What is the Fair Market Value of Your Promissory Note?

The Internal Revenue Service’s Revenue Ruling 59-60, which provides guidelines for valuation of closely-held companies, presents 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.

Promissory notes are written promises to repay a debt under specific terms.  These notes (sometimes called notes payable) allow companies to borrow money from sources other than public debt markets or commercial lenders.  Typical promissory note lenders are individuals connected to the company or other companies who are willing to lend the money for various reasons.

A promissory note consists of a contract which details the terms of the promise of the borrower (“maker”, “issuer”, “obligor”) to pay an amount to the lender (“payee”, “holder”, “obligee”).  The contract usually identifies the parties, the amount of the obligation (principal), the date of issue, the interest rate charged, the payment amounts and payment dates, prepayment privileges or penalties, any security for the loan, what constitutes default, and default remedies.  If the note is secured a security agreement or deed of trust will also be issued.

Companies generally carry promissory notes on their balance sheets at the amount of the debt yet to be repaid.  Fair market value for a promissory note is determined by calculating the present value of the expected payments on the note.  In a world of alternative investments, a hypothetical investor considers the current situation of the borrower and the default remedies available under the terms of the note in developing a return requirement (discount rate) sufficient to induce investment.  If that return requirement is different than the interest rate stated on the note, the fair market value of the note is not the principal balance, but rather the present value of expected future payments, which will be higher if the discount rate is lower, and vice versa.  The fair market value of the note is sensitive to the contractual timing of the scheduled payments as well as the required return.

Repayment Schedules

There are several ways to schedule repayment of the principal amount.  As with all financial instruments, the sooner cash is received, the more valuable the financial instrument.  The most common payment schedules include:

1. Amortized payments where the same amount is repaid periodically and part of each payment is applied to interest while the remaining payment is used to reduce principal.
2. Equal periodic payments and a final balloon payment, where the periodic amount has lower monthly payments than an amortizing loan, but the final payment is much larger as the principal has not been reduced as quickly as in a fully amortizing loan.
3. Interest only periodic payments and a final balloon payment, where the principal does not decrease during the life of the note, but is repaid in its entirety at maturity.
4. A single payment of principal and interest, in which all interest and principal is paid off at the end of the term.  Most likely this type of loan could only be acquired from friends or family, not a commercial lender.

Determining an Appropriate Discount Rate

The value of a fixed income security is sensitive to the discount rate used.  The appropriate interest rate will recognize the time value of money, the risk inherent in the investment and the relative liquidity of the investment.  In order to derive an appropriate interest rate for the note, one must examine the interest rate environment at the valuation date.

The time value of money represents the return available from an investment with no risk.  U. S. Treasury debt securities are considered risk free investments as they are backed by the U.S. Government.

Corporations raise capital by issuing bonds and notes and these instruments are often evaluated by various rating agencies to provide a current opinion of the creditworthiness of a maker with respect to a specific financial obligation.  Corporate debt securities rated AAA to BBB are considered investment grade and most regulated institutions are allowed to invest in these instruments.  Obligations rated below BBB are considered to have significant speculative characteristics.

Financial institutions lend money to individuals through secured and unsecured loans.  Mortgages and home equity loans are the most common types of secured loans offered.  These loans are secured by the underlying property making them less risky to the institution than an unsecured loan.  While financial institutions often make short-term business loans at or near the prime rate, short-term unsecured personal loans are generally considered riskier and carry higher rates.

Depending upon the terms of the promissory note and the strength of the borrower, a base discount rate is chosen based on the interest rate environment at the valuation date.  To this base rate various premiums would be added to capture risks not pertaining to the instruments used to derive the base rate.  Several characteristics of a particular promissory that might give rise to a premium to the base rate include:

1. Premium for lack of protection and/or collateral might be appropriate for debt issued with no collateral backing the instrument and/or no recourse other than a court proceeding in the event of default.
2. Premium for lack of underlying financial information about the borrower may be a source of significant uncertainty regarding the ability to collect on the note.
3. Premium for note structure may be warranted for long term notes with no paydown of principal scheduled as the borrower’s circumstances could change unfavorably over time.
4. Private placement premium is warranted as a differential between privately placed debt and similar SEC registered debt.  Academic researchers have provided empirical evidence regarding the potential magnitude of this premium.

Once the appropriate discount rate is determined, it is used to calculate the present value of the promised cash flows over the life of the note, which is the fair market value of the note.  This article has outlined a few of the important considerations in determining the fair market value of promissory notes.

At Mercer Capital, we have extensive experience valuing promissory notes.  Please give one of our professionals a call to discuss valuation issues in confidence.

Reprinted from Mercer Capital’s Value Matters (TM) 2009-08, published August, 2009.