Compulsion to engage in a transaction by a party to a transaction usually works adverse to that party’s interests. A “motivated buyer” is likely to pay more than a rational price to acquire an asset. On the other hand, a “motivated seller” is likely to sell for less than he or she would otherwise accept for the sale of an asset. Hypothetical buyers and sellers in the fair market value world, being equally uncompelled, can negotiate the price and terms of their deals based on their rational financial and economic consequences.
Recall that we suggested above that attempting to ascertain why specific persons did not engage in a transaction is speculative and subjective. Analyzing actual transactions to attempt to ascertain or estimate the motivations of market participants is a far more objective process and can often add value to the process of determining fair market value.
A specific buyer for a subject interest with strategic or synergistic motivations may pay a price that is unaffordable to a typical buyer who lacks synergistic opportunities or strategic motivation to enter a market. So fair market value will likely not reflect the highest price that might be obtained. It more probably should reflect the consensus rational pricing that might be discerned by a group of buyers with typical motivations to achieve reasonable returns based on the expected cash flows of an investment.
This logic also suggests that a transaction in a company’s stock may not be indicative of fair market value, even if that transaction occurred between independent parties. The mere fact that the parties were independent of each other says nothing about the motivations of either party. In many, if not most cases, we may never know or understand the actual motivation of the parties. But we can analyze the economics of actual transactions and assess whether they occurred under rational conditions that reflect the elements of fair market value. If a transaction in a subject company or a guideline transaction involving another company cannot be explained rationally, chances are neither is a candidate for inference regarding the fair market value of a particular subject interest.
Both parties are assumed to have reasonable knowledge about the relevant facts. This is an important assumption, because knowledge about certain companies, interests in companies, or other investments is not generally available to everyone. For example, there is one universe of investors making investments in the public securities markets, and a substantially different universe investing in large, private placements of debt or equity. A small investor in the public securities markets may, for instance, lack the wherewithal, interest or ability to understand a complex private placement document.
The term fully informed is often used to describe the state of reasonable knowledge of relevant facts. In real life, we know that buyers and sellers of equity interests are seldom fully informed. Why is it that the surprises that happen after acquisitions are invariably adverse to buyers? From a seller’s viewpoint, the refrain that “nothing will change after the merger” is so often wrong as to be laughable. And some of the issues that come to light after transactions are quite knowable beforehand, based on reasonable analysis or investigation. They are, however, frequently ignored or overlooked by participants in real life transactions who might be motivated, compelled, or not quite fully informed.
Reasonable knowledge and the future. Real life transactions are based on facts and circumstances known up to the minute of their closings, and consider reasonable outlooks for the future. Reasonably, or fully informed does not mean having a crystal ball that eliminates uncertainties by forecasting the future with precision.
After-the-fact valuations should not abuse the standard of reasonable knowledge based on facts that clarified themselves shortly or long after an historical valuation date. Attorneys representing the side in a dispute benefited by knowledge of post-valuation date events may want to believe that the certainty of those events was reasonably knowable at the valuation date. Independent appraisers do not have this luxury in the context of a fair market value determination.
In some instances, the fact that an event might occur in the future is known at the time of a transaction or at a valuation date. What is not generally known is when or with what probability the event might occur. Appraisers must assess those probabilities and incorporate the risks or potential benefits appropriately in their appraisals – the way that reasonably informed hypothetical willing investors might, based on information available as of a valuation date.
This brief discussion of the reasonable knowledge component of the definition of fair market value should illustrate that following its implied guidance requires the exercise of common sense, informed judgment and reasonableness.
The hypothetical willing buyer and seller are assumed to be able to engage in a transaction. The implication is that each of the parties must have the financial capacity to engage in the subject transaction.
Consider the following specific example: the subject interest has no market, is worth about $500 thousand, and provides a market yield for similar assets. In the context of such a cash flowing investment, the universe of hypothetical buyers would include individual investors who, in the context of diversified portfolios of investments, would have the ability to purchase an investment in this value range. Such investors would likely be fully taxable individuals or corporations paying taxes at the maximum statutory rate.
If we assume that most rational investors would not place more than 10% or so of their portfolios in any single investment (about the minimum number of investments to achieve reasonable diversification if all the individual investments are publicly traded securities), then we are discussing a group of investors with liquid financial capacity on the order of $5 million or more.
Yet consider that investors are usually willing to place smaller portions of their wealth in specific illiquid assets. The universe of hypothetical investors for our $500 thousand asset might, in reality, be those with a net worth of $10 million or more who might be willing to place only about 5% of their assets into any single, illiquid security. This universe of investors will likely have different return requirements and investment expectations than the broader group of investors who invest in the public securities markets.
So, the universe of hypothetical investors should be considered in making their determinations of fair market value. Specifically, appraisers should consider the impact of the investment requirements of the relevant universe of hypothetical investors on the fair market value of particular interests. Attorneys and other users of appraisal reports should have the expectation that such considerations are made, either explicitly or implicitly, in appraisal reports.
Both parties must be willing to make the trade. It should be clear that hypothetical investors are rational investors. They engage in transactions and approach the issue of price from a rational economic and financial perspective.
Both parties are assumed to be well-informed about the property that is the subject of the appraisal. In other words, the parties must have the knowledge and the ability to investigate the potential investment. This aspect of the definition carries the point of being reasonably informed in a general sense to being well-informed in a specific sense.
Gaining such knowledge about a specific property or transaction can be time-consuming and expensive, so it is an important characteristic to consider in an appraisal. Further, the hypothetical investors are negotiating over the economic and financial value of the property itself, and not on the synergies, strategic impetus, or psychological benefit it might provide to a particular buyer.
The last element of the definition of fair market value carries the concept of reasonably informed one step further. Both parties are assumed to be knowledgeable, not only about the specific property, but also about the market for the relevant property. This fact adds a layer of time and expense or experience to the process of investigation by hypothetical buyers. Knowledge about the market for a property assumes an understanding of industry conditions as well as local, regional and/or national economic conditions.
The markets in which properties trade in the fair market value world are rational markets and they are consistent markets. This can create occasional disjoints between actual market pricing and fair market value. In speculative markets, publicly traded shares of companies may trade at values significantly greater than the value of the entire company if it were sold. This can occur as a result of general speculation as with Amazon.com, which currently trades at a minority interest value per share that no rational analysis can justify. It can also occur in the shares of publicly traded companies in consolidating industries. Appraisers sometimes have to rationalize market guideline company evidence before it can be applied in a determination of fair market value.
As mentioned earlier, ESOP participants, appraisers, and attorneys should have more than a superficial understanding of the valuation implications of the standard of value known as fair market value. Fair market value is not the real world. Appraisers, attorneys and other users of business valuation reports who operate every day in the real world need to continue to develop a better understanding of that other world, the hypothetical market in which fair market value transactions occur. As noted in the IRS Coursebook:
. . . the consideration of any valuation case would ensure that both sides, including their respective appraisers, if any, are employing the correct definition and criteria for determining fair market value. No case is stronger than its weakest link and if the wrong valuation standard is applied, the conclusion will be defective.
It is important for appraisers to focus specifically on the definitional elements of fair market value while describing valuation opinions in their reports. And attorneys and other users of valuation reports should expect this in their reviews of valuation reports.