FAIR MARKET VALUE
THE BASIS OF VALUATION

by
Ron J. Lint, ASA, CEO
Business Valuation and ESOP Specialist

ATI Capital Group of Colorado, LLC
3578 Hartsel Dr., Unit E, PMB 321
Colorado Springs, CO  80920
719-282-1722
ron@aticolorado.com

When valuing a closely-held company, perhaps the greatest point of contention is the value as perceived by the seller/founder in comparison to the value as perceived by an unrelated third party. "Your valuation is wrong. My company is worth at least twice that amount. I guarantee that I could sell this company for at least twice the amount of your valuation by this time tomorrow. This company is worth more than that in liquidation."

These are common complaints heard by all valuation consultants. The problem arises when a business owner requires a Fair Market Value appraisal of his business for financing purposes, or an ESOP, or for tax purposes, for example. The business owner, however, is operating under a value concept known as Intrinsic Value. Intrinsic Value is defined as the value to a particular individual, based on individual investment requirements, knowledge of the asset, personal attachments and personal investment considerations. Some of those investment considerations are as follows:

  1. Differences in estimates in future earning power
  2. Differences in perception of risk
  3. Differences in tax status
  4. Synergies with other operations owned or controlled

Clearly, Intrinsic Value is a very personal measure of value. Fair Market Value, however, is based on detachment and cool, calculated, emotionless negotiation. Fair Market Value, which is the required premise of value for appraisals dealing with estate and gift taxes, ESOPs and most litigation related assignments, is defined by Revenue Ruling 59-60 ". . . 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." The Revenue Ruling goes on to say that, "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."

Fair Market Value, therefore, is based on a hypothetical buyer and seller. Intrinsic issues are not considered; indeed, they cannot be considered. Instead, Fair Market Value places the company on an "as if publicly-traded" basis. A detached, yet informed, marketplace studies the company with one thought in mind - "What is in this for me in terms of return on investment."

The focus of Fair Market Value, therefore, is on detachment, competing investments, risk perceptions and, most important, returns on investment. Furthermore, this concept of value assumes an ongoing business, with management, equipment, plant and customer base in place. Whether or not the company is worth more or less in liquidation is quite beside the point, because liquidation is not the underlying assumption.

With these parameters in mind, net earnings, cash flow and accumulated earnings are of paramount importance. The business owner, however, has been running the company with the proverbial "tax tail wagging the dog." Earnings have been purposely depressed with high expenses, and retained earnings are consequently slight. Capital purchases are expensed and owner's compensation is often excessive.

The trouble with this type of so called planning is that equity value is depressed, and earnings appear to be nonexistent. Make no mistake about it. Financial statements are important. They are a history of past performance. It is as if a business owner spends his career avoiding taxes and destroying his balance sheet.

In the midst of all this, a Fair Market Value appraisal is required, which focuses on fundamentals such as return on assets, return on equity and net return on sales. All these measures depend heavily on booked net profits. A business owner's explanations as to where all the profit went are of little interest to the detached market investor looking for return on investment.

Fair Market Value is the required legal premise for most, valuation assignments. The business owner should carefully think through these issues, always keeping an eye on the main goal – Building Wealth. Preserving wealth is the next step!




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